Scott Burns, director of exchange traded securities analysis at Morningstar, discusses active management combined with ETFs and investing in REITs
Active management and ETFs
The topic of active management in ETFs is heating up again, following Grail Advisors launching four actively managed funds. The Grail ETFs will be run by single fund managers in the traditional active sense, as opposed to the fund of fund structure in the Grail American Beacon Large Value ETF. By all appearances, Grail is bringing a stable of established and well-known managers to manage these ETFs.
On top of that, AdvisorShares launched the Dent Tactical fund, which is the first traditionally active ETF of ETFs. The fund is run by financial celebrity Harry Dent and carries the distinction of being the most expensive ETF on the market with an expense ratio of 1.56%. This is off the charts for ETFs and also above the average expense ratio charged by actively managed mutual funds.
Admittedly, I am more of a passive investor and if I want active management I generally prefer to do it myself. However, I’m not afraid to acknowledge that there are plenty of managers out there who earn their keep and there are a lot of investors who want active management in their portfolios. So why shouldn’t investors who want the tax efficiency, transparency, and liquidity of ETFs be able to combine that with active management? The answer is there is no good reason.
Over the past few years, ETFs have become categorised as “passive” while there has been a growing perception that open-end mutual funds are “active.” But in fact, the amount of money invested in passive mutual funds dwarfs the entire ETF market. Although the vast majority of ETF assets are in passive funds, this is a relic of regulation that mandated ETFs must track indices. Since this rule was repealed, the only thing keeping active management from harnessing the ETF structure has been the fund companies themselves.
Yet this attitude is clearly changing among fund companies. You don’t have to look further than Pacific Investment Management Company’s (Pimco) filing for active bond ETFs or, more importantly, BlackRock’s acquisition of iShares, the largest ETF provider in the world. We think the change of heart has less to do with all the structural advantages that ETFs have and more to do with how the funds are distributed. My colleague on the mutual fund team Eric Jacobson pointed out the benefits fund companies and investors will have purchasing funds directly from the exchange. Currently, many funds need to be sold through what are known as mutual fund supermarkets or mutual fund wholesalers. This distribution mechanism can add 15 to 30 basis points to an investor’s fund costs. By offering a fund in the ETF format, the fund company can circumvent the middleman, make the same fee it would have anyway, with lower costs for investors.
Of course, the downside of this, at least for the fund companies, is that this completely changes their marketing strategy. How will they evaluate the performance of their sales people? Maybe funds will be purchased based on their cost, performance, and strategy and not because of slick-talking sales representatives.
Earlier this year, we disputed the claim that real estate investment trusts (REITs) constituted a separate asset class for a diversified portfolio. We came to this conclusion by studying the rolling correlations of the Dow Jones U.S. Real Estate index versus the small-cap Russell 2000 Value index and the S&P 500 index. The results showed that since 2001, the correlation of REITs and equities had been creeping steadily higher until topping off in the 0.80 range in 2008. As a result of this study, we kicked REITs as a separate asset class out of our model hands-free portfolio.
It was a fairly controversial position, and the National Association of Real Estate Investment Trusts (NAREIT) contacted us to discuss the issue. The main disagreement was over our claim that REITs had lost their diversification benefits.
The NAREIT team made a strong argument that REITs still had diversification benefits and deserved to be a separate asset class. They presented some statistically superior measures of rolling correlation that smoothed the rise in correlations over the past eight years. However, even in this model, the correlations still began to rise at the same time, if not to the same level as our more simple study. We also learned that major stock indices, such as the S&P 500, excluded REITs until October 2001. This might explain why REITs have since behaved more like stocks than they did for most of the 1990s.
Despite NAREIT’s sound argument for specifically allocating assets to REITs in a strategic portfolio, there are still a couple of issues that give me pause. Given the modern REIT era didn’t really begin until 1991, we have less than 20 years of data to look at. In that short time frame, we have had two near-cataclysmic crashes. Should a separate asset class in a moderate-risk portfolio be something where we have a high probability of suffering significant capital impairment every 10 years or so? I’m sure that question crossed many REIT investors’ minds over the past year.
Although correlations were a lot lower 10 years ago, the trend is clearly showing an increase in correlation. The point of a diversified portfolio is to provide diversification, and REITs have still lost some of that attraction in our view.
We encourage you to check out the NAREIT website for some well-conducted research and see their arguments for yourself. As for us, we are sticking with our stance that REITs are more like stocks than they were historically and we will be satisfied with the allocation allotted through our broad equity index holdings in the hands-free portfolio.
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