Two takes on the growing list of exchange-traded products

Note: This episode was filmed using Zoom on the 22nd of July 2021. Click on the video below to watch the video or read an edited transcript below.

Edited Transcript

Bella Kidman: Welcome to this thematic discussion brought to you by Livewire markets. My name is Bella Kidman and today we will be putting the age-old active versus passive debate to rest. As a wise old El Paso ad once said, 'Porque no los dos?' Or why not both? But it's probably not as simple as choosing whether to have a soft or a hard taco. So to get to the bottom of it today, I'm joined by Chris Brycki from Stockspot and James Whelan from VFS Group to discuss their thoughts on incorporating active and passive into your portfolio, as well as what you should be considering depending on your stage of life.

James, I'll start with you. Passive ETFs, they've become very popular. They've got low fees, they're often low maintenance, they're a great way to get your foot into the old investing door. But there are of course active ETFs and LICs, which have strong records. So is it a case of sticking to one or should investors be blending both in their portfolios?

James Whelan: As much as a diversified portfolio should be diversified in stocks, you should absolutely be diversified in the type of ETF and also in your passive versus active. As a general rule, you'd want to have your passive ETFs being the core part of your portfolio and the active side maybe on things that you think are going to run or are going to be hot at certain times, and also based on your risk profile too. So a good blend is absolutely the way to go.

Bella Kidman: Chris, same question to you. Is it important to have both active and passive and potentially even LICs in your portfolio, or do you think one does the whole job?

Chris Brycki: Well Bella, I'll take the other side and say I think these days, the evidence pretty conclusively shows that there really isn't any reason you need active in your portfolio for the simple reason that any excess return that your active managers earn over the benchmark is generally paid away in costs because competition is really high.

Some active managers absolutely do well for a period of time, but unfortunately, that period of time is often fleeting and quite style dependent, which is quite hard to predict, and survivorship over the long run is very, very low. So I think if you do want active, the ETMF structure is certainly a better structure because it means that you're actually going to get the tangible assets more closely reflected and get what you pay for. 

LICs are only really useful in a few circumstances, I think, where they're investing into illiquid assets or private assets where they can't really be aided by that redemption and creation process that ETFs allow you to have, and where it is actually appropriate for the investors to be determining the price.

Bella Kidman: So taking that into consideration, when would you say it's best to use an active ETF versus a passive ETF, and what's the reason that you would choose one over the other?

James Whelan: I think that there are different times, different places for when you'd want to be doing that, and it depends on where you're going. So right now, say for example you want to be in different parts of the world. Right now, I think that having a passive ETF is probably not the best way to go about it. In times of high inflation, markets have a tendency to travel sideways or to dip down a bit, especially if inflation starts to pop out, and inflation really is getting talked about a lot. So maybe you don't want to be sitting in a passive ETF unless you're really okay with going sideways and hugging that index and that's fine. 

For the next quarter, it is going to be the age of the picker and making sure that you're in the right geography and you're making sure that you're in the right theme. And so now is the time probably to be switching away from your passive and having a look at some of your active and making sure that they're in the right places.

Bella Kidman: Chris, the two obviously serve quite separate purposes, they've got different benefits, so when is it best to use an active ETF versus a passive ETF and vice versa?

Chris Brycki: Well, I think it's actually a bit of a furphy that active managers do better in different environments. It's been widely studied and really there's no evidence that active managers do better in up markets, in sideways markets, in down markets, in high inflation environments, in low inflation environments. To be honest, 2020 was a perfect example of where active managers should have done well because ultimately, the skill of an active manager should have been able to predict what was going to happen and to get ahead of it. But really, if you look at the performance of active managers in 2020 when the market crashed 35%, they didn't do any better than an index ETF.

Similarly, in previous market drawdowns - 2008, the 2000 tech wreck, 1987 - there's actually no evidence that active management did any better. So market timing, although it's nice to think you could do it in hindsight is actually really difficult, and active management doesn't actually give you the ability to do that. And so it's actually much safer to own the index rather than rely on active managers because you know over the long run, the drag of their cost is going to pull you back. And the truth be told, they're not going to give you a better result in different environments.

Bella Kidman: All right, James, I'm going to add another piece to the puzzle. Let's talk about LICs, listed investment companies. Now, the million-dollar question that I would like to know is what is the difference between a LIC and an active ETF?

