FAQ on Evidence Based Investing
Why are traditionally “active” funds using traditionally “passive” products like ETFs?
A genuinely passive investment approach involves an objective, rules based approach to markets, the building blocks for which are passive ETFs and Index Funds. At the same time many active market participants adopt a hybrid approach, and express active macro views using efficient passive instruments. In doing so, these participants are foregoing one potential source of alpha, stock selection, and are focusing their effort on extracting outperformance (alpha) through market timing. This style relies on subjective decisions and manager skill, and is therefore not a passive approach, although it is often presented and marketed as such.
What is the role of tactical asset allocation?
Tactical asset allocation is another euphemism for a strategy which attempts to extract outperformance (alpha) through market timing, by identifying asset classes which are overbought (or oversold) and decreasing (or increasing) portfolio exposure to such asset classes. Empirical studies demonstrate that the vast majority of managers consistently fail to add value through tactical allocation, and indeed tend to destroy value through such decisions. A genuine passive strategy does not involve tactical allocation.
With over 2,000 ETFs listed in Europe alone, how does an investor know which one to choose?
The passive universe contains not only ETFs but also Index Funds. Portfolio construction should begin with a risk allocation process focussed on the investor. This should then be expressed as a benchmark in the form of a granular set of indices representing the relevant investable universe. The ETFs tracking the benchmark indices must then be screened for methodology, tracking error, liquidity, costs, tax efficiency, structure and counterparty risk.
Why pay a manager to select Index Funds and ETFs? Can’t anyone do it?
If the intention is to select a single product, then an investor can indeed self-select on the basis of product sponsor and cost. But single products tend to focus on large cap companies in major market, and they fail to address the full investable universe, the full market. This approach also forgoes the benefit of applying factor tilts to the portfolio (see below). Employing a manager also improves discipline, facilitates consistent rebalancing, reduces an investor’s behavioural bias and reduces the tendency to make ill-timed subjective decisions.
Should all of your portfolio be in ETFs and passively managed?
We are comfortable with a core / satellite approach, with the core portfolio invested passively with a view to harvesting market returns (beta) as efficiently as possible. This can be complemented by a number of specialist satellite products / strategies intended to capture alpha or to access other risk premia (an example might be property). It is important that the investor fully understand why and how each satellite strategy will add value, and that their performance is rigorously reassessed on a regular basis.
How do you know when you should rebalance?
The primary purpose of rebalancing is to ensure consistency of portfolio risk. As with all aspects of a passive strategy, rebalancing must be carried out objectively in accordance with pre-defined rules. Much work has been done to identify optimal rebalancing frequencies, thresholds and timing, but ultimately the most important component of a rebalancing process is discipline.
What is factor investing?
Academic studies have revealed that certain sub-sections of the market have persistently experienced higher returns than the broader market. Factor investing tilts the portfolio, again using a rules-based approach, towards these rewarded risk factors. The resulting strategy remains focused on harvesting market returns (beta), but the components of the market are weighted toward persistently rewarded factors (selective beta).
How do you diversify?
Modern portfolio theory relies on a multi-asset class approach to ensure multi-layered diversification. We advocate liquid, global, multi-asset portfolios comprising ETFs and Index Funds which, in turn, ensure maximum diversification within each investment layer.
If everyone is rushing into passive investing, what is the future for asset management and hedge funds?
The emergence of highly efficient passive investments is forcing active managers to up their game substantially. Managers with low active share (including closet indexers) will be competitively forced to lower fees and increase efficiency; we are already seeing related merger activity as this industry looks to consolidate and achieve economies of scale and scope. Smaller active managers will be forced to increase active share and focus on genuine consistent alpha production in order to justify fees and remain viable. We expect the industry to be smaller and more competitive in the future.
Is passive investing a fad in a rising market? What happens when markets fall?
Passive investing has been practiced since the 1970s and has stood the test of the global financial crisis. By definition, an investment designed to replicate the market return will efficiently track markets downwards as well as upwards, but the important question is whether this outcome will be better or worse than that of a managed investment in the same conditions. Our analysis shows that managers succumb to the same behavioural biases which are known to damage the performance of individual investors in turbulent markets, and that attempts to protect a portfolio from volatility tend to significantly destroy value across the cycle.