Roger Nusbaum, who runs the popular blog Random Roger, wrote in a post today that one area in which an actively-managed ETF could add some value is the financial sector. Roger makes the point that the financial sector is exactly the type where some active management would be beneficial to investors because of the number of potentially bad bets out there amongst banks. I couldn’t agree more.
Passive indexing appeals to many because of its simplicity and straight-forward approach to investing of holding all the securities in index. Simplicity sounds very good in theory but in reality, it’s not the best recommendation in certain situations, as Roger illustrates. Most passively-managed financial sector ETFs would hold all the big names like JP Morgan, Bank of America, Citigroup and other big global banks, just because they are obligated to track the indices. The indices in turn include all those securities as components in order to meet their objective of being a good representation of the sector. Looking at that carefully, you’ll notice that neither the objective for the index (to be a good representation of the sector) nor that for the passive ETF (to track the index closely) has anything to do with picking the “right” investments for investors. And therein lies the issue when it comes to investing passively in sectors that represent minefields more than they represent investment opportunities. And this is especially true when you hold index ETFs that are cap-weighted. For example, if you invested passively in the financial sector using the Financial Select Sector SPDR Fund (XLF) on July 21st, you’d end up holding more of Citigroup (5.69%) than of Goldman Sachs (4.84%). Anyone who has followed the markets in the last 2 years would never in their right mind make such an allocation, given the market dominance of Goldman Sachs and the severe ongoing troubles of Citigroup. An active manager operating an actively-managed financial sector ETF would be able to make those choices instead of being forced to provide the investor with market cap weights of each security in the sector.
Of course, one actively-managed ETF for the financial sector already exists – in the form of Grail Advisors’ RP Financials ETF (RFF: 24.56 0.00%), which was launched in October, 2009. According to numbers from Google Finance, RFF has been able to outperform the Financial Select Sector SPDR (XLF) by about 100 basis points since inception. And looking at the holdings, where in XLF, 5.69% of your money would have been in Citigroup, RFF does not even hold Citigroup in the portfolio. Which specific active manager you end up choosing is, of course, another debate all together. RFF, for instance, is still very light on assets, has a short track record and little investor recognition.
To further the original point though, some of the most successful actively-managed ETFs provide investors with exactly the value-add highlighted above – the ability to utilize the expertise of an active manager in a sector where it would be most useful in avoiding pitfalls. For example, PIMCO’s Enhanced Short Maturity Fund (MINT: 100.78 0.00%), which is the 2nd largest fund in the Active ETF space, operates in the short-end of the yield curve, providing cash management solutions through investments in money-market instruments. Dislocations in the cash market through the credit crisis have made investing in money-market securities less reliable, thus making an actively-managed money-market fund more suitable than a fund tracking a passive money-market index. Another instance where Active ETFs are more relevant is the municipal bond market. In a time when huge budget deficits are the norm across US states and cities and states have even issued IOUs, the credit quality of the issuer becomes a key factor when investing in municipal bonds. A credit manager who has the ability to distinguish the nearly bankrupt municipalities from those with strong balance sheets would again definitely add value over a passive municipal bond index.
To sport some other ideas on areas where active management could come in handy – emerging market equity, emerging market bonds, high yield bonds and maybe even real estate could be areas where holding a representative index of the sector might not be the best idea.
Disclosure: No positions in above-mentioned names.
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