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Exchange Traded Funds: Rise of Passive Investing

This article was posted here on July 18 2017. The present section has undergone considerable revision over the earlier note. 

ETF,  Exchange Traded Funds are on a meteoric rise globally. According to a report by PWC, ETF’s in the US is going to grow to $5.9T by 2021, a whopping 23% cumulative annual growth compared to $1.6T in Europe and $560B in Asia. ETF’s are passive investment products which track an index with no objective in beating their respective benchmark indices. Exchange-Traded Funds are linked to multilpe asset classes like equities, fixed income and alternative investments. In the US, the S&P 500 would be the most diversified example of an equity index. An ETF linked to the S&P 500 would replicate this index to deliver similar returns. ETF are passive funds and not intended to outperform the underlying index, i.e. they make an Alpha of zero. 

Alpha means outperforming the underlying index. Mutual funds form a collective pool of underlying assets benchmarked to various indices; to deliver superior returns compared to the benchmark. Example, equity mutual funds in the US, benchmark indices like NASDAQ, S&P 500.  If S&P 500 provides a return of 10% a year, an open-ended actively managed mutual fund linked to the S&P 500 is expected to return a rate higher than 10%. Hypothetically if the fund returns a 15% return, the fund has an alpha of 5%, i.e. the excess return compared to the benchmark index. There are many ways to measure superior performance, usually known as a risk-adjusted return.

Examples of Risk-Adjusted Returns are the Sharpe Ratio, Treynor Ratio etc. Beta helps in understanding risk-adjusted returns better. 

Beta is the covariance of a stock or fund with the benchmark index. Example, a fund with a beta 1, means that if the benchmark index returns 10%, the fund is expected to give a similar return. The beta of 1.2 means the fund will return 12% when the index returns 10%, i.e. 1.2 * 10 while a beta of 0.8 gives 8% return when the underlying index returns 10%.

The higher the beta, the more aggressive the investment strategy of the fund. Funds with the beta higher than one are known as active funds since they work on the investment strategy to return higher returns. Funds with the beta of 1 or less than one are known as passive funds. ETF’s will always have a beta of 1. ETF’s linked to equity indices like S&P 500, NASDAQ and SENSEX to share a few examples, usually replicated the index in many ways. The simplest is to have the exact weighted average mix of stocks in the portfolio as compared to that of the benchmark index. There are more advanced ways, based on optimization techniques to replicate the index. However, these funds, including ETF’s do include tracking error which needs to be monitored closely. 

Over the long-term, few equity mutual funds have beaten the returns of the underlying equity indices. Peter Lynch is one of the few fund managers who consistently outperformed the markets and has written many books on his investment philosophy. Research has shown that very few mutual funds and hedge funds have regularly returned superior returns compared to the market. At the same time, actively managed funds expenses are much higher compared to passively managed funds. Hedge Funds, usually take a fund management fees of 2% of the assets under management and a percentage of profits as a model of revenue sharing.  Assume that a hedge fund has 1B under management. A 2% management fees would translate to expenses of 20M per year on the top of a revenue-sharing model on profits. The mutual funds, on the other hand, don’t have revenue sharing of profits built-in within their expense structure. 

Exchange-Traded Funds have a marginal management fee structure and over long-term, i.e., more than three years can deliver better returns than the majority of actively managed equity funds. Other investment options like Angel Investing, Venture Capital, and Private Equity come under alternative investments. They usually invest in unlisted companies, are illiquid and have a nonnormal return pattern compared to returns from listed securities. 

ETF’s due to their passive investment strategy, have a low churn ratio compared to active funds, i.e. buy and selling of stocks in the portfolio and therefore, less administrative and other expenses. ETF’s are very cost-effective compared to actively managed funds and should be part of your diversified equity portfolio. The amount of ETFs within the portfolio would depend on the investor profile, the cash flow requirement, risk-adjusted profile, among other parameters. 

ETF’s are an excellent pathway of taking exposure across multiple asset classes, including alternatives like Gold. Holding physical Gold is not easy since one has to maintain a standardized measure, especially in denominations of 1 Kg with 99.5% purity. Reselling is not easy in physical form and has a carrying cost, i.e. locker costs in banks etc. Exchange-Traded Funds provide a cost-effective way of investing in these asset classes, including providing liquidity through exchanges for not liquid assets . ESG which makes up the bulk of sustainable finance includes ETFs based on different styles of investment i.e. negative exclusion, best in class etc. As the market of ESG rises among the global investment community, ETFs remain one of the most popular investment options for taking exposure across asset classes. 

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