The real source of alpha – stock picking or ETF selection?

There was an article in the FT recently by the journalist Dave Baxter that caught my attention, “Passive ETFs are cheap, but stockpickers cannot be ignored”. What really jumped out was the comments by the FT's readers at the end of the article. It seems gone are the days when one could make loose claims about the merits of stockpicking and get away it.

Don't let me mislead you here, I'm a fan of Terry Smith, who is quite possibly the UK's most lauded fund manager and yes, he is a stockpicker, but as I read through the article, I was reminded of a recent podcast that I participated in with Jeff Prestridge, Personal Finance Editor at Mail on Sunday and The Daily Mail. Jeff has been offering his insights about the fund industry for over 25 years, and when he tells you that he thinks the ETF industry does a very poor job in making their products appealing to the end investor, it’s worth paying attention.

Judging by Dave Baxter’s article it seems he hasn’t entirely been sold on the appeal of ETFs either, so what is it that’s been missing from that narrative? The most likely answer is that for many commentators the idea of being able to select stocks to outperform the index is so compelling that every other aspect of building a robust portfolio barely gets a look in.

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For example, if you are an investor that wants to have exposure to UK equities, then all you need to do is select one or more stocks from the FTSE 100 Index every quarter that are in the upper half of the league table then you have outperformed the benchmark.  What could be more alluring than that simply stated goal? Accepting one might want to manage your risk, then before long the idea of a multi-asset portfolio will be your next goal. Which asset classes, gold, high yield bonds, corporate, government bonds? In fact, that list of questions then gets followed by more detailed questions, European or US bonds?

Need we say more. Selecting which asset and sub-asset classes to use in your portfolio will account for the lion’s share of your future performance. Having decided on your asset allocation models, don’t forget to decide if you want to use ETFs or active funds. That’s a lot of ETFs and funds to research and to select. And don’t forget that in the US, many active funds have been converted to an ETF structure, making the ETF vs. active funds debate obsolete.

All of this has taken us away from the not so simple truth that selecting which ETFs to use in a multi-asset portfolio is akin to stock picking and probably accounts for most of the portfolio’s return. If the ETF issuers want to improve the appeal of their products to the end investor, they need to sell the story that an ETF selection process has a lot in common with stock picking but with one important bonus feature. That is, should you wish to keep your diversified ETF portfolio unchanged, 99 times out of 100 it will still do what it said on the tin.

Given that stock picking can be fun, the challenge is to sell the message to the next generation of investors that ETF selection, and their associated risk premiums, is central to the process of delivering outperformance. Add this to the growth of themed ETFs and very quickly the ‘battleship grey’ perception of ETFs turns into a brightly coloured kaleidoscope. The investment ideas that are now available via ETFs is truly remarkable, with something available for everyone, and that is the story that needs to be told.

Until next time.

Allan Lane

CEO & Co-Founder

Algo-Chain

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