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Charlie Morris: ETFs leave alpha in their wake

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Few doubt that passive investment is a simple and cost effective way to match index performance. ETFs have enabled investors to move money more quickly to far away places that capture the imagination. In a world now overwhelmed by passive money, a raft of opportunities to generate alpha have been created and there are rich pickings for managers that can spot opportunities.

Too much indexation in a given area, can lead to stocks being over or under represented in the indices. For example, the Nikkei Index future trade with approximately 13 times more volume than the Topix future. The Nikkei, like the Dow, is price weighted, whereas the Topix is arithmetically weighted, which is considered the norm.

As Peter Tasker from Arcus points out, Fast Retailing, owner of fashion retailer Uniqlo (if you haven’t heard of it, your teenage children probably have), has a 9.2 per cent weight in the Nikkei simply because it has high price, yet just 0.45 per cent in the Topix. The huge flows into Nikkei ETFs in recent months have driven this stock up 182 per cent between last October and May; 100 per cent more than the index. On the flip side, Toyota has a 1.8 per cent weight in the Nikkei yet 5 per cent in the Topix, inferring that it may be underrepresented.

This sort of distortion is particularly rife in emerging markets where the large stocks benefit from the flows leaving the mid and small caps unloved.

‘Smart beta’ has been designed to take advantage of reoccurring anomalies. Examples include re-balancing; aiming to capture return from excess market volatility and fundamental bias; to steer an index towards value and avoid bubbles. Both of these strategies make good sense over the long term because the former keeps you invested in profitable businesses and the latter buys low and sells high; Simple yet effective.

However, the fastest growing area has been low volatility or variance indices that focus on ‘lower risk’ stocks. US low volatility ETFs gathered $11.4bn of assets at their peak, from a standing start in 2011. The broad thesis is that they own the stocks with the lowest historic volatility. The back tests are stellar, and whilst they failed to keep up during the dotcom era, their performance has been impressive, particularly during the market dips. That is until Bernanke first uttered the word ‘tapering’.

Stocks that have low price volatility have low earnings’ volatility which can come about in two ways.

The right way is demonstrated by steady growth stocks such as Coca Cola or Unilever. To use the S&P staples as a proxy, the annualised earnings growth has been 6.4 per cent since 2008 with no material dip even during the financial crisis. The other way, is to have stable earnings with no growth, and here I would cite the S&P utilities sector, where earnings have been broadly flat.

Whilst the first group are high quality growth stocks, the second are effectively bonds. Low volatility strategies have been dominated by sectors such as utilities, REITs and telecoms whereas their actively managed competitors have focused on staples and healthcare.

The ebullient algorithm that drove billions of dollars into these ‘bond like’ sectors caused overvaluation and what was seemingly low risk, soon became high risk.

While the index business has never been so creative, inevitably the smartest active managers will take advantage of the alpha they leave behind in their slip stream. The most excessive flows will lead to the greatest opportunities.

Charlie Morris is manager of the HSBC Wealth Opportunities Fund

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