ETF investors who follow passive indices could be making active investment choices without realising the performance impact, according to an analysis by Zenith.
In the year to August 2018, the market capitalisation of ETFs in Australia surged 34 per cent to $41 billion. Zenith found that behind the strong growth in ETFs has been a sharp increase in the number of ETFs that follow increasingly tailored indices, rather than a broad market index such as the S&P/ASX 300 Index.
There are now over 90 unique equity-based indices available through ASX-listed ETFs that pursue a wide range of sectors and thematics.
Traditional industry sectors such as financials, healthcare and resources have progressively been joined by more niche exposures such as battery technology, artificial intelligence and agriculture.
“There is a paradox at play. ETFs and other index-based funds have traditionally been labelled as passive investing,” Dugald Higgins, head of Property and Listed Strategies at Zenith said.
“However, we believe that any decision to concentrate exposure to a narrower group of stocks rather than the broad market index, should be viewed as an active choice.”
In addition, ‘Smart Beta’ indices that use a rules-based processes rather than market capitalisation are also seeing strong growth.
Zenith compared the yearly performance of the broad S&P/ASX 300 Index over 16 years with 13 sub-set ASX Indices based on a variety of industry sectors and market capitalisation sleeves. The analysis showed a wide dispersion of returns particularly in the shorter time horizons.
The report also found that over a longer period, what becomes more apparent is the cyclicality of performance where segments show periods of outperformance followed by underperformance, relative to the broad asset class.
Narrowing this analysis to individual ETFs on the ASX, Zenith noted that the results also visibly support this outcome.
Higgins added that the high dispersion of results relative to broader market ETFs, both positive and negative, means that investors need to be discerning and disciplined in their investment choices.
“What our research shows is that the pursuit of a more discrete index can certainly have merit. However, the outcomes compared to that achieved by broader exposures are highly variable,” said Higgins.
“Success is likely to be underpinned by a robust index selection process that matches the investors’ requirements, and using an appropriate investment horizon that allows the cyclical nature of returns relative to that of broader index-based ETFs to play out.”
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