James Whelan: Okay. So an active ETF, you just have the basket of shares, the basket of holdings that sit underneath it, so you buy and sell it on the market. With the LIC, you're actually buying the company that actually manages those holdings. That's the biggest difference in that one. I'm sure Chris will be able to go to the details of the actual tax benefits and the ups and downs on that one, but for the average punter that's looking at this, that's really the difference between the two.

Bella Kidman: Chris, there's word on the street that LICs are becoming a bit outdated. A lot of fund managers are establishing these managed ETFs, managed funds rather than LICs, so what would you say the main differences are and do you think investors should be gravitating towards one or the other?

Chris Brycki: I think, Bella, there's good reason that a lot of LICs are considering switching into that ETMF structure, so the Exchange-Traded Managed Fund. You said LICs are a bit outdated. I would say LICs are the equivalent of the horse and carriage of investing in Australia. So you might get to your destination, but you're going to get there very slowly, they'll probably break down a few times along the way, they're pretty inconsistent, pretty unpredictable, and we saw this last year. I mean, LICs, with these fantastic, experienced management teams, underperformed the market in a year that they could have outshone. So the ETMF structure is actually very beneficial for the end investor compared to LICs in a few ways.

There are the tax benefits that are a bit complex but are around the structure of the fund, and the other side is really that an ETMF will always trade very close to their NTA. And this is a pretty important one if you're an investor because if you invest in a LIC, it becomes permanent capital for that fund manager, and if they perform well or perform badly, it doesn't matter, they get to keep that money. And the reason why a lot of LICs trade at a big discount to their NTA is that investors no longer think that that manager has any ability to beat the index that they're trying to outperform, and so that discount reflects the present value of future fees. And so basically investors are saying, look, this is just like an index fund. Why am I paying 100 basis points when I can pay 10? So I'm going to discount the future value of fees that this fund manager is going to pull out of this structure.

So there's a big motivation from an investor perspective to have that structure converted because you actually realise the difference between what it's trading at on the market versus the NTA. Unfortunately, there's the opposite motivation for the fund manager because the fund manager wants that permanent capital, and they don't want to lose it from investors that no longer believe in their ability. So what we've seen over the last 10 years is obviously ETFs grow exponentially but LICs basically plateau and go sideways, and this is because there are very few of them that have been able to outperform, investors are growing sick of this, growing sick of not being able to realise their money at fair value, and I think a lot of managers are now under pressure and duress from their investors to convert the structure, but they're quite resistant and reluctant because they know that means they're probably going to have less money to manage. 

And this happened recently when Monash converted their LIC into an ETMF. Instantly, there's a lot of redemptions because people just want out. So I think from an investor perspective, you should be lobbying your LIC if it's trading at a discount to be converting, but sitting in the seat of the fund manager, I can understand why they don't want that to happen because that's a lot of fees they're going to miss out on every year.

Bella Kidman: Okay. So we know that no two investors are the same, so let's look at investing with an age spectrum here. So we'll start on the younger end of the investing spectrum. How would you, James, recommend younger investors incorporate active and passive funds into their portfolios?

James Whelan: I would say that the average younger investor probably needs to stay away from LICs. You don't need that fee hit from your portfolio coming out and eating away at your performance. So stick with your ETFs. If you like the actives, there's some amazing active ETFs that are on the market, that you can see that a super transparent, that you'd be able to see exactly what they're holding and where they're holding. And in fact, if you want to have a little bit of a cheat, go to some of the ETFs that are doing well that are in the place that you want to be involved in, take out the top 10 and maybe just buy those 10 stocks really cheaply on your cheap app if you can and then save on the brokerage fees there completely.

Bella Kidman: So then how would you compare that to maybe a more risk-averse, older investor, perhaps looking for a bit of income? How should they be incorporating ETFs into their portfolio?

James Whelan: So that's when you start to shift to the left side of the risk-reward spectrum. So the left side being your cash and your bonds and your yielders and then the other side over to the right, in my head, I've got it as being your higher risk, growth side of things. Right now, especially if you're moving towards your superannuation or pension stage, you want to be having some cash coming in and you want it to be on the cheap, not really eating way too much and so you shift to the left. That's where your good yielders are coming in and you want to have, and this is an important one, looking at the timing of the payouts - the distributions and the dividends that come out of some of these ETFs too. So you want to be having a good mix. Maybe semi-annually if annual payouts aren't really for you. You want a mix of quarterly and there's ETFs that do a really good monthly payout so that you've got a good residual income starting to come into your account.

