The case for active and passive management

The debate continues to wage on whether actively managed portfolios or those that passively track an index are better. We believe that you can have both working for you.

Opinions regarding passive versus active investment management strategies are firmly entrenched. Proponents of passive, or index investing, claim that it is impossible for the average active manager to beat the index after fees are taken into account. On the other hand, there are actively managed funds that continue to defy the odds. Furthermore, reducing risk or achieving higher returns – even by small degrees relative to the index – can significantly enhance wealth accumulation over time. Both camps are supported by numerous studies that seem to prove their position is indeed correct. How can this be?

Not so black and white

The problem is that this debate is always framed in black and white terms – that one approach is consistently better than the other. However, T.E. Investment Counsel believes that using these approaches in tandem can go a long way to helping our clients achieve their investment objectives. Incorporating both active and passive investments can result in a portfolio that achieves better risk-adjusted returns at a relatively lower cost.

Asset class matters

Some asset classes, by their very nature, lend themselves to a passive approach, while others are better accessed through active management. Within the equity space, data shows active managers have a difficult time outperforming the U.S. market – in 2014 only 19% of large-cap managers outperformed the S&P 500 index. With the high degree of diversification represented by the index, it is more difficult for an active manager to improve on this mix and deliver superior performance net of fees.

In Canada, the story is different. In their 2014 Annual Review of Equity Active Management in Canada, Russell Investments reports that 57% of large-cap managers outperformed the S&P/TSX Composite index return over the previous 10 years before fees and that the median manager return was 80 basis points above the annual return for the index. With 70% of the Canadian market’s capitalization in just three sectors, there is a more compelling case for active management, which can add significant value through diversification.

Similarly, active management can be effective when investing in International and Emerging Market equities because returns are often dependent on regional factors that aren’t reflected in an index.

In our April 2015 Investment Commentary, we looked at how active management might be better for bond portfolios over the next market cycle. The current yield of the FTSE TMX Canada Universe Bond index is 2%, yet passive investors have been achieving returns higher than the index’s yield-to-maturity, essentially borrowing from future returns. Eventually, this relationship will reverse, possibly resulting in negative returns for passive investors.

Not all managers are created equal

Part of our mandate is to source investment managers who can add value for our clients. Although there is a wide range of investment talent to choose from, by looking at both quantitative and qualitative measures and through careful analysis, we focus on finding those talented managers who are capable of consistently delivering superior results over time.

Our evaluation begins with screening the universe of active managers for consistent outperformance and demonstrated success in different market cycles. Within this selected group, we evaluate them on qualitative measures. We want to see that the investment process used is repeatable and that the manager adheres to their stated discipline or specialty. And we need to see evidence that what the manager says they are doing is indeed what they are doing.

We also look for a high active share – a concept put forth by two Yale School of Management researchers, Martijn Cremers and Antti Petajisto. A high active share results when there is little overlap between a fund and its index. A low active share indicates a high degree of overlap with the index – potentially a passive strategy masquerading as active. Since deviating from the index is the only way to outperform it, active share indicates the potential for a fund to beat the market.

In their 2009 paper entitled “How Active is Your Fund Manager? A New Measure That Predicts Performance” Cremers and Petajisto examined 2,500 U.S. mutual funds from 1980 to 2003 and found that the percentage of truly actively managed funds had significantly declined. Taking their place was a rise in low active share funds, which were deemed “closet indexers”. They found that active share was indeed a good predictor of performance, with those funds with the highest active share consistently outperforming their benchmarks after expenses.1 More recently, as the chart on this page shows, high active share coupled with a long-term focus has been a formula for outperformance net of fees.

Benefits of a Long-Term Active Approach2

In addition to crunching numbers, we also conduct on-site interviews with potential managers, and assess stability, looking at manager turnover, the ownership situation and whether investment professionals have a vested interest in the firm and their strategy. No decision is entirely without risk, but we rigorously monitor our managers to keep abreast of any potential changes in order to mitigate the possibility of any negative effects

Putting cost in context

One of the biggest knocks against active management is that higher fees are too big of a hurdle for the average manager to overcome with performance. But if you can reduce the size of that hurdle, you can increase the likelihood of outperforming the index. That’s why we have always focused on lower-cost investment options and have negotiated lower fees from managers for our clients.

Index funds are typically offered at a low cost because there is no research, modeling, analysis and trading going on. But lately, hybrid options have started to emerge. These so-called “Smart Beta” funds are based on an index with an active management component that determines which elements of the index to include based on certain criteria, such as valuation or dividend yield.

Not surprisingly, these hybrid options come at a higher cost.

Actively managed funds tend to be pricier for all those reasons that passively managed portfolios are inexpensive. What’s important is that you are getting what you pay for – a manager who is actively managing your money. When the concept of active share came into play, it became clear that far too many supposedly active strategies were not very active, essentially tracking the index.

Aligned with your interests

When we construct client portfolios, our interests are the same as those of our clients – we want to achieve the best possible performance with the least amount of risk assumed, while minimizing costs and taxes. As a result, we are not driven by any entrenched ideology. Instead, we prefer to keep our options open, choosing passively managed options when they make sense and pursuing active management where we believe it can add value and help clients realize their investment goals.

1 Cremers, Martijn and Petajisto, Antti, How Active is Your Fund Manager? A New Measure That Predicts Performance (March 31, 2009).
2 Almeida, Robert M., Jr., Cantara, Michael T., Flaherty, Joseph C., Jr., There’s No Substitute For Skill. The value of active management through market cycles. (June 2015, MFS).

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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.

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