Investing – when is active management worth the cost?
David Christianson, CFP, R.F.P., TEP
For decades, the debate has raged over whether or not active investment management and selection of stocks for a portfolio can consistently beat simply investing in a passive index, with stocks selected by a fixed set of rules.
I will dive into empirical research and expert opinions in a moment, but here are a few observations of mine:
The investment method or vehicles you select is less important to your success than having specific goals and a well-defined overall strategy.
Deciding on the big questions like whether you will pay down debt before investing, whether to place your investments in RRSP, TFSA or open investments, and placing the right investments in each account to minimize taxes, comes first.
With investing, an active manager who matches the relevant index over time, but does so with less volatility, has done her job. Decreasing risk is one of the most valuable services an active manager can provide.
When active managers say they are at a disadvantage because they must charge fees, it’s a specious argument. Either you earn your fees or you don’t. If you don’t, we don’t hire you.
On the other hand, the management expense ratio of most mutual funds includes a service fee paid to your advisor. This is a value-add that should be subtracted when evaluating the manager’s actual performance.
First – some disclosure on my biases. I continue to want to believe that a few exceptional active managers can consistently beat the index and do so with less volatility than the index, and we use those managers for our clients. However, we seldom use retail mutual funds, for a number of reasons.
Our clients pay an average of 1.2% or less for active management, not the 2.2% or more of retail funds. As well, we use pooled funds with high minimums, and separately managed accounts, both of which protect the managers from redemption pressures and other shortcomings of retail funds.
Having said that, we use ETFs that track indices for much of our client investments, especially for the core portfolio that is tracking a major index like the S&P/TSX Composite Index or the S&P 500, where the markets are very efficient. We tend to use active managers for specialty investments like small cap, or to manage tactical balanced portfolios, where those managers have proven their ability to decrease volatility and consistently make wise moves at the right time.
A lot of research has been conducted over the years to try to prove whether active or passive management is superior. No matter what each study “proves”, the other side tries to find fault with the methodology, the time period looked at, or some other issue.
Usually those complaints are by the active side, as the majority of research shows that only a small percentage of active managers consistently beat the index against which they are measured.
For 2009, the results were similar. Only 39.2% of actively managed Canadian equity funds beat the S&P/TSX Composite Index, according to the Standard & Poor’s Indices Versus Active Funds Scorecard (SPIVA), released this week. Similarly, only 39.7% of U.S. Equity funds were able to outperform the S&P 500 in 2009. Validating our approach, the “efficient” markets – ones where most of the relevant information is available to all market players at all times – are the markets in which active managers have the hardest time adding value.
On the other hand, 52% of active funds in the Canadian Small/Mid Cap Equity category beat the S&P/TSX SmallCap Index, while 52% of the International Equity funds outperformed the S&P EPAC LargeMidCap Index.
As well, 2009 was a tremendous “up” year for the markets. Rapidly rising markets make it tough for managers who must carry cash to fund redemptions, and who exercise a measure of caution, to compete.
The corollary, then, should also be true. In bad markets, active managers should be able to beat the markets, right?
Yes, active managers have tended to outperform the market in years like 2008, but that also reveals the weakness of a system that measures success only by comparison to the index – relative returns – and puts too little emphasis on absolute returns.
So, in 2008 lots of active managers beat the index by, say, 5%. That means they lost “only” 30%. Most investors cannot live with that, and as a result make unwise decisions like bailing out of the markets. To me, the real value that active managers can add is managing risk, and mitigating the damage from a calamitous event like 2008.
I nearly punched out a fund company representative in December 2008, when we were discussing why his equity managers stayed invested, when their own economist had told us two months earlier that he expected the markets to drop further. His response? “We can’t play the absolute performance game.” In other words, buyers of investment management services evaluate managers by comparing them to the benchmarks.
The obsession with beating the index had blinded these people to their true role – being stewards of people’s money; protecting it, valuing it, and then making it grow.
Luckily for us and our clients, the core managers we used beat the index by more like 15% to 20% in 2008, losing some money but doing a masterful job of preserving capital. They have not gained 40% in 2009, and we are fine with that.
We know that as financial advisors, it is OUR job to play the absolute performance game – protecting clients’ capital, taking money off the table when things look too good, putting more back in when panic allows us to buy stocks at bargain prices, and keeping the focus on meeting each client’s goals with the least amount of risk possible.
Sorry, I have digressed a little from the research. This article will explain a specific study showing that active managers whose investment choices are most divergent from the index are the ones who consistently beat the index, and that this outperformance can be predicted, by looking at the divergence in stock seleciton from the index.
I welcome your comments, and will provide more research and alternate views in the coming weeks.
Post questions and comments.
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David Christianson is a fee-for-service financial planner and portfolio manager, whose team at Wellington West Total Wealth Management Inc. provides comprehensive financial advice and management. You can e-mail him at dchristianson@wellwest.ca or visit his website at www.davidchristianson.com.