Sunday, June 17, 2012

The Active vs. Passive (ETF) Investment Debate

The differences between watching golf and football are similar to the differences in active vs. passive investing.  Viewing a golf tournament such as the US Open, one focuses on the shots and skills of individual players. Each player addresses each shot and each hole somewhat differently. At the end of the day it is the way the individual utilizes the combination of his/her skills with specific shots that will translate into being a winner. Equally enjoyable is watching intensely fought team sports. In league competition such as American or European football, the different teams develop certain attributes (strong defense, high scoring, deceptive plays, and extraordinary athletic abilities) which make some teams winners over others that have many of the same skills and talents.

Advantages of passive ETFs

As an analytical device the differences between watching team-focused sports vs. individual-focused competitions are useful in the selection of funds and managers in a multi-asset portfolio. Recently I was in a couple of investment meetings with advocates of using, or completely using exchange traded funds (ETFs) as contrasted with selecting individual funds or managers. In the institutional world this issue is an extension of the passive vs. active manager debate.  One reason for the growth in popularity of ETFs over the choice of good managers/funds is that the latter group can and has underperformed the “market” benchmark (a statistical index of individual securities usually selected by a financial publisher such as Dow Jones, S&P, or Russell to describe a group or an absolute numerical goal). As passive vehicles do not utilize investment management, they are able to charge considerably less total expenses. All other things being equal, the lower the fees deducted from the gross returns of an account, the better the performance.

Being the best in a poor league is not good enough

The professional football teams that meet in the Super Bowl have the best records in their leagues and/or their play offs even though at any given game any team can win, occasionally not the expected winner.  One of the reasons that I did not comment on the 2012 running of the Belmont Stakes is that I felt that this year’s crop of three year-old horses were not as good as past classes. On the same basis, some Super Bowl winners are not as good as winners in the past. Nevertheless, on a relative basis they were the best at the time.

Because most of my accounts are directed to the long-term, individual annual winners are not usually helpful to me in building portfolios of funds and managers.  When taking a long-term approach, some individual years and other data points are not very revealing; e.g., extreme performance outliers are less critically important than market cycle turning points.

Over the last couple of years, correlations between various investment classes has narrowed significantly, “bunching” fund performance results on top of each other. Unfortunately this concentration makes it much more difficult for individual managers to assemble distinctively different portfolios that are capable of producing outstanding results.  For example, if you invested in the entire technology sector, you would have significantly under-performed a portfolio investing in only three stocks, Apple (NASDAQ: AAPL), IBM (NYSE: IBM) and Microsoft (NASDAQ: MSFT).  

Active management: picking more winners

Active management, particularly my style of investing, is quite different than passive approaches, particularly those of exchange traded funds (ETFs). All ETFs are built around a single specific metric. Some use market capitalization, sector groupings based on sales, earnings, dividends/yields, book values, growth rates, or other easily determined sorting mechanisms. Some use market capitalization weighted as distinct from others that use equally weighted portfolios.

As an analyst of electronics, broadcasting, aerospace, steel, brokerage firms and financial service companies, I regularly ranked the companies I covered against each other. In order to carry out this exercise I made a good attempt to adjust all of the issuers’ data to the same standard of disclosure. For example:  paid and accrued tax rates, product and customer mixes as well as revenue and income recognition policies. In addition I attempted to array shareholder orientation, tables of organization, motivations, etc. Using these screens I could rank with some difficulty the companies from best to worst. 

That was half the job. Next I turned to stock price. Except in some periods of stress, usually the better companies were more expensive in terms of normal valuation techniques, which rarely led to the identification of bargains. To find bargains I needed to find ignored critical observations, particularly those that were likely overlooking some vital facts. The next task was to analyze the stock price. This entailed examining who owned the most sizeable amounts of shares (insiders and large institutions) and whether they had a history of being good investors. Other factors to be considered included the identity of the floor specialists, when we had them, or other market makers, and the history of transaction volume. While I was conscious of global macro trends, rarely did they fundamentally affect the attractiveness within a sector of stocks in vital companies.  I cannot remember a single time when I recommended buying the entire list or sector. This rather long winded recitation of my analytical approaches is why I have problems buying a pre-fabricated list found in ETFs or other index funds. However, I have used index funds in some portfolios when I was unable to conduct enough research, or when there was a lack of pertinent information to confidently pick winners.

Are you an active, passive or hybrid investor?

Let me know which and why.
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