ETF: When passive looks active

When I started writing this blog in 2016, the idea was to unpack the insides of local ETFs to help you choose the right one for your portfolio. This forced me to keep a close eye on the ETF industry. It’s been a great time to do so. While ETF investors are sometimes colloquially called “passive investors”, the ETF industry has been very active indeed.

Back in 2016, a battle was raging between index investors and active managers. Active managers accused ETF providers of trying to break the market by making price discovery and efficiencies impossible. They conceded that ETFs could deliver market returns, but claimed only active strategies could deliver above-average returns. (They call this “alpha”, in case you ever wear a popped collar to a costume party and wanted to sound the part.)

ETF issuers, on the other hand, had these criticisms of the active industry:

They charge too much for managing funds.
They’re not transparent enough, both in terms of investment decisions and fees.
When an investment strategy isn’t working, they pivot too soon, incurring unnecessary costs which eat away an investor’s return.
When funds fail to make money, they get shut down instead of being held accountable by the industry and investors.

If you’ve been in the market since 2013, you know it’s been an awful time to get market returns, especially if you hold a local, broad-market index. Nobody is bragging about their stellar ETF portfolio at social events. Believe it or not, hearing that other people are doing well in the market is a wonderful motivator to get new investors in the market too.

ETF issuers, feeling the effects of sluggish markets, decided to step things up a notch. Instead of offering boring old market returns, they started to offer “smart” ETFs. Initially these ETFs were ordinary ETFs with a twist – perhaps a cap on the weight of a single share, perhaps giving each share an equal opportunity to contribute to the performance of the fund. As the market continued to snooze and investors continued to stay away, these “smart” strategies became more and more clever.

These days, if you had to play a game of Choose the Index Fund* you’d have a hard time distinguishing between some index-tracking products and an actively managed fund. Instead of offering the market average, ETFs are seeking outperformance. We don’t call it alpha, because that’s a naughty active manager word, but alpha by any other name…

Last year and the year before, ETF issuers started tinkering with index methodology within ETFs. This year, three index-tracking funds became two different funds entirely, complete with new share codes and new methodologies. Last week, an ETF issuer announced that it will be closing five of its funds entirely, paying investors out in cash. Changing strategies and closing under-performing funds sounds slightly familiar.

As Simon pointed out, when we buy a share we accept the risk that comes with that share. In the case of ETF investing, a risk we never anticipated is that the issuer will fall out of love with the ETF methodology. There’s not much we can do about that.

As always, we have to focus on what we can control. A well-worded, formal investment strategy is your solution to this problem. Are you happy with market returns or do you want alpha? If ETF issuers are to be believed, you can do either. Understand that chasing alpha comes with the risk of getting less than market returns, even when you use ETFs to do it. Also understand that index-tracking products that promise above-average returns might not stand the test of time. If it’s market averages you are after, don’t be too smart for your own good. Broad-market, cap-weighted indices deliver market average minus fees. You can bank on that.

*Coming soon to a toy store near you.