There’s an exchange-traded fund (ETF) for just about every index and subindex in every sector and geographical region in the world. And while it might seem passive index-linked ETFs are a panacea for the diversified investor, COVID-19 is tipping the debate between active and passive investing in favour of active money managers who actually make investment decisions.
“Active management is critical, especially given where we are in the [market] cycle,” says Dean Orrico, president and chief investment officer at Toronto-based Middlefield Capital Corp., who oversees $4-billion in client assets, much of it invested actively across various sectors and geographical regions with corresponding ETFs.
Both passive and active investment styles are having a good run as equity markets rebound from the depths of this past winter’s global economic freeze, but Mr. Orrico expects the economy to take up to four years to recover fully. In the meantime, he expects a shakeup in the way sectors perform, which could leave traditional market-weighted ETFs vulnerable.
“We know it’s just been a handful of stocks that have been driving this market higher. As a result, they have become a bigger weighting within the passive, index-based ETFs,” he says.
Market-weighted ETFs are preset to hold stocks according to their current value in the index. That means the markets decide how much of a stock they hold and not which stocks have the most potential to go up in value. As such, Mr. Orrico says passive investments can’t differentiate stocks that will benefit most from the COVID-19 economy.
“If I were looking at health care exposure, I want to be overweight in biotech and pharmaceuticals because those are the companies getting all the attention on the back of the pandemic,” he says. “You also have the companies in the diagnostic area because they are coming up with new testing kits and tools for COVID-19.”
Mr. Orrico also points to technology and real estate investments that will continue to benefit from the work-from-home trend.
“If you have companies focused on platforms that service work-from-home [arrangements], those are the companies that are going to do really well as opposed to buying a broad swath of tech companies,” he says. “We have very little retail [real estate], very little office [real estate] and we’ve gone into areas that are leveraged to e-commerce.”
Reid Baker, director of analytics and data at Fundata Canada Inc., also says that market-weighted ETFs can fail to capture the dynamics of certain markets in uncertain times.
“A passive or index-based approach is based on a model or algorithm. That model or algorithm is going to depend on the data that are going in. If those data going in are not robust or don’t have the same predictive characteristics as other data might, then your model or algorithm is going to struggle,” he says.
Mr. Baker, who tracks mutual funds and ETFs, says active managers generally perform better in areas in which data are not robust or predictable, such as emerging markets like India.
“It really helps to have a team of analysts in a region focusing on that region or sector where they can learn the market and environment. That’s just something that a passive approach is not able to do,” he says.
However, Mr. Baker says there are areas that ETFs could have an advantage, such as technology or health care subsectors, including biotech, in which the outlook for that sector or subsector is bright but it’s difficult to determine which companies will be leaders.
“If you’re looking at a sector to outperform in the future, that’s a perfect time for an ETF. You’re going to get exposure to just about everything and one of the securities is probably going to pop. If you’re trying to cherry pick that one security, chances are you’re going to get it wrong,” he says.
David O’Leary, principal at Toronto-based fee-for-service financial planning firm Kind Wealth, says investors trying to decide between passive ETFs and actively managed funds should start by looking at the quality of the index that a passive fund tracks and an active fund holds as its benchmark.
“How is that index constructed and does it reflect the economy in that country accurately. We take it for granted in big markets like the U.S. and Canada because they’re so large and liquid, and [they face] so much scrutiny,” he says.
Indexes and market-weighted ETFs can also change holdings dramatically over time without human oversight. Only active managers are able control their portfolio holdings and employ risk-management strategies through levers like cash weightings and currency hedges.
Active risk-management hedges do come at a cost, though. While annual fees on passive ETFs are normally well below 0.5 per cent of the total amount invested, fees on actively managed funds can be as high as 3 per cent, leaving much less for the investor.
Mr. O’Leary says it’s difficult to quantify if risk management is worth the higher fee when comparing actively and passively managed funds.
“There are so many subjective variables to try to control and make decisions about: What time periods? What measure of risk? Do we talk about risk-adjusted returns? Which benchmark do we choose?” he says. “For the average person it’s almost impossible to say definitively that having an active manager added value. The higher the fee, the more compelling the evidence needs to be.”
For Mr. Baker the only result that matters is how the funds perform once the fee is deducted.
“If you’re getting the performance that you’re looking for, who cares what fee you’re paying?”, he says.