How well can active managers adapt to a market favoring passive funds and cheap ETFs?

One firm's response is to offer a passive ETF of its own with the goal of demonstrating it can be good at passive and active strategies.

"There's clearly a large interest in passive strategies," says Ric Dillon, CEO and portfolio manager at Columbus, Ohio-based Diamond Hill Investment Group. The firm, which manages $16 billion for clients, just launched its Valuation-Weighted 500 ETF.

"My best guess is that not only will we beat the S&P 500 by 50 to 100 points on an annualized basis, but I think we will beat the other competition as well in terms of our results."

Dillion and Craig Tann, Diamond Hill's national director of accounts, spoke with Money Management Executive about the ETF launch and the challenge of promoting active strategies in a passive-dominated market.

How will you position your offering so that it can get notice above the market noise and froth?

Dillon: Our ETF strategy is different in that it's forward looking. If you think about all the other second-generation passive strategies that are out there - for example, multi-factor and equally-weighted -all of them are backwards-looking.

This is forward-looking, which is a distinguishing attribute which we think will relate to much better results over the next 10 years in the broad based S&P 500. If that is the case, that alone will cut through the noise.

The strategy for some will be very easy to understand. People in our industry are familiar with the concept at a very high level of intrinsic value, and certainly familiar with discounted cash flow methodologies generally. So to be able to apply that into an ETF is unique, which some people will find appealing.

Tann: We have an installed base of $16 billion worth of clients, which is approximately 60% intermediary and retail, and about 40% institutional.

So we're certainly going to be talking to all audiences, but we're really going to focus on the RIAs, as they can really make decisions quickly and don't have the hurdles, for example, of having to put an ETF on a restricted list until it has a three-year track record, $15 million in AUM and certain liquidity levels.

Regarding the frothiness in the market and the new products, we're looking at this to be a buy-and-hold product. We don't view this as being a traded, tactical, in-and-out kind of product. Part of that is that we designed it that way. It follows our intrinsic value investment philosophy that permeates the $16 billion in active management; this just happens to be in a passive vehicle.

We don't want this to be the next thing that only has a light shined on it for the next three to six months. We're viewing the success of the ETF after four or five years of track record, and whether or not it's added value and added assets.

Dillon: There's clearly a large interest in passive strategies, and the first generation S&P 500 index is a target for us, as is the competition of the second generation, which are those multi-factor models and other kinds of approaches.

My best guess is that not only will we beat the S&P 500 by 50 to 100 points on an annualized basis, but I think we will beat the other competition as well in terms of our results. Clearly after five years that will be the most important aspect. It will be important for this strategy, but if we have that, it will also shine a light on our active strategies, so it has that benefit as well. And it's conceivable there will be changes in the regulatory space which may lend themselves to active strategies, and so that could help us. Clearly there could be some valuation-weighted ETFs that we could introduce in the future.

Do you hope the ETF attracts clients who want passive and get them interested in your active strategies?

Dillon: It could do that too. Right now, initially, people who are only interested in passive, at least in the large cap space, we had nothing for them prior to this. Now we have this, so we can talk to them. So it could allow us past doors where they use a "core and explore" approach. But I think initially it's going to be those advisors who really have some desire for passive.

Did you feel this launch needed to happen because of the market shift toward passive?

Dillon: No, this is something I had developed before Diamond Hill, I was managing this strategy for an institution on a separately-managed basis. When I started Diamond Hill in May of 2000, the opportunities on the active side were so great I wanted to be focused on that. When we launched this strategy as a limited partnership in 2011, the idea was we had our active strategies in place, and we could now do this. We ran it as a LP for over three years and had a good track record, so rolling it into an ETF made sense to us. But it was something that we'd thought over a very long period of time would demonstrate the efficacy of the tool, and with sufficient results attract enough assets. That would be five to 10 years before that happens. As a public company, you can see we have over $100 million in revenues; this won't be meaningful for years from a revenue standpoint. It can be very meaningful for some of the conversations we're having right now.

A number of executives are having a conversation about how to put a strategy into an ETF wrapper, for the main reason driving that shift to passive costs.

