Active vs. Passive management: Part 1

Over the next few days I’m going to post about some basic fundamentals of investing and financial planning.

Today I’m going to briefly discuss the active management vs. passive management debate.  It’s an interesting debate that has significant implications for your long-term wealth strategies. Although it may sound technical, you’ll probably find that it’s not that bad.  If you invest in mutual funds, this is absolutely a post you’ll want to read!

Mutual funds in Canada

The bulk of Canadian investment in stocks and bonds are in the form of mutual funds.  Understand first of all that a mutual fund is NOT an asset class.  You can invest in mutual funds that buy stocks, bonds, real estate, commodities, etc.

The idea of a mutual fund is actually quite simple.  You pool your money along with a group of other investors and together you hire a manager to invest that pool of money.  Rather than buying shares like a stock, you buy units, which represent a certain claim on the overall pool of money.

That’s a very simple overview of a mutual fund.

Active and Passive management

Where we complicate things a little is when we get into the terms active and passive management.

Active management is simply trying to selectively pick certain stocks or certain sectors that the manager feels will outperform the broader market.  In theory, a good manager should be able to beat a certain index.  For example, if you invest in a Canadian equity (stock) fund, that manager should be able to beat the TSX composite index after fees, expenses and taxes are considered, since you are paying them for their ability to pick winning stocks.  The vast majority of mutual funds employ an active management approach.

Passive management on the other hand simply tries to match the return of the appropriate index by buying and holding a representative selection of stocks that match the make-up of the index.  Very few funds practice this approach.  Those that do are called ‘index funds’.  There are also index funds that trade like stocks.  These are called Exchange Traded Funds or ETFs.

It seems intuitive that active management should be able to outperform passive management.  This is why the vast majority of stock investments are made in actively managed mutual funds.  But is this actually the case?

Which one produces the best results?

I’ll let the cat out of the bag right at the start.  I’ve done a lot of reading on this topic and I am quite convinced that passive management provides better results for the vast majority of investors.  I am more than convinced.  In fact I can say for certain that passive investment has been a superior strategy ever since the creation of the first index fund.  This is a numerical fact.  Now this doesn’t imply that they will outperform in the future, but there is a strong case for believing that this is the case.  I personally use a combination of passive management via broad-based ETFs, particularly for international exposure, and some active management to overweight certain sectors and also to make some small speculative investments.

For a great overview of the benefits of passive management, I strongly suggest you read either ‘A Random Walk Down Wall Street‘ by Burton Malkiel, or ‘The Little Book of Common Sense Investing‘ by John Bogle.

Here’s a brief outline of the arguments stacked up against active management:

1.  Academic studies have unanimously supported the notion that few professional managers can beat their index over time, particularly once fees and taxes are considered.

In 1 year index funds outperform 71 percent of all funds.  Shocking, I know!  It gets worse.

In 5 years index funds outperform 85 percent of all funds.

In 10 years index funds outperform 91 percent of all funds.

In 25 years index funds outperform 95 percent of all funds.

This includes funds that utilize tactical asset allocation (picking winning sectors that will outperform), value funds, growth funds, etc.  In general, it is exceptionally difficult for money managers to beat their respective indexes.  The reasons for this are well described in the books mentioned above.  If you’re interested in these reasons, I suggest visiting the library and reading them.  For the purpose of this post, it will suffice to note that active management has a VERY difficult time beating passive management over time.

2. They have lower costs than mutual funds

Part of the drag that mutual fund managers must overcome to get their clients a decent return are the fees and expenses involved in managing the money.  The manager and staff must be paid; the company must make a profit; advertising must be made; trading fees must be paid, etc. etc.

While these same fees often apply to index funds, they are minuscule compared to the fees involved in active management.  The fees to the manager are relatively small as they do not pour over documents analyzing specific stocks.  They just buy them once and forget about it.  The only time they need to repurchase is when an index changes (new stocks added or removed) and when additional units are created or redeemed.  This also means that trading expenses are very low.

3.  They are more tax efficient than traditional mutual funds

Due to the fact that index funds do not sell stocks and therefore do not incur capital gains, they are very tax efficient.  They utilize a ‘buy and hold’ strategy.