Bella Kidman: Chris, same question to you. The youngins, they like a little bit of risk, they want some return. Where should they be looking? Is it a case of sticking all passive or should they be incorporating a little bit of active in there? What direction are you giving them?

Chris Brycki: I think for young people, Bella, what we know about the market is about 4-7% of stocks drive all of the market return. And then out of the rest of the stocks, generally, they don't do very well. They either go sideways or fall. Actually, research has shown about 70% of stocks have catastrophic performance over their lifetimes and so people don't really understand the statistics of that and think that if you just buy a handful of stocks, 10 stocks, you're likely to do well. I would say for a young person, that is the absolute worst thing you could do because your chance of actually ending up with one of those 4-7% of stocks is very low and your chance of keeping it and holding onto it is also very low because people tend to sell their winners and anchor to keeping their losers, and you'll probably be behaviorally stuck in the wrong mind frame.

So for a young person, I don't think picking stocks is the right idea. I absolutely think that buying some diversified ETFs makes a lot of sense because you're guaranteed to always be owning those winners, and you'll enjoy the benefits of compound growth over time. I actually don't think that risk tolerance drives whether you should be buying active or passive. I don't think it has any impact at all, just as I would say that it's not really healthy to smoke, whether you're young and have a lot of risk capacity or whether you're old. It's unhealthy regardless of your age. Age doesn't determine the health benefits of smoking. So what I would say is your risk capacity, your investment horizon, these all determine what is the right mix of assets in your portfolio, which is what James has alluded to as well. But those mix of assets can all be constructed using low-cost funds. And regardless of whether you're 20 or whether you're 80, low-cost funds are the best way to do it.

Bella Kidman: Chris, time to shine. Can you give me one active fund and one passive fund that you'd recommend for the portfolio?

Chris Brycki: Well, Bella, it probably won't surprise you that I don't have any active ETF that I would recommend. Picking an active ETF to me is like being asked to pick the number that I think will come up on a roulette table. I think I would rather just not play roulette because I'd rather be the casino. So on the passive side though, what I would say is one that we have recommended to clients for the last seven years is the iShares Global 100 ETF (ASX:IOO), and it basically, as the label suggests, it gives you exposure to the largest 100 companies in the world.

And I think most people don't actually appreciate that that exposure has beaten a lot of the best-regarded and most well-known active funds over the last five years, including the likes of the Magellans and Platinum. So keeping things simple, keeping your fees low in the top 100 stocks in the world is actually a great way of getting global exposure.

Bella Kidman: Okay, James, your turn in the hot seat. Hopefully, you can give us an active and a passive. What are your picks?

James Whelan: Yeah, no amazing things that are going on. So the passive one I'll go with first for you, Bella, (ASX:VEQ) Vanguard European ETF. It's super cheap, I think it's only about eight basis points. They're investing in the European market, just tracks that European index and they track it quite well. For a basic premise that you're looking at, the European market trades at about a 20 times price to earnings ratio. Price to earnings isn't everything but if you want to pick a gauge, then that's a gauge. Europe also doesn't have the whole inflation issue, 'is it, isn't it? What's the fed going to do?' situation there. I think that inflation in Europe is going to be a nice, easy-listening sort of way that it's going to go up. I also think that Europe has a longer way to recover from where they were from COVID-19. 

So some of the names that are in there, Louis Vuitton, Siemens, Nestlé, some of the biggest companies in the world, so there's some big names in there and some really good ones that are in the recovery phase. Also in the food industry and also in the tech sector too, so Europe is a really good diversified ETF to be in.

For actives, little something special that I've got here that I've been in for a while, WCM Quality Global Growth Fund (ASX:WCMQ). They're a good active manager. They've got a different way of looking at it and they're there in quality, so the move to quality through the back half of the year is definitely going to be a trend that will continue and we've done quite well out of it so far. So have a look at this one. What they do is they find companies with a moat and really good barriers to entry, so what's your moat? But then they also overlay that with, we're going in depth with the culture of the company and does the company have the culture to maintain that moat? And for me, that's really innovative that that is there. If we talk about performance, they've also outperformed, inclusive of fees, the market and their benchmark every single year, and they go all the way back.

Bella Kidman: Well, there are benefits to passive and James thinks there are benefits to active, but it may pay off to consider both for your portfolio. When in doubt, 'porque no los dos?'

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