Your investment portfolio represents a belief system, reflecting core values ingrained in you outside the realm of finance and far before you were eligible to participate in a 401k. This fact — that your deep-seated personal convictions are revealed in how you allocate a portfolio — is fascinating and, quite frankly, what draws me to financial markets; there is so much to learn about the human condition by observing investing and market behavior.
Typically, a discussion of the merits of utilizing exchange traded funds (ETFs) as an investment vehicle leads to a larger debate over whether to pursue an active or passive investing approach. It is no secret that ETFs appeal to a certain demographic of investor mentality — those who favor passive investing.
Passive investing is an ideology, an opinion on markets and portfolio management that finds its roots in behavioral psychology. The question, “Can a stock picker outperform an index?” is actually digging at your greater psychological slant. The same question more accurately phrased would read, “Does your ego necessitate a belief in outperformance, or are you mindful enough to accept human fallibility?”
In this article, we will attempt to temporarily put aside this great philosophical debate between active and passive investors with all of its ideological and emotional undercurrents. We will experience — using ETFs as our vehicle — research outside emotion. In our examination of ETFs from an objective perspective, we will focus on one specific element: style drift.
By analyzing non-philosophical characteristics of ETFs, we can concentrate on tangible traits alone, thereby removing some emotion and bias from our assessment of ETFs and the overall decision-making process. Analysis without philosophical underpinnings or bias is an important and valuable tool both in financial markets and our lives.
The Significance of Style Drift
An ETF is a mutual fund that trades on an exchange. It is typically a basket of stocks or bonds that are determined through mathematical methodology rather than the selection of an investment manager. ETFs predominantly track a known index, though there are also ETFs that replicate the performance of real assets such as gold or oil.
In our assessment of objective traits, we will examine ETFs outside the influence of emotion, and therefore beyond the scope of behavioral psychology and the active versus passive investing debate. We will consider one highly significant aspect: style drift.
Investopedia defines style drift as, “The divergence of a mutual fund from its stated investment style or objective. Style drift occurs as a result of intentional portfolio investing decisions by management, a change of the fund's management or, in the case of stocks, a company's growth.” Style drift is often overlooked but extremely consequential. In the world of finance, risk and return go hand in hand — the greater the potential return, the greater the risk. If you are not knowledgeable, or not watching ever-closely, an investment manager may drift from his or her stated objective.
Many times the drift seems nominal, but at other times, the divergence from a manager’s stated aim can be severe. And even a small shift in holdings can dramatically change the risk profile of a portfolio. For example, if an investor allocates 10% to international equities by giving that 10% to an international investment manager, but that manager only deploys 70% of net assets toward international stock, the investor in reality has only a 7% exposure to international equity in their portfolio — a whopping 30% difference. If every manager in the investor’s portfolio drifts just a little, the investor will have an asset allocation that is disjointed and far different than planned. For this reason, investors could be taking much more or less risk than anticipated.
Conversely, ETFs never experience style drift — they are fully invested according to their mathematical methodology at all times. Style drift is therefore significant for two reasons: it has a real impact on a portfolio’s return and risk profile, and it is an advantage of ETFs that has nothing to do with solving the philosophical dispute over active versus passive investing.
There are many attributes that ETFs possess that make them worthwhile investment vehicles. But those most relevant to our investigation are attributes that reside outside this active versus passive debate — the benefits that ETFs provide that have nothing to do with your opinions or your belief system. If we get into a discussion on risk, fees, or even diversification, we are likely to get entangled in the endless active versus passive dispute — one that cannot find a conclusion as it is rooted in our philosophies and, therefore, an emotional argument on both sides, not a rational one.
The Bottom Line
Focusing on those qualities of ETFs that are not connected to our opinions or our belief system, and recognizing them as advantageous, is a powerful first step in impartially assessing and ultimately adopting ETFs as your investment vehicle of choice. And this process of removing bias and emotion by analyzing non-philosophical traits is not only a smart way to address decisions about your investments but also, a needed and healthy method of making decisions outside of your portfolio.