James Saunders Watson of J.P. Morgan Asset Management says ETFs are in vogue, but investment trusts have stood the test of time.
The recent popularity of exchange traded funds (ETFs) has raised the debate as to whether such a passive approach provides investors with the same opportunities as actively managed investment vehicles, particularly investment trusts.
Limited return potential
ETFs are sold as a simple and cheap way to gain exposure to a particular market or asset class. The key argument promoting ETFs is markets operate efficiently and active managers do not deliver consistent out performance over the long term.
This argument looks persuasive on paper; however, what appears straightforward is often not the case in reality. It is true most passive funds are cheaper than their active counterpart. The average TER for an ETF is around 0.5%; whereas a typical core investment trust has a TER between 0.75% and 1%.
However, costs should not be the sole consideration for selecting a fund, as both performance and return on investment are equally important. Such returns are often measured against a benchmark, which should be the return an investor receives in an ETF, less the fees. Active managers emphasise their ability to outperform their benchmarks as they can anticipate investment opportunities and take significant positions from the outset. Whereas an index fund will merely participate as the stock weighting increases within the index. Therefore investment trusts have the capability to generate superior returns to ETFs.
The active manager’s potential to generate superior returns comes with the risk that at times those managers might not outperform their benchmarks. ETFs, on the other hand, are promoted as consistently delivering index type returns. As ever it is not so simple and investors should be aware that in a number of instances ETFs do not always track the indices or securities they are supposed to mirror. For instance ETFs often hold a subset of the stocks in the index they are investing, ignoring stocks that are illiquid or perhaps too small. For example the MSCI Emerging Markets I Share has lagged its benchmark over the last five years. This tracking error can easily erode any savings made in fees.
Wider opportunity set
The strong relative performance of investment trusts in the chart, below, suggests active management works well across many markets and can therefore help enhance long-term returns.
Active management generally tends to be more effective in inefficient markets, where information is more opaque. An actively managed investment trust can perform well in such circumstances because it is able to take positions in rapidly growing, but very small companies that are not reflected in the index.
Even in the large developed markets active managers can exploit pricing inefficiencies that exist. These anomalies reflect human biases and sentiment, thus providing opportunities for active investors to invest in undervalued stocks.
Active management can also prove more attractive in markets that are highly concentrated, particularly those dominated by a small number of very large companies. ETFs based on these indices will have a bias to the very large stocks thus exposing investors to significant single stock risk. For example, the MSCI Brazil index is dominated by the two largest companies listed on the exchange, which account for around 45% of the market.
While such index concentration might not be a concern to an ETF investor, it is important to understand the reasons for making the investment. If an investor wishes to get to a particular market to benefit from domestic growth but the market is heavily skewed to exporters or commodities, the ETF will fail to capture the investment story
How transparent are ETFs?
Investment trusts are governed by company law and market listing rules which means the transparency of information is generally greater than other pooled funds. ETFs generally disclose their holdings on a daily basis. However, a growing number of ETFs’ use of derivatives to achieve their market exposure and the underlying positions are not disclosed, particularly those relating to credit and counterparty risk.
Pricing and liquidity
The structure of an investment trust can provide investors with liquidity as investors can buy and sells shares on the open stock market, as can ETFs. A main concern for investment trust investors is timing – when they sell or buy shares.
For ETFs, liquidity is dependent on the liquidity of the shares in the fund’s underlying index rather than the trading volumes in the fund itself and ETFs are often more liquid than investment trusts. However, investors should be aware an ETF is only as liquid as the least liquid stock in the index it is tracking.
Viable and attractive alternatives
ETFs can perform a useful role in an investor’s portfolio. However, the advantages need to be balanced against the potential limitations.
Investors should remember that by choosing a passive investment they are locking in sub-par returns and exposure to a constrained investment universe. It is also worth noting ETFs may not always be as transparent as they first appear, or always offer the liquidity or pricing certainty they promise.
Investment trusts offer the chance to outperform the market and can achieve enhanced returns, all be it at a higher risk level than a passive investment, as well as giving better access to smaller and more inefficient markets using the expertise of experienced fund managers.
James Saunders Watson is head of sales and marketing, investment trusts, at J.P. Morgan Asset Management
