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Have ETF Investors Gotten What They've Paid For?

Ben Johnson, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz for How can investors tell if a fund is a good value? Joining me to share some research on this topic is Ben Johnson. He is director of global ETF research with Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thank you for having me, Christine.

Benz: Ben, a lot of investors use expense ratios as a proxy for whether they are getting good value in an investment product. Another measure came along, it's been roughly a decade now ago, active share that some investors looked at to gauge whether a fund was taking active bets relative to its benchmark. Let's discuss active share because it's the starting point for some of this research that you've conducted in attempting to help investors figure out whether they are getting a good bang for their buck.

Johnson: Sure. So, what we know for certain about fees in particular is that they are perhaps the single most reliable predictor of a fund's future performance. That's a given. I think that's fairly widely known. When this active share concept was first introduced to the market by a pair of academics, Cremers and Petajisto, in their paper, they claimed that active share, like fund's fees, could be useful in predicting fund's future performance. Now, subsequently, that argument has been dismantled somewhat. It turns out that more than anything what it showed is that small-cap funds look a lot less like their index because there are 2,000 stocks in the Russell 2000, and a small cap portfolio manager might only have 50 stocks. So, there's a lot that sort of cause that argument to fray quite a bit, the predictive power of active share.

So, while this measure is not necessarily predictive, it is certainly descriptive. So, what active share does is it tells you exactly how active your portfolio manager is. It measures that manager's portfolio relative to an index, like the S&P 500, and it says, how much does that manager's portfolio look like that index's portfolio? Are there stocks in the manager's portfolio that aren't part of the index? If so, those would contribute positively to that manager's active share. Does the index have, say, 5% of its value in XYZ company and the manager has 10% in that same company? That overweight position would contribute positively to a manager's active share. So, it has a huge degree descriptive value and allows investors to assess how different from an index portfolio is my active manager? Are they truly active or are they so-called index-hugger?

Benz: And this is something worth looking at. You don't have to have an active manager jockeying among stocks to have this be something that might be useful for you. You actually went through some research in ETFInvestor where you looked at strategic beta ETFs and measured their active shares. So, even people who are using some sort of a strategic beta ETF can take advantage of active share to kind of gauge how different a fund looks from its benchmark.

Johnson: Absolutely. Active share in other like measures that might be more readily available to end investors, like tracking error relative to a given benchmark, again describe how active that strategy is, and indeed strategic beta ETFs, smart beta ETFs, factor funds are effectively active management. They are active management expressed in a different way from going out and kicking tires and looking under hoods and deciding which stocks or bonds to buy or sell or underweight or overweight, but they are a form of active management. So, it's equally useful in this setting to understand exactly how active is that strategy relative to a very ho-hum vanilla market capitalization weighted index or index fund.

Benz: OK. You created a metric that attempts to bring together expense ratios, which are obviously important along with active share, in an effort to help investors figure out, well, if I'm paying for some sort of an active strategy, am I getting my money's worth. Let's take a look at some of the examples. You mentioned that Schwab US Dividend Equity is a fund that looks good from the standpoint of, yes, some active bets but you are not overpaying for them to the extent that you are getting them.

Johnson: And that's important to understand. So, as I've termed it in my research, I call it the value for money proposition. Now, I've borrowed this concept from one of the co-authors of the original active share paper, professor Martijn Cremers, who is a professor at the University of Notre Dame. He subsequently went back and introduced on top of active share this concept of active fee. So, how much am I paying for the portion of a given portfolio that's actually actively managed because investors want to avoid paying active fees to funds that look for all intents and purposes a lot like index funds. You don't want to get price-gouged by an index-hugger.

So, I adapted this concept and created my "value for money" measure. So, it looks at active management or active risk relative to a passive fund in a given category. It takes the active piece of that fee and divides it by the active risks. So, I take the fee on, say, the Schwab US Dividend Equity ETF, I subtract from it the fee on the corresponding market cap-weighted ETF in its Morningstar category and divide that by the Schwab fund's tracking error relative to that vanilla index fund. Now, that ratio tells me what I'm getting in terms of value for money, what am I paying per unit, if you will, of active management. In the case of that particular ETF, you're getting an active bet for free, effectively. So, that's a very good value for money proposition.

Now, I should stress that this is strictly descriptive not prescriptive.

Benz: So, it may not hold true going forward.

Johnson: So, it may hold true, it will likely hold true going forward, but it is not a predictor of future performance. So, it's not to say that this fund is going to outperform that passive cap-weighted alternative. It's just saying it's a pretty good value. If you're going to make an active bet, you're not paying that much for it.

Benz: OK. On the flip side, you identified PowerShares FTSE RAFI US 1000 as a fund that has a less attractive value for money. Let's talk about that one.

Johnson: Yeah. So, the value for money proposition in the case of that fund, the ticker for which is PRF, is less compelling and that's twofold. On the one hand, it has a much higher fee relative to many of its comparable peers in its Morningstar category and then in the denominator of that equation, it's got a lower degree of tracking error. So, the level of active management, if you will, that is embedded in that particular strategy is less. So, when you divide one by the other, what you see is a value for money proposition that's far less compelling relative to what we saw with SCHD, which is the ticker for the Schwab fund that we discussed earlier.

Benz: So, I guess, there's another way to think about this that if a fund has a high expense ratio and isn't a lot different from its index, it has a headwind that it may not be able to overcome because it's not in its toolkit to overcome that high expense ratio?

Johnson: That's exactly right, Christine. So, it's a self-inflicted hurdle that's going to be difficult for that fund in all likelihood to surmount. So, investors should look at this, don't think that it's prescriptive. But if you see a situation such as you've just described, that should raise a red flag.

Benz: OK. Ben, interesting research. Thank you so much for being here to discuss it with us.

Johnson: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for