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April 23, 2019 / 3:32 PM / 4 months ago

ETF Investing Is Rarely “Passive”

The number of exchange-traded funds (ETFs) has proliferated in recent years, offering people a myriad of investment choices. Media coverage on this topic describes this as another sign of passive investing’s exploding popularity—a misnomer, in Fisher Investments’ view. Many ETFs are rather specialized , complicated and generally  passive in name only. That doesn’t make them good or bad, but Fisher Investments thinks it underscores why simply investing in ETFs doesn’t necessarily imply a passive investment strategy.

People tend to think of ETFs as passive investments because they seek to replicate the performance an index. That sounds an awful lot like an index fund—the original passive investment product. But this ignores some key differences. Index funds generally offer low-cost exposure to well-diversified indexes with minimal expense. They aren’t traded on exchanges and price only once a day at market close. The idea behind them—and passive investing—is that it isn’t possible for investors to beat the market benchmark over time, so you might as well just own the whole market benchmark for all of time and space, reap market-like returns, and enjoy life. Simple, cheap and—in practice—hard to do. As it happens, investors aren’t always great at buying and holding one thing for their entire investment time horizon.

But ETFs aren’t even built for this purpose. They trade intraday on exchanges—hence the name—so while some consider their construction passive, they are generally used actively. Many investors blend ETFs in hopes of beating the market, defying passive investing’s founding principles. Others use them to try and get in and out of the market or specific areas of the market—another clear effort to outperform broad indexes, even those the “passive” product tracks.

Newer ETFs drive this point home. As ETFs have mushroomed, so have niche stock indexes. There are now more indexes than stocks.[i] Rather than tracking established indexes, most new ETFs create their own index to track—seemingly a marketing trick aimed at capitalizing on “passive” investing, ETFs’ popularity and overall cool sentiment toward actively managed funds.[ii]

In our view, most  new ETFs also aren’t well diversified—representing only a narrow market segment—which can be confusing if you are attempting a passive approach. An ETF may have characteristics investors want, but it is important  to know how it is constructed, what is in it and how it behaves—on its own and with everything else in your investment portfolio. In Fisher Investments’ view, this isn’t a particularly “passive” strategy.

Furthermore, indexes are typically managed actively because they are weighted according to some specific criteria like valuations—or even qualitative factors, like gender diversity, “green” attributes or whatever other topic is popular. We aren’t opining on the merits of any of those factors, but none of these are actually passive strategies... Hence, even if you, the investor, manage to be passive, the ETFs themselves you may consider may in fact be managed actively, blurring the line.

This phenomenon is especially visible in the new class of “smart beta” ETFs. Their express purpose is to beat broad capitalization-weighted indexes, which runs fully counter to passive investing’s thesis. Rather than capitalization (i.e., company size in dollars)—what the market values index components at—these ETFs weigh companies according to other factors, like sales, earnings, dividends, volatility or any other quantifiable metric, by themselves or in combination. The idea is that one factor drives superior returns. 

Not too different from  mutual funds , which focused on value, growth or whatever other factor the fund manager favored.

Many of these quantitative ETF strategies have been back-tested to demonstrate their alleged superiority. In markets though, any edge—especially an identifiable formula or rules-based approach—is usually whittled away before too long. As the wildly popular disclaimer puts it: Past performance is no guarantee of future results. Factor investing presumes the criteria selected has staying power. However, in our view, this just replaces belief in an active manager’s abilities with faith in a model of an active manager. Yet if you don’t know how an ETF functions—and what it is designed to do—you could be making more active decisions than you realize.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return.  This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

[i] “There Were 438,000 New Indexes Created Over the Last Year,” Rachel Evans, Bloomberg, 11/14/2018.

[ii] “Exotic Indexes: Built to Sell or Built to Last?” David Allison, CFA Institute Enterprising Investor, 4/3/2019.

The Reuters editorial and news staff had no role in the production of this content. It was created by Reuters Plus, part of the commercial advertising group. To work with Reuters Plus, contact us here.

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