Specialist EFTs: actively managed funds in disguise?

It has been argued that specialist ETFs based on proprietary indices are simply actively managed funds in disguise. However, three important differences distinguish a specialist ETF from an actively managed fund.

Generally speaking there are two types of ETF indices: broad-based and specialist.

Broad-based ETFs

The broad-based ETFs track a diversified public index and are most commonly market-cap weighted. These are the lowest cost and require the least amount of rebalancing or churn. Designed as buy-and-hold investments, they will provide investors with the perfect core-holding and will outperform at least two thirds of the actively managed unit trusts over time. Typical ETFs in this category would track indices like the Top 40, RESI, Equally weighted, SWIX etc.

Specialist ETFs

Specialist ETFs usually track customised or private indices. Often, these indices are not market-cap weighted but based on proprietary research and can capture specific types of returns and risks that traditional market-cap indices like the ALSI cannot.

Specialist ETFs also provide investors with valuable core-portfolio holdings but often require some specialist allocation by a financial advisor, asset consultant or multi-manager. This is because, often, specialist ETFs are dynamic in nature and the allocations must be rebalanced based on some risk-target or strategic long-term allocation.

Opportunities for advisors

The specialist ETFs provide the biggest growth area for financial advisors and consultants to add value to their client portfolios. These “smart-indices” provide outperformance or excess return above a market-cap weighted benchmark for index fees.

They also can offer valuable risk management opportunities for investors, something that active managers cannot really do, because the active unit trust manager only sees a small part of the overall investor’s portfolio. Financial advisors should therefore focus on becoming risk specialists rather than trying to choose the next best performing unit trust based on past track records. Overwhelming scientific evidence shows that past winning funds are more likely to disappoint than outperform again.

Actively managed funds?

Some critics argue that specialist ETFs that are based on proprietary indices are nothing other than actively managed funds in disguise. This is, however, not strictly true. Three important differences distinguish a specialist ETF from an actively managed fund.

Firstly the holdings of the ETF are made available daily so there is complete transparency, which active funds are reluctant to provide.

Secondly, specialist ETFs are rules-based and involve no subjectivity or human judgement, other than what the rules of the indices declare upfront. These ETFs are like automated robots, rebalancing the portfolio precisely at pre-specified regular intervals. This automation and rules-based nature make these indices much cheaper and objective than having to employ legions of analysts, economists and strategists.

As a consequence, the third difference is that specialist ETFs are much cheaper than actively managed funds with no evidence of inferior performance over time.

Cost considerations

Financial advisors and investors should be aware that some specialist ETFs can be quite expensive. They have embedded performance-based fees of up to 20% which puts them right up there with active fund and hedge fund fees. If these fees are not compensated by with outperformance, the investor will be losing out in the long-run.

International evidence suggests that ETFs with performance-based fees are not widely used yet and have not delivered the required outperformance to cover the higher costs. The indices these ETFs are based on are also not very liquid and moving large amounts of assets in and out of these indices can incur higher transaction costs and wider bid-ask spreads due to the lack of liquidity.

In South Africa, specialist ETFs have not been around long enough to estimate whether they are outperforming after costs or not. The specialist ETF with the longest track-record in SA is probably the Satrix Divi which has trumped most actively managed general equity funds since inception in Aug 2007.

One thing is however certain, broad-based ETFs like Satrix 40 that have been around up to ten years now, have consistently outperformed over 80% of actively managed general-equity unit trusts at less than one-third of the annual costs of these active funds.