Welcome back to another issue of the ETF Insights Newsletter.
This month’s newsletter is primarily inspired by the trend of questions I’ve been receiving from investors over the past while via my Q&A.
Which, by the way, is an outstanding resource for addressing any of your burning questions. I answer these questions directly myself, and I have helped many investors identify funds they didn’t know about, or I have prevented them from buying funds that have underlying issues.
All you need to do to access the Q&A is simply log into your account and select the Q&A from your dashboard.
The trend I’m seeing? It is regarding actively managed funds and the high levels of interest in them from members. Actively managed funds are tricky. The vast majority of them will fail to outperform their benchmarks over the long term. Yet, many investors get sucked into them by the allure of higher returns and promising investing strategies.
In this month’s newsletter, I will go through the exact process I use to analyze an actively managed fund to determine if it is worth people’s hard-earned dollars today.
Let’s get into it.
Step 1 – Analyze the fund’s history
This is particularly important when investing in actively managed funds.
When we invest in an index fund like VFV, we are buying a fund that simply holds the S&P 500, and we realize the returns from the index itself. Its past returns will be relatively close to the index, minus fees and potentially some tracking error.
However, it is a whole new ballgame with actively managed funds. Yes, past returns have no impact on future potential returns. But the past returns of an actively managed fund can tell you a lot about its potential future returns. Why?
Because these funds are managed by humans individually picking equities, bonds, etc. Tracking an index requires 0 skills. You buy the index and realize the returns. Actively managing a portfolio, however, requires extensive knowledge, experience, and a great deal of patience.
The vast majority of these funds are managed by financial professionals. However, don’t mistake this for the idea that every financial professional is suited to actively pick stocks and turn out solid returns. In fact, it’s quite the opposite. Most actively managed funds are going to leave you with less money in your pocket than a basic set-and-forget index fund.
Previous history is critical because it highlights the management team’s ability to generate outsized returns. Could they falter moving forward? Sure, they could. However, with a long-standing history of strong returns, we at least have a credible history to try and predict the likelihood of outperformance moving forward.
This is primarily why, except in extreme outlier situations, I would not touch an actively managed fund with less than 3-5 years of history to look at.
I find these types of funds, the newer ones with less history, are what members are mainly asking about. I am not surprised by this. Newer funds typically have higher marketing budgets and are trying to attract investor capital, while more mature, actively managed funds are typically just doing their thing in the background.
Let’s look at one of the better actively managed funds in Canada, the BMO Low Volatility Canadian Equity ETF, as an example.
The fund has a long-standing history of being a market outperformer in regard to the TSX. This is the exact chart I want to see when I am looking up an actively managed fund and working to decide whether or not it’s worth my money.
What I’d likely pass on? A similar fund that Harvest just launched, the Low Volatility Canadian Equity ETF. When I see a chart like this:
My thought process generally gravitates toward “I have no idea as to whether or not this fund’s low volatility strategy is going to work over the long-term, as the fund has only existed for a few months. I’ll revisit it in a couple of years.”
Step 2 – Manager track record
Another important area we need to look to is the fund’s management. It is possible I’d consider investing in a newer, actively managed fund if the fund manager had a strong history of previous outperformance at a prior fund.
Additionally, and this relates a bit back to Step 1, you must take into account management turnover. If you look to an actively managed fund with a strong history of outperformance in the past, but they’ve had management turnover in the last few years, it’s something you need to be aware of.
Ultimately, the management of an actively managed fund is the backbone of the fund itself. Because these are humans making individual decisions on which equities to buy, swapping out those people for new people can lead to a material change in strategy and the underlying decisions made by the fund.
Peter Lynch ran the Magellan Fund for 13 years up until the early 1990s, achieving a near 30% annualized return. Once Peter Lynch left the fund, his successor, over the following 5 years, would extensively shift the fund’s strategy to bonds, resulting in large underperformances relative to the S&P 500. A strategy that Lynch likely would not have utilized.
If you are looking toward actively managed funds, whether they have 1 year of history or 15 years of history, looking into the current management team and its history is an absolute must.
Step 3 – Look to the turnover ratio
The “turnover” ratio of a fund is expressed as a percentage and is the amount of the fund’s holdings that are bought and sold. In a nutshell, it reflects the level of trading activity that is going on within a fund.
An actively managed fund is almost always going to have a higher turnover ratio than an index fund. However, an alarmingly high ratio can signal some issues. Let’s look to an example and compare a couple of funds.
VFV, an S&P 500 index fund, versus the Global X Big Data and Hardware ETF (HBGD), an actively managed fund focusing on, for the most part, artificial intelligence.
The turnover ratio for VFV is 3.67%, meaning approximately 3.6% of the portfolio is bought and sold every year. This is likely just due to rebalancing in the index.
HBGD’s turnover ratio is a whopping 81%, meaning 81% of the portfolio is bought and sold every year.
A high turnover ratio combined with strong performance is not an issue. However, when we get into high rates of turnover with underperformance, not only do our returns suffer because of the performance, but they also deteriorate through the tax implications of the fund buying and selling so many holdings, as well as overall commissions for buying and selling these holdings.
