Pitfalls of passive investing

On May 31, 2017, Dag Rodewald, Head of Passive and ETF Sales Germany and Austria at UBS ETF, gave a presentation named “Are you making the most of passive investing?” Since he gave a number of hints on how to research exchange-traded funds (ETFs), I thought it would be a good idea to revisit his points because the increasing number of ETF promoters and indices can lead to a steadily growing number of ETFs in the market. The increased competition, especially for “plain-vanilla” products, has led to falling prices in this segment, while themes and strategy-based products—such as factor investing and environmental, social, and corporate governance/sustainable, responsible, and impact investing (ESG/SRI)—have a sufficient margin for their promoters.

Not only the ETF segment is crowded; index promoters also face a lot of competition from the more than 200 market participants offering indices. With the upcoming trend toward in-house indexation the competition will increase even further, especially for strategies beyond plain-vanilla ones. The increasing complexity of the markets has been noticed by a number of market participants and observers who have already raised their concerns. My personal view is that professional investors and advisors have to treat ETFs like other mutual funds: they need to do full due diligence on the respective indices to really understand the performance drivers of each index. Rodewald showed in his presentation that selection of the right index could have much more impact on the performance of a portfolio than the selection of the best ETF covering the index. In this regard it is key from my perspective that investors analyse the index’s methodology, since this defines the composition and therefore the performance of the index.

Market Capitalization-Weighted Indices
Investors have to understand the index they are buying, since even if two indices are in the same investment universe, they can have totally different performance drivers and therefore different risk/return profiles. This is not just true for the equity segment, where for example the EuroStoxx 50 shows a different risk/return profile than the MSCI EMU index or the S&P 500 compared to the Dow Jones Industrial Average.

Rodewald brought up the example of U.S.-dollar corporate bonds: an investor can buy ETFs that focus on U.S. corporates only or ETFs that invest in U.S.-dollar corporate bonds issued by companies from Europe, Asia, or the emerging markets. The investment focus can make a huge difference, since ETFs that invest only in U.S. corporates are fully dependent on the developments in the U.S. economy, while the other ETFs offer global diversification with regard to economic risks.

Another concern raised by Rodewald was that—especially in the bond segment—some indices such as the Barclays US Aggregate Bond Index and its respective ETFs cover only part of the market and not the whole market, as some investors may expect. In this regard the risk/return profile of the index may look quite different compared to the overall market.

Factor Strategies
Concerning factor strategies, the market gets even more complex, since the methodologies of the different indices (even if they are offered by the same index promoter to exploit a given factor) can vary considerably. It is essential for any investor who wants to buy a so-called smart beta ETF to understand the rules for inclusion and/or exclusion as well as the methodology for weighting the securities within the index.

One issue that arises from factor-based investing is that not all factors deliver outperformance all the time, and investors might need to rotate their factor exposure from one factor to another over time. Since timing is always one of the most difficult tasks in portfolio management, some investors will neglect to invest in factor strategies.

To serve the needs of investors with regard to timing of the use of single factors, some ETF promoters have developed so-called multi-factor ETFs that deliver a combination of factors as a one-stop shop solution to investors. With regard to these products, it is key that the investor understands how the single factors are weighted within the portfolio. Rodewald made the point that investors who want to use these kinds of funds need to pay close attention to the index rules, since they define how the portfolio is created and therefore how it will react to different market environments.

The European ETF industry has written a true growth story over the last 16 years, and the assets under management as well as the number of products available for investors are steadily increasing. The increasing number of indices tracked by ETFs offers many opportunities for investors, but these opportunities come with the price of higher market and product complexity. Therefore, it has become essential for investors to introduce proper due diligence if they want to select the ETFs that really suit their needs and deliver the returns they are expecting. In other words, investors need to select ETFs in the same manner that actively managed portfolios do in order to make the most of their passive investments.

Detlef Glow is head of EMEA Research, Thomson Reuters Lipper

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