This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Dan Egan, director of behavioral finance and investing at the New York-based automated investing service Betterment.
Printers and active index funds have something in common: the potential for longer-term hidden costs.
A printer may not be expensive to buy upfront, but the necessary ink and toner refills can be quite steep. Consumers may get a great deal on a printer, yet hidden costs await them in the ink.
The same is true for active index ETFs. Unlike passive or “market-cap-weighted” indexes, which rely on the market’s valuation of securities to determine weightings, an active index aims to systematically deviate from market-cap weighting, in pursuit of outperformance.
This is done through a defined process that frequently changes the weighting of each holding based on other information.
As a result, these ETFs tend to have higher turnover, concentration risk and tax exposure, and drift away from market returns.
Costs Can Erode, Or Drive Returns
The higher expense ratios these active ETFs may charge can also be problematic, and neither equate to, nor guarantee, higher returns.
According to a Morningstar study, expense ratios were touted as one of the most important determinants of a fund’s long-term performance relative to its peers.
But contrary to general assumptions, paying higher expense ratios does not guarantee higher returns in an investment portfolio.
A separate Morningstar report showed an inverse relationship between fees and performance. Analysis among U.S. equity fund ETFs in the lowest quintile of expense ratios produced the highest total returns, whereas those funds in the most expensive quintile of expense ratios produced the lowest returns.
A Vanguard study also found that high expense ratios are often an effective predictor of fund underperformance, yet even low-cost active funds still underperformed their benchmark about 70% of the time.
Defining Indexes
Think of an index as a formula or equation. This formula tells you in which securities to invest, and in which specific weights and allocations.
Indexes have two main positive properties:
● Systematic: rules-based, not based on a manager’s preferences or gut-feelings
● Transparent: investors can replicate the index weights at any time
| Tracks Index | Infrequent Trading/Changes | |
| Active Mutual Fund | No | No |
| Active Index Fund (new) | Yes | No |
| Passive Index Fund | Yes | Yes |
However, this doesn’t mean that all indexes are passive. Imagine if we created a daily “top winners” index that invested in yesterday’s top five performing stocks, with weights determined by their relative returns.
While this approach is systematic and transparent, it’s certainly not a passive strategy. It has very few holdings, which will change daily, and the weights of the index will also change daily, producing significant turnover and concentration risk in any fund that attempted to track that index.