Dillon: When we started this as an LP, there wasn't the thought that at some point, we'll turn it into an ETF. We thought we'd turn it into a mutual fund. The reason we chose an ETF in this example was that because it was passive, it lent itself to an ETF. We wanted to learn more about ETFs too, so that if regulations change, that would be valuable too. Also, if we want to do other passive strategies, ETFs would be the logical format.

This was a strategy I developed a long time ago. I don't know if I'd want to come up with something just to put it in an ETF. But something I had a history with, I was very comfortable doing.

There are plenty of products in the market that are meant to take advantage of ETF demand.

Dillon: Everything that we do at our firm is very long-term. The reason were capping the expense ratio at 10 basis points, which is comparable to the very lowest S&P 500-type of funds, is because we want it to be a very good value proposition over the long term.

We did that with our mutual funds 15 years ago, and we absorbed $1 million in costs that we didn't pass on to shareholders. But we did that so that the returns would be better to the client. So clearly, this will not be a profitable strategy any time soon. But that's OK; 10 years from now I think this could be very profitable.

Some fund executives say the pressure to offer low cost products is hurting the industry. Do you agree?

Dillon: The investment management industry -at least the asset management part of it - has to be about one thing: delivering value to clients. If you have a passive strategy that will have results similar to something that can be offered at practically free, you can't charge much for that. But if you're going to be a good active manager, you can charge for that.

All of our strategies have fees that are a calculation based on our goals for the strategy for excess return. All of our fees, our philosophy is we're charging a quarter of what we think our excess return will be. We're capping the fees at 10 basis points but we think we'll do much better in our excess returns. If so, we'll lift the cap and price it accordingly.

We have a long-short mutual fund that's one of the oldest in the industry, and we're actually closing it to new investors next month. We run a hedge fund. So we have the whole spectrum. This just allows us to isolate a tool and to give people who want something passive, something that we believe will be better than the alternatives there.

Was there a concern that introducing an ETF would detract from the brand?

Dillon: Chuck Bath, who runs our large cap strategy, said, 'I'm really glad we're doing this, because there are people who like passive, and if I can't beat the passive strategy, I don't deserve any money.' So we believe we'll beat the passive strategies, and we believe Chuck's large cap will do better than this strategy.

This tool is a part of our brand. That's the way we're thinking about it. We're not feeling threatened by a passive strategy. Our goal in the active world with $16 billion is to beat passive strategies, and that's not going to change. This will beat other passive strategies. But it won't beat our active strategies.

As passive investing has become so popular, do you see it as a validation of Jack Bogle's vision?

Dillon: We wrote a piece, "Is the S&P 500 Safe?" and it was written in 2001. What we said was, people have confused passive strategy investing with being conservative. It's still an equity portfolio, and if it's an overvalued portfolio, it can underperform, as it did then. We wrote another piece on why closet indexing exists. It's because there are people who hold themselves out as active managers, but they really are not. What they are trying to do is protect their business as opposed to their clients' money. These are the issues for our industry. Passive will probably take even more market share, because there are a lot of people in our business who shouldn't be because they can't add value with their active strategies. For people who use passive, passive makes a lot of sense. I just think the first generation suggests the efficient market hypothesis is correct, and we don't believe that.

As behavioralists what we say is that people get excited about certain things and then stock gets overvalued. In this ETF, we underweight the stocks.

Is the ETF market overheating?

Tann: I don't know. With the fund launches and the rise of strategists, new products and AUM, it's hard to say if it's overheating. Client dollars are going in that direction. I believe it's a world of supply and demand, and I think the wrapper offers a lot of unique benefits. Some of the products out there are, 'Let's take advantage of the euphoria over the wrapper. and launch a product.' Those are the products that have been closing. But certainly, the growth in the industry has been phenomenal. We've never seen anything like it.

For every new ETF that gathers $100M in AUM, there are a number of funds that die within a year of launch.

Dillon: Over the next six months, we'll put $10 million into the fund. We won't even evaluate it from a business perspective until it's been five years. That's what we do with all of our strategies. 

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