One topic that has dominated investors' conversations over the past several years is the active versus passive debate. As active managers have failed to provide value for money, and others have just tracked a basic underlying index in order to avoid underperforming, the question of whether or not investors should stick with them or invest in passive instruments, which provide primarily the same service for a fraction of the cost, has resulted in trillions of dollars moving from actively managed mutual funds to exchange-traded funds.
But are these instruments suitable for value investors?
Passive value
The idea of factor investing has grown in prominence over the past several years, and value is one of the five primary factors that investors usually follow. As there is clear evidence that proves value has outperformed over the past few decades, it is one of the most popular, but due to the constraints of passive investment funds, there is little evidence as to whether or not these instruments provide a better offering than their active alternative.
In fact, it could be argued ETFs will never actually be able to replicate the service provided by active value managers accurately. The biggest problem with these products is the fact they have to invest in liquid securities because they need to be able to trade in and out of the positions without moving the market. Not only does this limit the positions ETFs can take, but it also restricts the weight each holding can have in the portfolio. For example, a liquid small-cap trading at 0.25 of book value may be an attractive investment for an active independent manager to take a significant stake, but a large, liquid ETF is not going to be able to make the most of this opportunity.
The problems of an ETF
The list of value ETFs to buy for 2018, according to Investopedia, is a great example of this problem in action. The top holding on this list, the Guggenheim S&P SmallCap 600 PureVal ETF, has a total of 165 holdings with an average price-book ratio of 1.1 and a price-earnings average of 15.
For investors who want the most diversified value portfolio possible, this may be a good solution, but it will also impact your returns. Rather than buying a concentrated portfolio of undervalued equities, you are instead buying a well-diversified portfolio of stocks that look cheap compared to the rest of the market. But when compared to Benjamin Graham's criteria of value, they are not particularly inexpensive. In other words, you are just buying some of the cheapest stocks relative to the rest of the market.
One of the reasons why value investing has outperformed over the long term is the fact many value opportuniites actually fly under the radar. They are also illiquid and small. These are exactly the kind of qualities ETFs cannot buy into because of the limits of their structure. In addition, an automated ETF structure does not have the intellectual ability to be able to stand back from the market and wait for the perfect pitch. ETFs have to be nearly fully invested at all times according to their prospectuses. Many value hedge fund managers are currently holding elevated levels of cash, unlike the Guggenheim S&P SmallCap 600 PureVal ETF, which continues to be fully invested.
Conclusion
So to answer the question of whether or not ETFs provide a sensible replacement to active value management, I would say the answer is no.
One of the reasons why value investing works is because value investors by their very nature have to be contrarian. They have to be buying when others are selling and selling when others are buying. ETFs follow almost the exact opposite structure. They are invested all the time and are very limited in the actions they can take when the market changes.
Disclosure: The author owns no stocks mentioned.
