ETFs track the performance of a market, giving investors “passive” exposure to an index such as the S&P 500. Active fund managers use stock selection in the hope of beating the index. Which should you pick to invest in the USA?
Active: “Index trackers will generally underperform due to impact of fees”
Manager of the Old Mutual North American Equity Fund.
The US market is not one where active managers have covered themselves in glory. We cannot hide from the empirical evidence that, in general, active managers underperform the US market. Active managers can, and often do, beat indices at an individual level, but in aggregate they struggle to beat US index trackers due to a lack of consistency.
To explain this, many investors highlight the efficiency of the US market, arguing that there is a very large number of informed investors in America, so it is much harder to spot good investment stories.
I sometimes wonder whether this argument suggests there are more stupid investors in Europe – surely that cannot be the case.
In general, it is difficult to believe my industry is populated by idiots (there are a few about, but they do not make up the majority). What’s more, active management is highly Darwinian. Fund managers get “relieved of their duties” quickly if performance is not up to scratch.
The issue in the US market is the changeability of the market itself. Active fund managers are trying to outperform the index with one hand tied behind their backs.
They tend to run concentrated portfolios, whether having large numbers of cheap stocks, those showing good growth, or perhaps a focus on historic price movements which support future outperformance.
This concentration can lead to periods of underperformance, when the market is not rewarding that particular style. So it is not that a fund manager suddenly becomes unable to pick cheap stocks, or identify companies likely to have strong growth. Rather, the market, at that point in time, is not rewarding that type of style.
CONSISTENT INVESTMENT STYLE
This is where the answer lies. Active managers need consistency of outperformance, and this can only come from having several types of stocks in the portfolio at any one time. This will allow the power of compounding returns to come through when the stocks outperform the market.
The high “style” concentrations run by many active managers (which can be styles they are not even aware of) will lead to periods of significant underperformance when the style moves out of favour. This can ruin the long-term track record of a typical active manager.
In my Old Mutual North American Equity fund, the approach is to be humble and aware of the areas of the market in which you can and cannot add value. And remember at all times: the blend is your friend.
WHAT’S THE POINT?
Ultimately, choosing between active management and passive funds depends on what you are trying to achieve.
If the point of an investment is pure exposure to a particular market, then it is pointless paying active fees. That said, it is worth remembering that index trackers will generally underperform the index they shadow due to the drag of fees.
However, if the investment is intended to mitigate some risk and to add to returns from a particular asset class, active management can certainly play an important role.
Passive: “In the US it is very difficult for active managers to outperform”
Head of ETPS, EMEA, Deutsche Asset & Wealth Management
The US has the largest and most actively traded equity market in the world. In such a developed market, it is very difficult for active managers to consistently outperform a low-cost exchange traded fund (ETF).
ACTIVE FUND FAILURES
The evidence here is extensive. Index provider Standard & Poor’s performs regular analysis of active managers in the US, to assess which managers have beaten passive benchmarks. Its latest 2014 numbers show that 86 per cent of large-cap fund managers in the US underperformed their benchmark in 2014.
The issue is the same over longer timeframes. Over five and 10-year periods respectively, 88 per cent and 82 per cent of large-cap managers failed to deliver incremental returns over the benchmark.
You may be tempted to think that mid-cap and smallcap active managers would fare much better, given they are not competing in the most liquid space. Again, the evidence suggests otherwise.
This is not to say that there are no active managers who consistently beat the market. Highly-skilled managers can continually produce alpha, or risk-adjusted outperformance, in developed markets. On average, however, it is clear most do not.
Not only does history show there is a strong case for using ETFs to access US equities, but as the ETF market continues to develop it is becoming even more advantageous.
Product management fees have dropped significantly on ETFs tracking major developed market indicies. For example, we have a low-cost range and our db x-trackers USA Index UCITS ETF (DR) has an annual all-in fee, or total expense ratio (TER), of 0.07 per cent. TERs of under 0.1 per cent are not uncommon these days on ETFs tracking major benchmarks.
As investors become more aware of the importance of fees and their impact on long-term performance, low-cost index tracking is becoming more prevalent.
Investors also appreciate other aspects of using ETFs. They can be bought and sold during market hours as easily as any other listed security, and they provide full transparency in terms of fund holdings on a daily basis.
The S&P 500 index returned 13 per cent in 2014, which was its third straight year of double-digit gains. UK investors who have had exposure to US equities over the past few years will be happy with that outcome. Those who minimised their fees, and passively tracked the market using an ETF, will likely feel most pleased of all.
OUR VERDICT, BY ANNABELLE WILLIAMS
The attractions of buying an ETF to access US equities are pretty compelling. The basic fees advertised by product providers are low, and as long as the market rises, so too will your investment. However, many ETFs have additional fees alongside the headline figure, which can raise costs substantially. But overall, the cost of owning an ETF will generally be lower than buying an active fund. But cost should never be the sole basis of an investment choice. Performance matters too, and it seems absurd to believe – as some in the ETF world argue – that investment is the sole area of human endeavour where skill cannot ultimately win.
It is well-known that many active funds fail to beat the index. But many funds do, and this prospect of outperformance is what the industry – and investors – thrive on. While higher fees do not necessarily mean better performance, Ian Heslop’s fund, for example, has outperformed the benchmark by a considerable margin (see chart on left).
Fees for both active and passive funds will reduce investment returns, but this is particularly problematic for ETF investors during periods when many active managers substantially outperform the index. The trade-off is a tricky one, and both sides will provide evidence to support their case. Investors should take their risk tolerance and level of investable assets into account before siding with either active or passive.