If You Can’t Beat ‘em, Join em: An Exploration of Passive Investing and The Evolution of ETFs
ETFs have come a long way, and can provide decent returns to those patient enough. But it pays to be mindful of the pitfalls.
Written by Victoria Kent, Senior Investment Specialist
This information does not take into account your personal objectives, financial situation or needs. You should consider if the relevant investment is appropriate having regard to your own objectives, financial situation and needs.
You may have heard the ‘you can’t beat the market’ expression. According to the Efficient Market Theory (EMT), still taught in finance today, it is impossible to consistently achieve higher returns than the market average by using any publicly available information. The market is self-correcting, all-knowing, and dynamic in nature.
So, why even bother trying to beat the market? And hang on, if EMT holds true, how did Warren Buffet make his money?
Here are some things we know:
markets aren’t always efficient,
people don’t always trade on publicly available information only,
behavioural finance – which suggests that our cognitive biases and emotions can affect decision making – can be used to exploit market inefficiencies and;
active investors like Warren Buffet have beaten the market, and been rewarded handsomely.
It’s the age-old passive versus active investment debate. It’s been argued since before the introduction of the first index fund by John Bogle in 1975 (the Vanguard 500 Index Fund).
Bogle’s folly, not so fallacious after all
The Vanguard 500 Index Fund was considered by many to be a "folly", and that it could not possibly outperform actively managed funds.
Bogle, however, believed the vast majority of actively managed funds (where a fund manager picks stocks) would underperform the market. He believed an index fund, which simply tracks the market, would be a more efficient and cost-effective way for investors to achieve returns.
Index investing is a passive investment strategy where an investor buys a portfolio of assets designed to mimic the performance of a market index, such as the S&P 500. The goal of index investing is to match the performance of the index, rather than trying to beat it. Index investors aim to achieve market returns by diversifying their investments across a broad range of assets, rather than trying to pick individual stocks or time the market.
At a time when many experts believed active management was the only way to achieve superior returns, Bogle had the foresight to believe passive investing could be a valid approach for investors. His vision of low-cost passive investing has revolutionised the investment industry, and paved the way for the average punter, or ‘retail investor’, to enjoy market returns.
Thanks to Bogle, Vanguard has become one of the largest, most well-known investment management companies in the world. While it didn’t create the first Exchange Traded Fund (ETF)*, Vanguard has played an important role in the development and growth of ETFs.
*That was the Toronto 35 Index Participation Units (later known as the SPDR S&P/TSX 60) created by the Toronto Stock Exchange (TSE) and the Bank of Montreal back in the early 1990s.
Market returns are pretty good over the long term
It’s worth mentioning here market returns can be pretty good, especially over the long term. Take the S&P 500 for example. If you invested $100 in the S&P 500 at the beginning of 1950, you would have about $216,719 at the end of 2022, assuming you reinvested all dividends. This is a return on investment of 216,619%, equal to 11.12% per year or 7.38% per year when adjusted for inflation.
The big disclaimer here is market returns vary widely from year to year, and an “average” year never generates the average return. Historically, the stock market has gone up more years than it has gone down. Take 120 years of the Australian Sharemarket (ASX), for example. Since 1900 to 2020, it has returned 11.8% per annum including dividends. Over that time, it has had 23 negative years (19%) and 97 positive years of returns.
What are ETFs?
Exchange traded funds (ETFs) are managed investments that are listed and traded on a securities market. Original ETFs were passive and broadly tracked an index, giving investors exposure to the entirety of the market (or largest companies by weighted market cap).
The popularity of ETFs is driven by the fact they provide investors with the ability to gain diversified exposure to an underlying index, sector or asset class in a cost-effective and convenient way. Their structure allows for easy trading and performance monitoring, flexibility and transparency. The key appeal for many investors is sheer passivity of it – there is no need to read earnings reports or look at business fundamentals.
