Active vs. Passive Management
In this month's missive, we are going to focus on the differences between active and passive investing. Both are two different investing strategies which can be advantageous during appropriate time periods.
For those who aren't familiar with the terms, active management refers to an investment style that is selectively picking stocks or bonds within a portfolio or fund in an attempt to beat the performance of the benchmark index it's compared to. (For example, an actively managed Canadian Equity fund would compare itself to the TSX.) This can be done through a mutual fund, hedge fund, or an individual portfolio manager.
Passive management refers to the investing strategy of mimicking the holdings of an underlying index in an attempt to track the performance of the index it's compared to. Although this can be done through a low-cost mutual fund, the popular vehicle today is through ETFs (Exchange Traded Funds).
Over the last decade there has been a monumental shift towards passive investment vehicles. You can see from the chart below that passive investing has been growing in popularity and may overtake the market share of active investing in 2019.
The argument against active management is generally the high fees associated with hiring a team to manage the investments. This team analyzes market trends and changes to political landscapes and performs deep research and due diligence on individual companies they are invested in, etc. Portfolio managers attempt to take advantage of discrepancies in the pricing of markets or securities hoping to generate alpha for the portfolio. (Alpha is the excess fund return compared to the benchmark). All of this requires time and money for the research.
Now high fees aren't always bad - who wouldn't mind paying 5% per year to a manager that can consistently generate 15%+ returns? We all would.
The challenge lies when money managers underperform their respective benchmark. In Canada, studies have shown that over 76.92% of active managers have underperformed their benchmark on a 1yr basis, and 91.01% of managers have underperformed their benchmark on a 10yr basis.
Given this information, you'd either have to be darn good at picking managers or you risk underperforming the market. So why are portfolio managers underperforming?
You see, there are tons of actively managed products out there in the marketplace, with some companies employing a strategy called "closet indexing". What this means is that they are charging higher fees but placing investors into funds that mirror the index. (Very little portfolio management.) This isn't considered active management, but these mutual funds get lumped into the category and bring down the average.
As a recent Globe and Mail article put it, “Two of Canada’s largest investment managers are being threatened with a class-action lawsuit that claims investors were overcharged for actively managed mutual funds that did little more than mimic their benchmark indexes.”
You want to avoid these funds like the plague, or you risk eroding your returns over time.
The more appropriate way to select funds is to pick funds with a high active share. Active share quantifies how different the fund looks compared to its respective benchmark. If the holdings inside the fund look much different than the individual weightings inside the benchmark index, chances are you will have a much higher active share. Studies at Yale examining a 23 year time period have shown that selecting funds with an active share of 80% or higher would outperform their benchmark index by 1.49%-1.59% annually, net of fees.
Source: Martijn Cremers and Antti Petajisto, 2006
To be clear, all the funds we recommend have a high active share.
I'll leave you with one more reason why you may want to hold actively managed solutions over the next number of years.
People generally talk about equities when comparing passive investments and their actively managed counterparts. But what about fixed income (or bonds)? Let's say you want to hold some allocation to fixed income with a passive investment strategy and you buy the FTSE Canada Universe Bond Index. This strategy would have proven effective over the last number of decades as interest rates have been in a decline and debt levels have increased.
But now with record worldwide debt and low interest rates, would you really want to hold debt of all the companies that are held inside the index?
You see, in the 1970's the average credit rating of companies was AA or AAA rated. However, since the amount of leverage (debt) that has been introduced to the economy over the last couple of decades, the average credit rating of this debt has been reduced to just above "junk" bond status. (Junk bonds carry a much higher degree of risk for defaulting on their debt)
Instead of blindly holding debt of all these companies with a lower average credit quality you could be better served with a research team analyzing each company and their credit quality to ensure you're getting the maximum return while avoiding default risk.
The bottom line is simple: don't fall for the trap of doing what everyone else is doing. You hire professionals in your life for a reason, and having a great portfolio manager looking after your investment is a prudent decision. Everyone investing passively can look like a hero in a bull market, but not everyone can mitigate losses on the downside - that's what active management is for.
In the coming weeks we will be announcing a new fund to our recommended list - one that mimics the investing style of the world’s best investors. Stay tuned for more.
Financial Advisor, BASc