This In Practice piece gives a practitioner’s perspective on the article “Are Passive Funds Really Superior Investments? An Investor Perspective,” by Edwin J. Elton, Martin J. Gruber, and Andre de Souza, published in the Third Quarter 2019 issue of the Financial Analysts Journal.
What’s the Investment Issue?
While a great number of academic papers purport to show that passive, or factor-based, investments outperform actively managed funds, often these passive strategies are not practically applied: They are not investable or not replicable, or the costs result in them underperforming the benchmark of the strategy they are designed to mimic.
The authors seek a passive strategy that can replicate the risk–return profile of an active mutual fund strategy, is relatively simple to execute, and can outperform the active strategy after fees.
How Do the Authors Tackle the Issue?
The authors aim to find a small set of exchange-traded funds (ETFs) that capture all the risks in active strategies and determine whether a combination of these ETFs has the potential to deliver higher returns than active mutual funds.
Using correlation analysis, they find that just five ETFs can explain the returns from all the indexes tracked by ETFs. That is, investing in large-cap value, large-cap growth, small-cap growth, and mid-cap value plus the overall market index is sufficient to capture the key risks in all mutual fund strategies.
The authors use ETFs because of their flexibility and investability: They are liquid and can be held long or short.
The authors examine how different combinations of these ETFs, each of which is risk-matched to an active fund, performed against 883 matching active funds in the sample. Two methodologies are applied: one that allows short selling ETFs and one where ETFs are held long only. The authors compare returns over the following year between each ETF and active fund pairing.
What Are the Findings?
The performance of the ETF portfolios versus the active strategies is impressive. Returns from the long-only matching ETF portfolios beat returns from the active funds 78% of the time. The average outperformance of the ETF portfolios is 1.37% a year. With unlimited short selling—a more complex strategy to implement—the risk-matching ETFs outperform actively managed strategies 77% of the time. Even a simple strategy of investing in the lowest-cost ETF matching the active fund benchmark outperforms 72% of the time.
If sales commission is taken into account, the ETF portfolios outperform the active funds more frequently still—90% of the time. In addition, the ETF, or matching, portfolios have lower standard deviations. That is, they reduce portfolio volatility, an important consideration for many investors.
What Are the Implications for Investors and Investment Managers?
The authors’ results show that using a small number of ETFs in a risk-matching combination can very often deliver better performance than investing directly in the comparative active fund.
The methodology the authors adopt shows that a combination of just five ETFs can account for the risk–return profiles of all ETFs. This finding could help investors streamline their portfolios, saving them time, effort, and expense.