Buy the dart board, don’t buy the darts
Assets currently invested in ETFs globally hover around the $10 trillion dollar mark. Here in Australia, the ETF market has grown from only two ETFs on the ASX in 2001, to 240 ETFs as at January 2023. If you haven’t personally invested in an ETF, chances are, you’re exposed to one through your super fund.
“ETFs have also cemented their status as a preferred investing vehicle – especially for retail investors – replacing buying individual securities and mutual funds.
I still think the ETF industry has a lot of room to grow on a global basis, and in the U.S.” – Deborah Fuhr, founder of ETFGI
The number and variety of ETFs available has also grown significantly, with ETFs now available that track a wide range of indices, sectors, themes and even actively managed portfolios. Examples include bond ETFs, real estate ETFs and commodity ETFs. Some new examples to enter the commodity ETF scene are Copper Miners ETF (WIRE) and Uranium ETF (ATOM) by Global X ETFs Australia (formerly ETF Securities).
Increasingly, ETFs are thematic, seeking to take advantage of structural changes which could have a transformative effect on society over the long term. These ETFs provide investors with the opportunity to invest according to their convictions, and capitalise on long-term trends they believe will play out over the coming years and decades.
Investors can also incorporate their personal values or philosophy into their portfolio construction. For example, the environment or emerging and disruptive technology.
The popularity of thematic ETFs has accelerated rapidly over the last few years. According to Morningstar, more than 60% of thematic ETFs listed globally today were launched since the beginning of 2020.
In Australia, by mid-2021 there was about $2 billion in assets under management in thematic ETFs, having grown from only $8 million four years earlier.
What are the pitfalls?
Any investment asset comes with potential benefits and risks, and ETFs are no different. Here are some things to consider:
Rotten eggs
As ETF investing means you forfeit the ability to pick and choose individual investments, you may gain exposure to some unwanted investments ‘in the basket’– whether its poor performers or poor social actors.
High concentration
Increasingly, markets, and therefore indexes and the ETFs that replicate them, are becoming highly concentrated.
By design, the S&P 500 contains only the biggest companies with massive market caps ($13 billion or more), so it’s dominated by tech giants Apple (6%), Microsoft (5.3%), Google (3%), Amazon (2.6%). This means the diversification you assume you might be achieving from ETFs may not necessarily be true.
Take the Vanguard Australian Shares Index ETF (ASX: VAS), the most popular ETF in Australia by total amount invested ($12.22 billion as at time of writing). It aims to replicate the top 300 companies in Australia, making it top heavy and narrow. Its largest single holding is BHP (10.7%).
From a sector perspective, it is heavily weighted towards financials (28%) and materials (24%). For a deep dive into VAS, check out this Australian Finance Podcast episode here.
Slow play
Generating a decent return is a slow play. This goes to the previously mentioned fact that market returns tend to be positive over the long term, and an ‘average’ return is never likely to be achieved in any one year.
Thematic ETF considerations
It’s important to recognise they can carry increased risk. Not only do the higher fees eat away at your potential returns, correlations among its constituents increase significantly, therefore reducing some of the diversification.
Additionally, discerning between a major developing theme and an overhyped fad is easy with hindsight, but very difficult with foresight. Investors need to objectively challenge whether the theme represents a long-term structural change, or is just a good story.
Even if the correct theme is chosen, profiting from it is not a given. The next step is to choose an ETF that successfully capitalises on the theme, and then timing the purchase of that ETF.
Final thoughts
ETFs are a remarkable invention and have undoubtedly been a democratising force in the investment world, driving down costs and making investing accessible to individuals.
However, they are not the be all and end all, and not without risk.
Both active and passive investment management can have a place in a well-diversified investment portfolio, and the choice between them depends on the individual investor's goals, risk tolerance and investment horizon.
If you are considering investing in ETFs, it’s clear you have lots to choose from, and knowing whether one is right for you will also depend on your personal goals, risk tolerance and investment horizon.
Every fund has a PDS (Product Disclosure Statement) with all the information you need, and the fund websites should have further information on underlying holdings.
Remember: ETFs can increase and decrease in value, and past performance is not a predictor of future performance.