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May 7, 2014

ETF or actively managed funds? Part II

The decision to gain exposure to an asset class like US equities via index ETF or via actively managed funds can be different at various points in the market cycle. While we would have recommended actively managed funds coming out if the crisis in 2009, we would now prefer ETF to cover the US equity market.

In essence, actively managed funds have the best chance to beat an index if there is a large valuation dispersion. But what if there are no cheap stocks left? Then most actively managed funds will struggle to outperform their benchmark as they have to overcome the inherent higher costs in their business model. In our opinion, this is the environment we are finding ourselves in today.

Valuation Dispersion

We can draw several imporant conclusions from this chart on the US stock market:

  • In 2009, valuations were more spread out and there were lots of very cheap stocks
  • In 2014, valuations are closely clustered and there are fewer cheap stocks
  • Compared to the long term average (1970-2014), the market looks unusually homogeneous today. We believe this is due to the aggressive monetary policy of the FED which has suppressed volatility in the markets since 2009.

Is it any different in Europe? Not really. According to reseach from Goldman Sachs, the dispersion of valuation between stocks has narrowed, mirroring what has happened in the US. In early 2013, 21% of stocks in the STOXX Europe index traded below 10x 12m forward P/E; now just over 7% do.

Key take-aways:

  1. There is no right-or-wrong when it comes to choosing between ETFs and actively managed funds. Investors always need to re-examine the market environment before they make a decision. Therefore, we would caution against comments that point out the undeniable cost-advantages of equity ETFs and erroneously conclude that they are always the right choice.
  2. When investors decide to go with actively managed funds, they need to make sure they avoid funds that resemble too much their benchmark-index.
  3. Investors who want to pick individual stocks (not something we recommend for most investors) should maybe look outside of the US and European equity markets. We currently see a larger valuation dispersion and thus a more fertile hunting ground for bottom-up analysis in the Emerging Markets.
  4. Low volatility is not the same as low risk. The continued lack of a yield on cash remains a powerful stimulant for financial assets and has depressed volatility so far. But volatility rarely stays this low for long.

Further comments on the discussion „ETF or actively managed Funds“ can be found here and here and here.

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


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