What You Need Might Cost More Than Three Basis Points

A different view on the active/passive debate.

Justin Castelli tweeted the following;

Discussing the modern index: @MebFaber suggest anything not market-weighted is active. I’d have to agree with that statement. A great conversation regarding the confusion that has been created by the terminology of active vs. passive.

I replied;

Not why sure active/passive matters; 1) Does it help client get to where they need to be? 2) Does the fund do what it is supposed to? 3) Is the pricing reasonable for the exposure offered? 4) How much does it overlap or not over lap w/other holdings?

Justin said it was about fees which I can partly agree with but want to dig in a little more. I believe that exposure offered under the hood is at the very least, just as important as the fees, I would argue more so. Consider the following chart;

It tracks the Invesco FTSE RAFI US 1000 ETF (PRF) against the S&P 500 since the fund's inception. PRF charges 0.39% and I think the cheapest S&P 500 ETFs or various 1000 index funds charge three or four basis points. PRF has not outperformed at every turn, no strategy can but over time the strategy has demonstrated there's at least a couple of things working right (performance is obviously net of fees). Here is another chart comparing the AdvisorShares Dorsey Wright ADR ETF (AADR) versus the iShares MSCI All Country ex-US ETF (ACWX) going back three years which is how long I believe Dorsey Wright has managed the fund.

AADR charges 0.89% (that is a recent fee reduction) versus 0.32% for ACWX. AADR is a momentum fund, it has not always outperformed but obviously has outperformed the vast majority of the time. I know the fund manager very well from my stint at AdvisorShares and one time he mentioned that the strategy might lag for a bit when the market cycle transitions from bear to bull. That hasn't occurred in the time DW has managed the fund so we'll see if that is what happens but has AADR earned the extra 57 basis points? Hard to argue it hasn't.

The flaw in my argument thus far is that you can't know what a fund will do going forward. As an advisor or do it yourselfer you can only assess the merits of the strategy, look at past performance not to guess about future performance but to see if it did what the fund provider said it was intended to do. Like, was a low volatility fund in fact less volatile? Nothing can always be the best performer, the two charts prove that is true of market cap weighting. Cap weighting is not bad, it is like just about every strategy, it will be the best at times and far from the best at other times like most of the 2000's.

A slightly different example now with more specialized funds. If someone has a huge position in company stock, say they work for Pfizer (PFE) and half their liquid net worth is in it (sometimes there are various share awards and compensation that can't be diversified until some sort of milestone is reached). The ProShares S&P 500 Ex-Healthcare (SPXV) becomes an attractive choice for diversification purposes. That fund costs 0.27% which is probably worth it as the last thing this person with the PFE needs is more healthcare/PFE exposure. Another option would of course be to build a portfolio with narrow exposures that avoids healthcare, this would be my preference, but is unlikely to be as cheap at three or four basis points like the cheapest 500 or 1000 index ETF.

I made a mention above in passing to low volatility ETFs. Clients/do it yourseflers have all sorts of things they can or cannot tolerate or other circumstances that need to be addressed and managed to give them a reasonable chance of getting to where they need to be. Often that is going to cost more than three or four basis points.

I will circle back to my tweet; does it help the client get to where they need to be, does it do what it is supposed to do, is the pricing reasonable, how much does it overlap or not overlap with other holdings.

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