They are unbeatably cheap and broadly diversified: ETFs have become an integral part of equity investment. Active fund management, on the other hand, is considered outdated and too expensive. However, there are good reasons why active investing can be worthwhile again. This article aims to shed light on these reasons.

Revolution: ETFs conquer the financial markets

Advantages of ETFs

The history of classic equity funds dates back to the beginning of the 19th century (1924), when the first investment funds were created in the USA. Initially, active investment funds, which are managed by fund managers as part of a fixed investment strategy, were particularly popular. A distinction is made between open-ended (freely marketable, without a time frame) and closed-ended (limited shareholders and predefined terms) funds. In 1971, the world's first index fund ‘Samsonite Pension Fund’ was launched, which consisted of 1500 shares listed on the New York Stock Exchange. The idea of such a basket of shares was to invest in a broadly diversified manner and thus minimise risks. Its successors include the S&P 500, Dow Jones and the German DAX share index that we know today.

A new chapter began with the emergence of exchange-traded funds (ETFs) in the 1990s. ETFs quickly became very popular due to their low costs, liquidity and transparency. They also offer a tax advantage depending on the region. They therefore offer significant added value compared to traditional active (open-ended) funds, which are comparatively expensive, non-transparent and less liquid (Figure 1).

Advantages of ETFs compared to traditional active funds

Rapid growth

Since the 2008/09 financial crisis, ETFs have recorded almost continuous inflows of funds. Estimates of the market share of ETFs vary widely in some cases. Morningstar estimates this at 38% in 2022, while Bloomberg even puts it at just under 50%. ETFs are already clearly ahead when it comes to new fund launches. According to Morningstar, 70% of new fund launches in 2022 were ETFs (Figure 2).

New fund launches in the USA: ETFs vs. active funds (mutual funds)

It is not only the advantages of ETFs that have contributed to this success story, but also the scepticism towards active funds and traditional financial institutions. The main point: trust. Customers now know that many banks and bank advisors take a commission for active funds sold. The financial incentive for advisors is therefore to sell the funds that generate the most commission and not those that suit clients and their needs.

According to a study by EY, only 25% of Germans still consider the banking and insurance industry to be ‘somewhat or very trustworthy’. As many as 31% rate the industry as ‘explicitly not at all’ or ‘rather not trustworthy’. This is why online sources or Friends & Family are now preferred to bank advisors. There are also numerous studies that prove this: On average, active fund managers are not worth the money, i.e. they do not create any added value compared to the index. The main reason: the high costs. The logical conclusion and frequent recommendation is therefore rightly: reduce costs and invest broadly in the overall market, i.e. ETFs! But which ones?

ETFs: spoilt for choice

With the success of ETFs, more and more providers are pouring into the market vying for investors' money. According to Statista, the number of ETFs has risen from 276 in 2003 to 8754 in 2022 (Figure 3). The choice is huge and difficult, as there are many different investment strategies. In addition, there are numerous ETFs that track the same index. For example, there are over 100 ETFs that track the S&P 500. Sometimes even several from the same provider. The same applies to the well-known MSCI World.

Number of ETFs from 2003 to 2022

This quickly makes it clear that simply recommending ETFs is not enough. Although ETFs solve the cost problem because they are significantly cheaper than active funds, the huge selection means that investors are faced with an active investment decision that applies equally to ETFs and active funds: What do I invest in? In which regions? In which sectors? Large or small companies? And if it is to be as broadly diversified as possible, then with what weighting?

The answer to this question is initially a philosophical one, as nobody knows which regions of the world or which sectors will perform particularly well in the future. Empirical studies from the past can help with decision-making, but firstly the past cannot be extrapolated 1:1 to the future and secondly the empirical result varies depending on the period being analysed. For example, Fama and French are known for their academic research that shows that various factors have historically generated excess returns. All this empiricism has been of little use over the past 15 years, because one of the factors - the value factor, according to which favourable companies generate added value - has performed significantly worse than the market as a whole. The same applies to small companies (small caps) in the current market environment. In the past few years, ETFs with a value or small-cap bias in terms of sector and country weightings would have been at a disadvantage.

