'Father of ETFs' says long-term bets on tech firms are the right call

Exchange-traded funds have become the dominant force in the Korean stock market. The number of listed ETFs stood at 1,163 as of the end of last month, more than double the 502 recorded at the end of August 2021. Net assets have surpassed 450 trillion won ($328 billion), a jump of 600 percent over the same five-year period.

Active ETFs have grown even faster, rising more than tenfold to 322 products from just 30 five years ago. Unlike passive ETFs, which simply track a benchmark index, active ETFs give fund managers discretion over stock selection and trading timing in pursuit of returns that exceed the benchmark.

Bae Jae-gyu, chief executive of Korea Investment Management and widely known as the "father of Korean ETFs" for spearheading the country's first ETF listings in the early 2000s, said in a recent interview that "how you define 'active' is what matters" when assessing the growth of active ETFs.

Bae has long held that active management rarely beats passive investing, and championed passive strategies even when active funds were at the height of their popularity. He said smaller asset managers tend to focus on what he calls "pure active" — "a method of pursuing returns by diligently selecting individual stocks."

"However, this approach can work well when instincts are right, but it can also go wrong," he added. "It is difficult to guarantee sustained performance when you are relying on stock-picking ability."

Korea Investment Management's preferred approach is to pursue a fundamentally passive strategy while incorporating a degree of active flexibility in its management. "Rather than aggressively swapping out stocks, what I consider active is having flexibility in how we manage the portfolio," Bae said.

He pointed to the firm's ACE Global Semiconductor TOP4 Plus ETF as an example. The product allocates 20 percent each to the largest company by market capitalization in four semiconductor subcategories — memory chips, non-memory, foundry and equipment — with the remaining six holdings weighted equally.

"Samsung Electronics was initially the top memory chip company, but as the market shifted, we wanted to switch it to SK hynix," Bae said. "Just getting the index provider to agree to the change took six months, and switching it back to Samsung Electronics as the market shifts again will take time all over again."

The anecdote illustrates a limitation of passive investing: despite its many advantages — transparency, ease of trading and diversification — it struggles to keep pace with rapid market changes.

Bae recalled a similar experience at a previous employer. The ETF in question invested in leading US technology stocks. "The structure included eight US companies and two Chinese companies, and when Donald Trump first became president, conditions for the Chinese firms deteriorated," he said. "At the time we were running a fully passive strategy, and we tried to remove the Chinese holdings and replace them with US ones, but the index operator would not make the change."

In the meantime, a rival launched a product focused on major NASDAQ technology stocks, and investor money flowed out.

"The issue was not whether returns would be good — it was that investor demand in the market had shifted and we were unable to respond," Bae said. "That is why I believe active management has value at the level of providing operational flexibility."

Korea Investment Management recently announced it would spin off its equity fund and money market fund businesses through a personnel split and transfer them to Korea Investment Value Asset Management. Industry observers expect the restructuring to leave Korea Investment Management focused on its core strength in passive ETFs, with active strategies handled by the value management unit.

Under Bae's framework, however, active products that preserve a degree of operational flexibility are expected to remain at Korea Investment Management even after the reorganization. Pure active products, where a fund manager's stock-picking skill is paramount, are widely expected to be among those transferred.

Bae also addressed the regulatory dimension of the flexibility question. In July, four of Korea Investment Management's ACE active ETFs were delisted en masse after failing to maintain the required correlation coefficient with their benchmark indexes. Active ETFs must keep a correlation coefficient of at least 0.7 with their benchmark; if it falls below that threshold for more than three months, the fund is removed from the market. In Korea Investment Management's case, the ETFs' returns so far exceeded their benchmarks that the correlation coefficient dropped below 0.7 — making them the first funds ever delisted for outperforming their index.

While multiple ETFs had previously been delisted for falling below the 5 billion won net asset threshold, a delisting triggered by returns that exceeded the benchmark was unprecedented, drawing wide attention across the industry. Timefolio Asset Management and others subsequently went through a similar process.

The government has this year reviewed scrapping or relaxing the correlation coefficient requirement for active ETFs to give managers more autonomy, but discussions have stalled recently. "Flexibility is needed here as well," Bae said.

On the growing controversy over copycat products as the number of ETFs surpasses 1,100, Bae said: "Copying is a matter of professional pride, and what is needed is self-regulation within the industry rather than government rules. The reality is that competition is playing out in a way where firms are willing to forgo profits just to grow assets under management, which makes it genuinely difficult to address."

Bae identifies two requirements for successful investing: direction and time. Direction is the logical judgment of where to invest; time is the emotional discipline needed to endure the volatility that follows. Because the optimal entry point can never be known in advance, he argues the best approach is to invest whenever funds become available — and that if the direction is right, returns will follow even if the timing is off.

He is particularly emphatic about ETFs because they make it easier to hold through the emotional turbulence of market swings. Bae cited Nvidia and NASDAQ as illustrations. An investor who put money into Nvidia on Feb. 1, 2016, and held for 10 years would have seen a return of 266.5 times their investment as of the end of January this year. The NASDAQ 100 returned 5.5 times over the same period.

The numbers alone suggest individual stocks win by a landslide, but Bae drew the opposite conclusion. Over that decade, Nvidia fell more than 30 percent from its peak on two separate occasions, and suffered one decline in the 50 percent range and another in the 60 percent range. Reaching a 266-fold return required riding out enormous swings.

"With NASDAQ, you have confidence that holding many stocks means you will not suffer a catastrophic loss, but an individual stock lurches up and down sharply and anxiety compounds," Bae said. "If you were lucky enough to hold on, you would be wealthy — but it is not easy for an individual investor to endure that."

On the debate over an AI bubble, Bae offered a different perspective. His view is that a technology that generates no bubble is not truly transformative. The internet era spawned countless companies, and those that survived the bubble became today's big tech giants.

He also noted that every new technology requires infrastructure to accompany it. As the AI era unfolds, he said, big tech companies are leading the world — and investors should pay close attention to the semiconductor, computing and energy infrastructure firms that underpin them.