The exchange-traded-fund industry is being shaped by a new paradigm — not active vs. passive.
It was the image of dart-throwing monkeys that got me. I would like to think it was the analytics, the white papers or even the raw performance data of active managers over the years. But if I’m being honest, it was that image of active managers as dart-throwing monkeys that really hooked me.
I was in my early 20s and reading Burton Malkiel’s “Random Walk Down Wall Street” for the first time. The way Malkiel wrote about it, there was just something rebellious and cool about the index side of the index vs. active debate — so I became an index guy.
In the 15 years since then, we have continued to see index funds beating active funds by performance, and doing so at a fraction of the cost. So why I am rethinking everything? And how could it be that Vanguard was the firm that caused this introspection?
Here is what happened: In late 2017, Vanguard — the flag-bearer of index investing — filed to launch six active ETFs tracking alternative-weighting methodologies to provide exposure to single factors. While the funds will technically be actively managed, they are following systematic processes to provide rule-based exposure to those factors.
The Vanguard filing is the latest shift in the entire paradigm. What was once a simple argument to understand — market-cap-weighted index investing vs. secret-sauce active management — has now become far more complicated with dozens of shades of gray in between the two camps.
The only way I really can make sense of this change is to define it as a new paradigm: systematic investing vs. faith-based investing. Systematic investing includes classic market-cap-weighted index investing, but it also includes any number of transparent rule-based processes to provide broad market exposure.
Faith-based investing, in contrast, doesn’t require transparency; it requires trust in an active manager to provide alpha through a non-disclosed strategy. That could be picking stocks because of the firmness of the CEO’s handshake or the glint in his eye, it could be jumping into crypto-currencies because a manager’s gut says that Bitcoin has more room to run, or a manager telling you how an investment firm has incorporated AI and machine learning into its models yet is unable to elaborate on how the algorithm sources its positions.
Traditionally, index investing has been synonymous with market-cap weighting.
Some say that is for good reason — a company’s market capitalization is an accurate measure of its representation of the overall stock universe at that time. However, Oppenheimer has been making a convincing case that revenue is a better measure.
Pacer ETFs recently launched an ETF that weights companies by their free cash flow, and I can’t help but wonder if that is an even better representation.
Both revenue and free cash flow are far more stable metrics than market capitalization, and they represent actual financial results rather than the market’s hopes and dreams of such.
At Exponential ETFs, we have done extensive research showing that not only is market capitalization just another factor to consider for weighting an index, it is even a sub-optimal one. In fact, we have found that on a historical basis, based on back-tested data provided by S&P, weighting stocks by the reciprocal of market cap can provide systematic and repeatable alpha — so we launched the Reverse Cap Weighted U.S. Large Cap ETF.
RVRS is still an index fund, technically, and I am still an index guy if active management is the only other choice. But this new paradigm fits me better — I am a systematic guy. And Exponential ETFs runs systematic funds more so than classic “index” funds — moving in the same direction as Vanguard.
This article is from ThinkAdvisor. the original article can be viewed here.