But even if the future cannot be predicted, investors should at least know what a particular product is investing in in order to be aware of the potential opportunities and risks arising from this allocation. So before you decide to consciously take on certain cluster risks or try to avoid them, you first have to recognise them.

‘No-brainer’ ETFs with risks

All-rounder MSCI World

The MSCI World is familiar to many and is often regarded as an all-rounder or even a ‘no-brainer’ when it comes to investing, because - as its name suggests - it covers the entire world and is therefore extremely diversified. It has also outperformed pretty much all other indices in the recent past. However, the classic version of the MSCI World does not invest in the whole world, but only in industrialised countries and completely excludes emerging markets such as China or India. It also only invests in large companies. If emerging markets or small companies perform better, the investor in an MSCI World ETF hardly participates in this.

Procyclical weighting method

In addition to the stock selection, one thing in particular has a major influence: the weighting method of these stocks. In the classic version of the MSCI World and almost all other well-known indices, companies and countries are weighted according to market capitalisation, i.e. the current stock market value. The companies with a higher absolute value therefore receive more of an ETF saver's capital than those with a lower value. This is a systematic approach that develops dynamically with the performance of the shares invested in. If a company increases in value, its weighting in the ETF also increases. This can lead to cluster risks. Large and/or historically successful stocks always receive more money than small and/or less successful stocks when new investments are made in these indices due to their higher weighting.

High cluster risks with classic stocks

The MSCI World is a prime example of such a cluster risk. Since the financial crisis, the USA has been the best performing stock market among the industrialised nations. Due to years of outperformance and the resulting rise in the value of equities, US stocks are weighted at over 70% in the MSCI World (Figure 4), while the US share of global GDP is just 25%.

Sector and country weighting MSCI World

For example, if you invest €10,000 in the MSCI World, you are investing almost €7,000 in the USA and almost €1,000 in Apple and Microsoft alone. Although the quality of the two companies is undisputed, there can hardly be any talk of global diversification here. If you look at the MSCI USA index with 610 American companies, the largest 5 companies make up over 20% of the index (Figure 5). Such a cluster weighting is a historical peculiarity and is strongly reminiscent of the dotcom bubble in 2000. If an equal-weight version of the index is chosen instead, in which companies are weighted equally rather than according to market capitalisation, then the weighting of these five companies should only be 0.3% instead of 20%.

Weight of the top 5 in the MSCI USA Index at an extreme level

Although - or precisely because - this is currently almost inconceivable, it should not be forgotten that the US equity market is not invulnerable either. Historically, there have been phases in which US equities have significantly underperformed the market and, consequently, the MSCI World is no panacea either. A few decades ago, active fund managers even explicitly chose the MSCI World as a benchmark because it was easy to beat. Times have changed and there is a good chance that times will change again in the future. 

Therefore, in my opinion, one should not be too optimistic about American equities for the next 10 years, given the current high valuation and weighting. The same applies to ETFs in which US stocks are prominently represented, such as the MSCI World. Long-term investors in particular would therefore do well to diversify geographically and at sector and company level.

The crucial question: active or passive?

One thing is clear above all: the introduction of ETFs was a blessing for the democratisation of equity investments and offers enormous advantages. And because a large proportion of assets are still invested in traditional funds, there will continue to be an influx towards ETFs. However, it is also clear that the success of ETFs and the resulting wide range of products on offer is presenting investors with decision-making problems. In the beginning, there was little choice, so the recommendation could simply be: get out of active funds and into (one of the few) ETFs. Today there are so many ETFs that there are providers whose sole task is to maintain and constantly update an ETF database.

