Is this the end of the active portfolio managers and stock pickers, such as value investors? Many market participants think so.Getty Images/iStockphoto
Exchange-traded funds, which are investment funds that trade like common stocks and normally "passively" track an index, are booming, smashing new records year after year. Canadian ETFs, for example, reached a record $89.6-billion in assets under management at the end of 2015, according to National Bank Financial. The number of ETFs listed on the Toronto Stock Exchange has more than doubled since 2011. Pundits forecast these trends to continue in the future both in terms of asset growth and number of new players to enter the marketplace.
Is this the end of the active portfolio managers and stock pickers, such as value investors? Many market participants think so. I beg to differ. Developments that made ETFs attractive in the past may not be as supportive in the future. Here are some trends that, in my opinion, may reverse the tide toward ETFs.
First, increased volatility in the months and years ahead. A slowdown in economic growth around the world, particularly in China, as well as a slowdown in productivity, lower population growth, aging baby boomers, higher taxes and lower government spending will lead to an increase in stock-market volatility. An expensive market and declining earnings growth in an environment of artificially low interest rates that have encouraged leverage both at the individual and corporate level will also contribute to rising volatility, both realized and expected.
On top of this, awareness that central banks around the world have used all the aces in their sleeves to help their ailing economies will exacerbate volatility – not to mention uncertainty about the Fed's next move in relation to interest rates. What this all means is that the auto-pilot investing offered by ETFs will not cut it as investors will not be able to handle such volatility on their own. However, for active portfolio managers who know what they are buying and why, and have a long-term perspective, volatility is a friend as it offers an opportunity to buy assets cheap.
Second, changing correlations among assets in the marketplace. Artificially low interest rates and central bank intervention in the markets have distorted valuations and have changed correlations between asset classes, thus reducing the benefits of diversification, according to Mohamed El-Erian, the chief economist of financial services multinational Allianz. One benefit of ETFs is instant diversification. But if correlations are changing and assets, in general, are becoming highly correlated, then the benefits of diversification are reduced. Active portfolio managers, such as value investors, advocate and invest in concentrated portfolios, which, in light of increased correlations, will give them an advantage as the assets they invest in are not normally related to the overall market.
Third, the threat of and the increased likelihood of negative interest rates spreading around the globe. This is an uncharted territory. Human and institutional relationships are breaking down. A dollar today is no longer worth more than a dollar tomorrow, and this is against human nature. Humans like to consume. If someone asks us to postpone consumption to the future by making an investment in the current period, the human inclination is to ask for a compensation to do so.
In an environment of negative interest rates, the opposite is the case. We now have to pay for the right to make an investment. More specifically, in a negative interest rate environment, when we discount future cash flows (in order to convert them into current values), the discount rate is less than one, making the cash flows worth more today than in the future. Pension funds and insurance companies in this environment will have difficulty selling their products, making institutional relationships and long-held practices break down. Cash is "king" when interest rates are negative. Stock pickers who stay in cash, many times quite significantly, when no investment opportunities are found will thus have an advantage. On the other hand, ETFs have to always be fully invested.
To take advantage of the market dislocations that will follow, investors will have to put their money with active portfolio managers who invest in concentrated portfolios, understand stocks in depth, are not afraid of volatility, stay in cash if necessary and have a long-term perspective.
In this environment, stock pickers, such as value investors, will shine.
George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.