Exchange-traded funds (ETFs) have survived the stones being thrown at them and passed the coronavirus crisis with “flying colours”, according to Sparrows Capital’s Mark Northway, who said many of the pre-crisis arguments against passive investing no longer stand up. 
Northway (pictured), investment manager at wealth manager Sparrow Capital, said traditional portfolio management has been challenged by the Covid-19 crisis, given the rapid sell-off, an initial recovery and the greater uncertainty of its longer-term impact on markets.
“It’s been an interesting study as to how the active world has performed in this crisis, because for many years the argument – active vs passive – has been [summed up as] ‘oh, it’s been a rising market, but wait for the volatility [to hit passives]’.”
However, Northway – who uses passive funds and ETFs to build portfolios – said actively-managed portfolios have actually underperformed in the current crisis, which is "counterintuitive".
“If you think about a downward move [in markets], the only real decision that an active manager tends to be making at that point is taking risk off the table and that must slow down the decline in values and therefore it should be easy to outperform in a downturn,” he explained. “But, actually, we haven’t seen them do particularly well in the downturn.”
Northway said much of this could be explained by UK wealth managers’ home bias, which has been painful for investors given the way that the FTSE All Share and sterling have performed.
At the product level, however, ETFs have stood up to scrutiny in their first real crisis, the investment manager said.
“In the first 2008 crisis, there wasn’t enough in the ETFs to question what happens when everybody goes for the door at the same time,” said Northway. “But now what we’ve seen is, actually, the ETF has taken over to a large degree from index futures in terms of the way a trader will look to express a view. And I think that’s a validation of the ETF concept.”
While there were some pricing dislocations in markets during the March sell-off, said the Sparrows Capital investment manager, ETFs led on price-making – particularly in the fixed income space, where there had been serious concerns about the amount held in passive products before the crisis struck.
“ETFs have passed with flying colours but the thing you have to remember is that there are multiple users,” he noted. “They are used by investors, by traders, speculators, market participants: there’s a big catchment all sharing the same instrument.”
As a long-term investor, said Northway, pricing dislocations can be a benefit in more volatile market conditions, but that had not arisen during the current crisis.
“If equities are going down hard and an ETF is going down faster than it should be, the only trade that we’re going to make is a rebalance,” he explained. “We will be a buyer of the underperforming asset class. But we haven’t seen that.
“And I think that where there’s been an awful lot of wanting to throw stones at passives and wanting to say that they will underperform [in a crisis],” he added.
Ahead of the pandemic, there had been serious questions over whether the ETF industry had become too large for markets to function properly but this too has been resolved during the current crisis, said Sparrows Capital’s Northway. The investment manager said the ETF industry was growing naturally with inflows coming from regular savings rather than investors putting additional money to work.
“There isn’t any indication that the democratisation of investment through ETFs has actually hugely increased the amount of savings; the amount of savings is broadly consistent,” he said. “It’s just that less of it is going into active and, in fact, some has been pulled out of active and moved into ETFs.”
Nevertheless, the growing size of the global ETF and exchange-traded product (ETP) industry – estimated at around $6.3trn at the end of June by research and consultancy ETFGI – has continued to fuel concerns about the market functions and ‘peak passive’.
“Is there an amount where passive [strategies] are obviously a price-taker and active [management] is a price-making process?” asked Northway. “The more price-takers you have in the market, the more opportunities of price-making you have to take advantage of.”
Northway said there is an equilibrium where active and passive managers can both thrive.
“As the number approaches 100 per cent [passive], then the one-eyed man is king,” he said. “But there is definitely an equilibrium, we’re probably in the 30-40 per cent now and you can make an argument that there’s nothing wrong with 60 per cent in index-based, that gives an opportunity to the non-index [funds] to make some money.”
A bigger problem, said Northway, is that the number of active asset managers in the market “is way too high”, particularly as their costs are borne by investors.
“We are clearly years overdue for a sort of Darwinian rationalisation of the asset management market and it still defies logic that that doesn’t occur,” he said. “We are seeing consolidation but it’s slightly different because that increases barriers to entry and it’s maybe reducing some of the arguably more exciting and more value-adding smaller entrants.”
Investors also need to start thinking differently about ETFs and index funds and how they fit in their portfolio, said Northway, because they are anything but ‘passive’.
“We’ve used the word ‘passive’ a lot but we tend to avoid it, we talk about ‘evidence-based’ and ‘rules-based’ [investment] because we see ‘passive’ has a sort of zero-thinking connotation about it,” he finished. “We have a mantra which is ‘this is simple in concept and complex in execution and that’s why we exist'.”