Is it possible to invest using passive strategies?
As the market for passive investment funds, such as ETFs, has developed over the past decade, there has been plenty of talk about the death of the active investment manager, but I believe it's way too early to start contemplating the complete failure of active management.
Indeed, it is still possible to achieve outperformance by investing in undervalued equities. It is only subpar active managers that have lost assets to cheaper and better performing tracker funds.
And rather than marking the death of active management and value investing, I believe that ETFs provide an excellent opportunity for value investors to gain exposure to assets and even countries that they would usually be unable to invest in.
Combining ETFs and value
ETFs are a great financial innovation and, if used correctly, they can complement existing active strategies very well.
Investing overseas is a tricky process, especially in the markets where the most value can be found -- regions such as Russia and Eastern Europe as well as Asian and South American markets. As an individual investor, trying to gain access to these markets and trade individual securities (not to mention conducting financial research on stocks) is extremely difficult and time consuming if you don't already have experience in the market.
ETFs solve this problem into ways. First of all, the instruments provide access to the markets and second, ETFs usually track a broad basket of stocks, reducing the need for you to do in-depth research on each company. If you think a region is cheap, it's easy to buy exposure to the whole market at a low cost.
A sector bet
ETFs also enable you to gain access to entire sectors closer to home.
For example, during the past few years I have owned ETFs tracking a basket of mid-stream master limited partnerships, which have seen substantial selling by investors who wanted to reduce exposure to the sector following the oil price crash. ETFs have enabled me to bet on the entire industry without taking much stock-specific risk. I believe that there have also been some opportunities in European banks and global miners.
You could argue that this approach has more risk because you’re not doing enough research on the underlying securities. Indeed, I have argued many times that the best way to reduce risk is to do in-depth research. Coupled with high conviction positions, this is the best way to outperform over the long term.
There is nothing to stop you from combining these two strategies. An ETF acts as a large bet on the sector, and some single stock positions, on your most high conviction bets. There is nothing to stop you using this strategy, however, in industries such as master limited mid-stream partnerships and European banks, where the risk of contagion is high and even the most in-depth research will not save you if everything suddenly goes downhill.
In the financial crisis, if you had brought a basket of stocks (or ETF) of banking stocks at the lows, you could've made a healthy profit, but buying single stocks would have exposed you to plenty of contagion risk that even the most rigorous research wouldn't have been able to detect. (Of course, you could also have followed Buffett's strategy of just buying of the most prominent, most profitable companies in the sector.)
Another argument, if you see value in the sector: Why waste time and effort trying to pick the best companies? If the whole sector seems attractive, it makes sense to buy an ETF to gain exposure.
In conclusion, the rise of the ETF has many benefits for value investors. The instruments give cheap access to a diversified portfolio in a particular sector, if you're looking to make a sector-specific bet, or gain access to low-cost overseas markets. Some ideas: The Czech Republic market has a Cape score of 9.1 and Poland trades at a Cape of 12.5.
Disclosure: The author owns no stock mentioned.
