Exchange-traded funds can allow financial advisers to execute the basics of diversification and asset allocation for their clients at a very reasonable cost. Given the history of the investment management industry, it is perfectly rational to seek lower fees, especially considering the investment returns delivered by active money managers since the beginning of the recession.
As often happens on Wall Street, however, an excellent premise inevitably becomes an oversold and overdistributed product. ETFs have about $1.5 trillion in assets, and that is predicted to grow.
This oversaturation has spurred the re-emergence of investing in individual securities. In fact, the more ETFs grow, the more opportunities are created for investors willing to do the intensive work.
We reject the myth that indexing strategies and the popularity of ETFs represent a self-fulfilling negative for active investment management.
The underlying premise is that as short-term money moves stocks as a herd, outperformance becomes more difficult. This argument can be easily dismissed based on an investor's time horizon.
An investor with a time horizon of three days or three months shouldn't be investing in stocks. However, for an investor entertaining a longer-term horizon, some businesses and some management teams are simply better than others.
Active managers do the research that uncovers stocks that are cheaper than others at any given point, regardless of their industry classification.
The fact is that stocks represent small pieces of real businesses run by real people. Not everyone who went to high school with Steve Jobs created a $500 billion company.
Yet when an investor buys a technology-focused ETF, it's assumed that all stocks inside it are as good as Apple Inc.'s and are therefore investible. As money flows into the tech ETF, all stocks are levitated without any discriminatory analysis.
"EASILY TRADED FUNDS'
We find it odd to see large-cap stocks such as Apple (AAPL) held in more than 80 ETFs, including value, growth, large-cap, high volatility, low volatility, domestic and international.
Again, short-term money flows can raise stocks that don't deserve it, a condition that is exacerbated by the capitalization-weighted construction of most ETFs and index funds. Specifically, the highest- valued and best performers keep attracting the most money — until they don't.
Very simply, ETFs are “easily traded funds” and are making the stock market less efficient as they erroneously move in and out of stocks irrespective of valuation, essentially assigning the same value to businesses and management teams that aren't comparable.
Accordingly, the opportunities created by the proliferation of ETFs are numerous for those willing to do the research. When more and more investors are buying a broad basket of securities based upon a macro view and fewer investors are reading 10-Ks, visiting companies and attempting to discriminate, the odds tilt in favor of those who expend the effort.
Active managers have opportunities to invest in stocks that aren't held in ETFs, or that are held in only a few ETFs or in ones that are rapidly losing assets. This is especially true with small-cap and midcap stocks, where smaller floats and limited liquidity cause them to be whipped around mercilessly when ETFs buy and sell them.
It is also possible to execute a hedged strategy, in which an investor closely analyzes the components of an ETF and goes long the better values/companies and shorts the nondiscriminatory ETF.
In this risk-on, risk-off world, opportunity exists to buy orphan stocks that have clear value but are undiscovered. A quick study of financial history suggests that higher returns accrue to those who own value stocks and perform discriminating security analysis, which inevitably results in a more focused portfolio.
Not surprisingly, this is the opposite of today's consensus.
Active investing is difficult. Like that of good poker players, the goal of investors is to tilt the playing field in their favor.
As such, if we had to choose between owning an ETF that holds hundreds of stocks — and buys and sells them indiscriminately — and a concentrated portfolio of carefully researched, undervalued stocks, we would select the latter.
Jeffrey Bronchick, a chartered financial analyst, is the founder and chief investment officer of Cove Street Capital LLC. Ben Claremon is a research analyst with the firm.
