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The Big Question – ETFs vs Funds

Are low-cost tracker funds and ETFs a serious long term threat to active management?

Ben Johnson 23 September, 2010 | 10:42AM
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Morningstar's European ETF strategist Ben Johnson joins a discussion on the relationship between actively and passively managed investment vehicles. His comment first appeared on Investment Week.

ETFs pose a serious threat not to active management as a whole—we believe that active and passive vehicles can and will co-exist peacefully—but to the level of fees charged by active managers. Taking this argument one step further, ETFs are a severe long-term threat to subpar active managers. There is no economic rationale for paying large fees to an active manager that consistently lags their benchmark.

Of course, not all active managers miss the mark on a regular basis. There are plenty that can and do generate alpha on a fairly regular basis, and demand for alpha will never die. So as for the tug-of-war between low-cost beta offered by ETFs and relatively more costly attempts at regular alpha offered by active managers, ETFs have room to gain market share, but in the long run both will live together in harmony.

It is also important to realise that the line between active and passive management is becoming increasingly blurred. This is because ETFs can serve as the sole building block of an active (or passive) strategy, a way to make tactical bets, or as a liquidity supplement within an active strategy, amongst other uses. The ever-expanding number of fund managers that employ ETFs exclusively or as portfolio supplements is evidence of this increasingly cloudy division.

The broader adoption of ETFs will ultimately be a winning proposition for investors in active and passive vehicles alike. If there is one factor that is proven to have predictive power with respect to investment returns over time, it is expenses. Low-cost funds consistently outperform high-cost funds. Those active managers that cannot regularly generate performance results to justify what are generally far greater expense burdens may ultimately have to compete on price, if they cannot rationalise their expenses through superior investment skill.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.