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January 11, 2014

Actively managed funds or ETF – what to buy

Whether we’re talking about sports or investing, people have an urge to win. In investing, investors seek outperformance. Thus, most mutual fund shareholders aren’t satisfied with the performance of a humble passive benchmark such as the S&P 500 Index. Instead, they search for an actively managed fund that they believe will beat the benchmark. But are they making the right choice? Both actively and passively managed funds have their own pros and cons.

 Index ETFActively managed funds
Costs+ low
+ transparent
- usually more expensive
- hidden costs
Performance+ small tracking error- few beat their reference index
Consistent performance+ small tracking error- even less beat their reference index over >3 years
Potential for outperformance- no+ possible
Liquidity+ intra-day- 1x daily
Transparency+ all positions are known- top holdings only published 4x a year

Hope springs eternal and most investors are still surprised to hear that very few actively managed funds actually beat their reference index on a consistent basis. But all studies show the same result: on average ¾ of all actively managed funds UNDERPERFORM in any given year. Worse, out of those funds that beat the index, less than 5% remain in the top quartile in the following two years.

There are basically two reasons why actively managed funds underperform on a consistent basis:

  • In order to succeed, the fund manager will employ a variety of tools, of which the most common are economics research, company research, company visits and financial data news and analytical services. All of these specialist resources don’t come cheap, hence management fees and, in an increasing number of areas, performance fees. But the sum of all funds are basically „the market“. So once you subtract the costs for these specialist resources, you end up with market return minus fees. Only very few fund managers beat consistently the index by making up for these costs and it is debatable that investors can recognise this skill-set ex-ante.
  • By far the biggest problem for fund managers is dealing with career risk, i.e. protecting their own job as an agent. It is therefore no surprise that most fund managers are mirroring their reference index very closely. In this way, they cannot fail, i.e. they cannot lose their job. But this also means the investor is unlikely to see outperformance.

In conclusion, due to the overwhelming positives of index funds, we believe that investors should use as much ETFs as possible and as few actively managed funds as necessary. As a result, we advocate a core-satellite strategy. In this case, the portfolio consists of a passively managed core and a few satellites consisting of actively managed funds. The mix between active and passive funds is driven by the risk appetite of the investor.

But we are not dogmatic – there are lots of cases where active fund management makes sense and represents the better alternative.

  1. Not all parts of the capital market are equally efficient. Less efficient markets are more conducive to active management. Examples would be High Yield Bonds or Frontier Equity Markets.
  2. ETFs are mostly but not always the cheaper option. High Yield ETFs for example cost at least 0.5% p.a. To that you have to add the bid-offer spread for buying AND selling so that the total costs can easily exceed 0.7%.
  3. Actively managed funds can be a good choice if the fund manager is not benchmark oriented, has a good long-term track-record and a convincing investment process.
  4. The benchmark on which the ETF is built can be flawed. For example the Brazilian Bovespa Index includes 2 companies that account for nearly 40% of the total index and both belong to the volatile commodity sector. This index does not reflect the Brazilian economy.
  5. Not every active strategy can be easily replicated with an ETF

Investors expend much energy searching for low-cost funds and trying to decide between an active and passive fund strategy in building a portfolio. The larger issue may be investor behaviour – whether an investor can stick with a strategy and stay invested in order to earn the long-term equity premium in the stock market. Too many investors fail to stay the course with their investment strategy, and instead tend to sell funds when they underperform, or rush in when a manager has been performing well. In doing so, investors can be their own worst enemies. So perhaps a better question to contemplate than whether you can do better with an active manager or a passive one is, do you have a sound long-term investment strategy, and do you have the discipline to stick with it.

For further questions please contact us at info@ipanema-capital.com.

The author previously covered actively managed funds in London and Hong Kong while working for a global investment bank.


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