 

Closet index funds

You may still be inclined to believe that you can pick the ‘winning’ mutual fund by looking at past performance or following certain managers.  The problem is that you’re not alone in this, and money will typically pour into ‘hot’ mutual funds, swelling their assets under management.  Don’t take comfort from being part of that herd.

The fact is that as a mutual fund gets larger, it starts to mirror the index.  This is because the manager must invest all this cash that’s pouring in.  But it becomes harder and harder to take advantage of  attractive opportunities without affecting the price of that stock.  If you have to invest $1 million dollars into a large cap stock, you may be able to buy it without pushing the price higher.  But $10 million becomes trickier.  You’ll likely push the price of that stock higher in trying to purchase it cheaply, negating the price  advantage that may have existed.  Therefore, managers of large mutual funds have to spread that money around anyways.  Over time, their portfolio starts to look a lot like the index anyways.

Check out these 5 examples of large Canadian equity mutual funds.  Each has at least $500 million under management and a couple are around $2 billion!  Each also has a management fee (MER) of at least 2% of assets under management.  All are compared with the underlying index (TSX).  You’ll note the strong correlation in each case.  It begs the question of why you would pay someone 2% of the total money you have invested each year to essentially match an index, when you could buy an index fund for 0.25% and keep more of your money.  Also note that in many cases the index outperforms, and that’s not even considering the tax drag associated with buying these mutual funds in a non-registered account.

 

Examples of index funds and ETFs

TD has arguably the best line of index funds in their e-fund series line up.  It takes a bit of work to get an e-fund account set up, but the MER savings is fantastic, averaging 0.25-0.3% per fund.  CIBC and RBC also offer index funds, though the MERs are considerably higher.

For those looking to create an ETF portfolio, the Ishares and Claymore lineups offer lots of great choices.  We’ll look at them a bit more in a future post about asset allocation.

 

Still thinking about active management?

If you are still thinking about active management for your investments, consider the following tips:

1)  Avoid large funds.  Small funds have the ability, as discussed, to invest the money they have under management without moving prices.

2)  Select a fund with a below-average MER.  Globefund is a great resource for researching mutual funds.  Their fund selector and fund filter tools are particularly helpful.  As a rule of thumb, Canadian and US equity funds should be well below 1.5% MER, Bond funds well below 1%, International and emerging markets below 2%.  The cheaper the better.  You DO NOT get what you pay for!

3)  Make sure you are not buying a closet indexer.  Funds that make small, concentrated bets are more likely to outperform their index and will certainly have lower correlation.  I really like the approach of Steady Hand asset management.  If I were interested in investing in an actively managed product, I would certainly give their line a lot of thought.  NOTE:  That is a completely unsolicited recommendation.  I receive no remuneration for making them.

At any rate, if you have questions about specific funds that you may hold, I’m happy to offer my opinion, which is worth at least the price of admission to this lowly blog.

We will look at the idea of asset allocation in a coming post.

Cheers

Ben

 

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5 Responses to Active vs. Passive management: Part 1

  1. crashcow says:

    Ben, are you saying technical and fundamental analysis provide no net profit after transaction costs? A technique as simple as varying your monthly investment based on P/E would have outperformed a fixed monthly investment. (eg. Invest $100/m when P/E = 16. Invest $150/m when P/E = 12. Invest $50/m when P/E = 20. Linear interpolate for other P/E values).

    This site has been sharing some great technical analysis to help in managing risk:
    http://blog.kimblechartingsolutions.com/

    • jesse says:

      I think Ben is only comparing active and passive management. He is not, yet, making any statements on asset allocation, so-called “market timing” or “entry points.”

      Though I’m sure he has thoughts on all these topics.

  2. In theory it could work. But keep in mind that the professional managers have access to the best technical tools out there and they have teams of people using fundamental and technical analysis. But the net results still speak for themselves.

  3. Earl says:

    Great blog Ben. I never considered the effect of having a large asset mutual fund, and how closely that could mirror the index. Very insightful.

  4. Pingback: Changing concepts of happiness that ( | Home cooking

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