Is my ETF run by a robot?

Morningstar’s Jose Garcia-Zarate explodes the myth that managers are absent and it’s all down to machines.

The growing popularity of exchange traded funds (ETFs) challenges traditional views about investing. One of these refers to the role that people play in the fund management process. You buy an ETF for its low cost, its flexibility and transparency, the easy access it provides to all sorts of markets, perhaps even for the reputation of the company that provides it – but certainly not because you’re awestruck by the publicised star status of the person managing it.

- How to invest: ETFs

In fact, can you even name or put a face to a single person managing ETFs? I bet not. And anyway, why would you? Isn’t the whole point of passive investing to buy the wisdom of the crowd (in other words, the market) and do away with that annoying habit of the individual stockpicker of eventually messing things up?

The problem is that by over-emphasising the faceless nature of the market, ETFs are perceived as devoid of the human touch. The notion that ETFs are exclusively managed by machines has been left to grow unchecked. And for some of us, even the tech-savvy ones, this can be a scary idea. Think about it this way: we all know that planes can – in fact, typically do – fly themselves; but are we happy to take to the skies without a human pilot in the cockpit?

Humans pick the index

Now, I’m not here to negate the fact that the management of ETFs is highly automated. Tracking an index can be easily codified. This is one of the key reasons why ETFs can charge low fees. However, this doesn’t mean that people are not involved in the process. They are, but not in the classic way one thinks about a fund manager.

At the very basic level, someone must choose the index. This is no easy task. There are hundreds of thousands to pick from, each with its own nuances and encapsulating a unique investment proposal. Make no mistake, picking an index is an active decision that involves research, consultations with investors and often intense negotiations between the ETF and index providers.

Replication

Once the ETF is put together there’s the task of replicating the index performance with minimal tracking error, day in, day out, while accounting for daily flows. Automated processes are fundamental; but not everything is left to the will of computers.

Some think of ETF management as a simple process involving buying or selling all the components of the index in the exact weights that the index dictates. That may be the case of ETFs tracking indices with a small number of highly liquid components, but these are the exception rather than the rule. Many indices come with a high number of constituents, and often there are important liquidity constraints that make full replication unviable.

Take the case of the Global Aggregate Bond index, made up of over 20,000 bonds representing the government and corporate bond markets of developed and emerging market countries. It is impossible to buy and sell all these bonds in real time, not least as many of them do not trade regularly. And yet physical ETFs tracking this index manage to replicate its performance. How?

Sampling techniques

Portfolio managers use sampling techniques. They slice and dice the index and pick a subset of bonds that mirror the risk/return profile of the entire index and are liquid enough to be traded. Computers do the heavy lifting, but there is always human oversight of the process. Someone must vet those samples, suggest and test changes to further optimise them and, crucially, decide when to trade the securities to get the best possible execution. This is where the expertise of the ETF portfolio managers and the teams supporting them, including traders and analysts, can make a difference.

The skills needed to make it as a good ETF manager are highly quantitative, and increasingly include coding and big data analysis. This is far removed from the classic view of what makes a successful fund manager. In indexing, no one will pay you to scent the next big opportunity. ETF management is a team-based effort, and the heavy use of technology means that the size of these human teams is small. Still, just because we don’t see them, it doesn’t mean that they don’t exist.

Jose Garcia-Zarate is associate director of ETF research, Morningstar.