Which ETF(s) should you buy? Which region to overweight or underweight? Which sectors should be favoured? And on what basis should these decisions be made? Past performance? Pretty much everyone has to ask themselves these questions. Traditional ETF indices are not the right choice, especially for people with larger assets or a shorter investment horizon or low risk profile, because they fluctuate strongly with the market and - as already described - harbour undreamt-of cluster risks. In such cases, ETFs that can be actively managed according to the investor's needs - so-called active ETFs - are the right choice.

Demand from European investors for active ETFs

The demand for such active ETF products is increasing, as shown by a survey conducted by PwC in 2023: 91% of the European investors surveyed expect the market for active ETFs to grow (Figure 6). The financial sector recognises these needs and is launching more and more such products on the market. In principle, they are nothing more than traditional active funds that are cheaper, more liquid and more transparent than their counterparts from the past. Active ETFs have to be managed just like active funds and do not simply track the corresponding index like passive ETFs.

In very black and white terms, this means that we are slowly moving back to where we came from: Towards active funds. This may sound regressive, but it is not a bad development per se, because the costs of active funds are the main reason why active managers do not beat their benchmarks. And these costs (whether active funds or active ETFs) are now very close to the low costs of passive index ETFs.

Active investing: Swimming against the tide is a must

This opens up opportunities for courageous active fund managers who dare to be different. And ‘being different’ is a must, because even low-cost active funds/ETFs cannot be as cheap as the index ETF due to the higher personnel and management costs. In the past, many fund managers have not been brave enough and have orientated themselves strongly towards existing indices. In concrete terms, this means that a German fund manager, for example, has based his stock selection heavily on the DAX share index. This is not reprehensible, as there are clear incentives for fund managers to limit their risk and not swim against the tide.

It is human nature to join the group. That is why it is fundamentally more pleasant to be conventionally wrong (‘everyone did it that way’) than unconventionally right (‘lucky outlier’). In addition, there is an enormous job risk, because being slightly behind the benchmark - in this case the DAX - (if only because of the costs) normally leads neither to a dismissal nor to large outflows of funds. Unfortunately, such an active approach offers no added value for the client, who would be better off investing in a cheaper DAX ETF instead.

So basically, ETFs have done some educational work with investors, which should result in those who want to invest actively also explicitly looking out for very active fund managers and, as a result, fund managers becoming bolder to justify the higher costs. There is still a long way to go before this happens, as there are still vast numbers of active funds that closely resemble their benchmark index. On the positive side, this is another reason why courageous active managers can benefit and stand out from the crowd.

The perfect breeding ground for ETFs is cracking

All well and good, but in the recent past the index ETF classics have been exceptionally successful. So why should the MSCI World or Nasdaq, for example, suddenly perform worse again? 

In the years since the 2008/09 financial crisis, central banks around the world have pumped money into the system on a historic scale. In addition, interest rates have also been cut to historically unprecedented negative levels. It is hardly surprising that asset prices skyrocket in such an environment. Accordingly, the financial markets only knew one direction: upwards. It should come as little surprise that products that track rising markets 1:1 - namely ETFs - benefit the most from such an environment.

GMO Asset Allocation Opportunity at 35-year high

The stock market performance is impressive, but should not be allowed to dazzle. A ‘keep it up’ scenario for the next 5-10 years is not only unrealistic, but would be a historic first. The US fund management company GMO has analysed the valuation discrepancy between various asset classes and their expected returns. The gap is widening considerably, which represents an exceptional opportunity for active asset allocators (Figure 7). The economist Vincenz Glode finds in his study ‘Why mutual funds ’underperform’„ heraus, dass aktive Fonds insbesondere in wirtschaftlichen Schwächephasen brillieren, während sie in guten Phasen schlechter abschneiden als der Markt. Unter der Annahme, dass die nächsten Jahre holpriger werden als die letzten, wird die aktive Anlage – sei es klassisch oder über aktive ETFs – eine Renaissance erleben.

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