It was the image of dart-throwing monkeys that got me. I would like to think it was the analytics, the
white papers or even the raw performance data of active managers over the
years. But if I’m being honest, it was that
image of active managers as dart-throwing monkeys that really hooked me.
I was in my early 20s and reading
Burton Malkiel’s “Random Walk Down
Wall Street” for the first time. The way
Malkiel wrote about it, there was just
something rebellious and cool about
the index side of the index vs. active
debate — so I became an index guy.
In the 15 years since then, we have
continued to see index funds beating
active funds by performance, and doing
so at a fraction of the cost. So why I am
rethinking everything? And how could
it be that Vanguard was the firm that
caused this introspection?
Here is what happened: In late 2017,
Vanguard — the flag-bearer of index
investing — filed to launch six active
ETFs tracking alternative-weighting
methodologies to provide exposure to
single factors. While the funds will technically be actively managed, they are following systematic processes to provide
rule-based exposure to those factors.
The Vanguard filing is the latest shift
in the entire paradigm. What was once a
simple argument to understand — market-cap-weighted index investing vs.
secret-sauce active management — has
now become far more complicated with
dozens of shades of gray in between the
The only way I really can make sense
of this change is to define it as a new
paradigm: systematic investing vs. faith-
based investing. Systematic investing
includes classic market-cap-weighted
index investing, but it also includes any
number of transparent rule-based pro-
cesses to provide broad market exposure.
Faith-based investing, in contrast,
doesn’t require transparency; it requires
trust in an active manager to provide
alpha through a non-disclosed strategy.
That could be picking stocks because of
the firmness of the CEO’s handshake or
the glint in his eye, it could be jumping
into crypto-currencies because a manager’s gut says that Bitcoin has more
room to run, or a manager telling you
how an investment firm has incorporated AI and machine learning into its
models yet is unable to elaborate on how
the algorithm sources its positions.
Traditionally, index investing has been
synonymous with market-cap weighting.
Some say that is for good reason — a
company’s market capitalization is an
accurate measure of its representation
of the overall stock universe at that time.
However, Oppenheimer has been mak-
ing a convincing case that revenue is
a better measure. Pacer ETFs recently
launched an ETF that weights compa-
nies by their free cash flow, and I can’t
help but wonder if that is an even better
representation. Both revenue and free
cash flow are far more stable metrics
than market capitalization, and they rep-
resent actual financial results rather than
the market’s hopes and dreams of such.
At Exponential ETFs, we have done
extensive research showing that not
only is market capitalization just another factor to consider for weighting an
index, it is even a sub-optimal one. In
fact, we have found that on a historical
basis, based on back-tested data provided by S&P, weighting stocks by the
reciprocal of market cap can provide
systematic and repeatable alpha — so we
launched the Reverse Cap Weighted U.S.
Large Cap ETF.
RVRS is still an index fund, technically, and I am still an index guy if active
management is the only other choice. But
this new paradigm fits me better — I am
a systematic guy. And Exponential ETFs
runs systematic funds more so than classic “index” funds — moving in the same
direction as Vanguard.
Phil Bak, CAIA, is founder and CEO of
Exponential ETFs. Earlier, he was a managing director at the New York Stock
Exchange and a senior product manager for
By Phil Bak
The New Game in Town
The ETF industry is being shaped by a new paradigm — not active vs. passive