In addition to this, even if we are investing in actively managed funds for outperformance, the goal of this outperformance should be to generate it over the long term.
A fund that is turning over 80%, 90%, 100%+ of the portfolio is one that needs to be scrutinized closely. A high turnover ratio is an indication that management is either deviating from their regular strategy or they just don’t have one. Unless the strategy is simply actively trading in and out of holdings.
Generally, the younger and more promising an industry, the higher turnover you’re going to have in funds targeting that industry. This is because newer and more promising players emerge routinely, and the fund may end up selling out of existing positions and reallocating to take advantage of that more promising option.
One area of the market I can think of where this is happening right now is artificial intelligence. Even larger AI funds often have turnover ratios in the 50%~ range.
This number will provide you with no added information if used in isolation. However, when combined with other factors, it can give you a good idea as to how well the management is sticking to its overall strategy and managing its capital.
Step 4 – Identify and avoid closet indexers
ETF managers are aggressive marketers. Actively managed funds and the allure of outperformance is how they draw investors into investing. However, you might realistically be buying a passive index fund but paying actively managed fees.
Funds will draw up fancy investing strategies and overall goals yet will pretty much own the underlying index. In return, they’ll charge you much higher fees. This is such a large issue that there are class action lawsuits in British Columbia against funds that charged actively managed fees yet simply owned a basket of investments close to the overall index.
I see this a lot with actively managed growth funds. They will charge higher fees, claiming to be actively picking growth stocks, yet will own a similar makeup to the NASDAQ 100, the only difference being a NASDAQ 100 index fund will have a fraction of the overall fees.
Step 5 – Is the juice worth the squeeze. Risk-adjusted metrics are critical
I find this is probably the most ignored element when it comes to retail investors. Whether it be your individual portfolio or actively managed funds.
Are the levels of returns achieved by the fund worth the risk the fund is taking on?
Risk-adjusted returns are utilized by investors and fund managers to decide whether or not the returns they’re getting are worth the risk exposure.
On a surface level, a fund that has put up a 30% annual return over the last 5 years seems like a slam dunk. However, there is a possibility when we look toward the risk-adjusted returns, that being returns that figure out how much volatility your capital is going to experience when invested in the fund, could be much lower than that.
There are two key risk ratios you can utilize when looking to actively managed funds:
The Sharpe Ratio
The Sharpe Ratio measures how much extra return an investment gives you for the risk you’re taking. It tells you whether a portfolio’s returns are worth the volatility. In the simplest way possible, it answers:
“Am I being fairly rewarded for the ups and downs I’m enduring?”
Generally, a reasonable Sharpe ratio is going to vary from 0.6-1. Anything over and above 1 means the fund is providing exceptional returns relative to the risk it is taking on. It is rare to see funds with a Sharpe that high. ZLB currently maintains a 5-year Sharpe ratio of 1.1, and this is one of the better ones I could track down among actively managed Canadian funds.
Annualized Standard Deviation
This metric is sometimes confusing to investors, but it is a simple one that you might find yourself looking at frequently once you get used to it.
This takes the monthly returns of an investment over the course of a year and measures the spread among those returns. So, a fund with a higher annualized standard deviation will have more volatility than one with a lower standard deviation.
Let’s look at the same two funds I spoke about above, ZLB and HBGD.
ZLB has returned 14.5% annually over the last 5 years with an 11% standard deviation. In the simplest explanation possible, this means the fund should return either 11% below or above its normal returns. In this instance, 3.5% on the downside and 25.5% on the upside.
HBGD has an impressive 30% annual return over the last 5 years. However, its standard deviation is a whopping 45%. This means that on the downside, one could potentially realize -15% annual returns, and on the upside, 75% returns.
A lot of investors simply look to the beta of an investment to judge the overall volatility. However, over the long term, the Sharpe ratio and standard deviation can give you a better idea of the swings you will realize owning a fund.
The longer the fund has been around, the more accurate these numbers will be. But, most data aggregation websites will have these numbers available to you for free. So, utilize them whenever you can.
Overall, most actively managed funds won’t be worth your time
I have a hard-set rule for actively managed funds. If they haven’t proven to me they can outperform most standard benchmarks over the duration of multiple years, I won’t give them the time of day, except for the very rare instance that a management team is brought in from a former fund that did quite well.
Investing in an actively managed fund on the basis of their strategy and story is like hiring an employee for a specific role in your company without first looking at their resume. I doubt any business owner would ever do that, so why invest your capital into a largely unproven fund, one that is no doubt going to charge you higher fees for its “active” nature.
Don’t get drawn into the high yields, the “explosive” growth potential, or the theme of the ETF being the “next best thing.” There are plenty of actively managed funds on the market with a decade or longer of history to review where you can make the logical conclusion as to whether or not they will continue to drive strong returns moving forward. There’s simply no need to speculate that a newer fund will earn you more money than a broad-based index fund.
Wait until an actively managed fund can prove it.
