By guest contributor Angus Coote, Director, Jamison Coote Bonds
The growth in passive funds management is staggering with nearly 16 billion dollars forecast to flow into Exchange Traded Funds (ETF’s) this year alone.
Most ETFs are designed to replicate a particular pre-defined trading strategy and have no human investment intervention once initiated. They are a great investment tool if you are looking for low cost product with a favoured strategy looking to capture a long term trading trend. They are a set and forget tool that should reflect the exact movement of markets thereafter, be that positive, negative or sideways. Generally, to benefit a marketplace will require significantly broad range for this strategy to run its course, and hopefully over time capture a large market movement. However, in the current volatile but low yielding environment, these passive investment strategies face significant challenges.
The major drawback for passive vs active strategies is the inability to capture the opportunity set presented by market volatility. Over the course of February, on a monthly close on close basis, 10 year Australian Government bonds look to be broadly unchanged in price (interest rate risk) opening at 2.44% vs current 2.42%. However, the trading opportunity set for active managers has been immense. 10 year Government bonds yields have enjoyed peak to trough moves of over 64 basis points. After opening at a yield of 2.44%, they rallied to a low of 2.28% after surprise RBA cut early in the month, sold off thereafter on stronger oil prices (deemed inflationary) to touch 2.60% before rallying back to 2.42% at time of writing on weak Australian CAPEX data. A good active manager should be able to smooth these moves to attain better investment outcomes for clients by actively adjusting portfolio interest rate risk to help capture the gains and conversely insulate the losses.
Secondly, an active manager can make a professional judgement on other risks presented at any one time in the market such as credit risk, evidenced over February in Queensland Treasury Corporation Bonds. After the Newman Government failed to be returned to power in the Queensland State election, planned State owned assets sales (helping reduce QLD debt) have been derailed. As such, the risk of Queensland backed Bonds has increased significantly as the debt burden will not be reduced as market had expected and consequently the bonds have moved 10 basis points wider (lower prices).
In the current volatile environment these types of moves are occurring with more frequency. With an ETF you have limited flexibility to adjust to changing market dynamics(be they good, bad or indifferent) and run fully exposed to the risks of the markets at all times. Good active management reduces risk at times when portfolios may be susceptible to losses, and allows portfolios to gain optionality over the opportunity set as it unfolds.
Fees are higher in an actively managed portfolio but an active manager has the advantage of accessing the movements and risk of markets and responding in a considered manner. With an actively managed fund your manager will be able to take advantage of market situations and mispricing’s and implement various trading strategies to ideally improve performance.
To date in 2015, 19 Global Central Banks have cut or intervened in their various interest rate or currency markets. Each intervention has knock on effects changing relative valuations across global markets. Bond ETFs will blow with the wind in this environment being fully exposed to the whim of policy intervention.
In a clear upward trending market ETFs are a good investment simply for the reason that the rising tide lifts all boats. Many would argue that markets do not have clear direction at the present time and simply locking your money into tracking an index with low returns and little absolute direction seems unwise. Active management is key to squeezing out the best from your investment in a low yielding and uncertain environment.