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INSIGHT
Volume 40 –­ July 2013
The Great Debate:
A Case for Active Management
2
Volume 40 ­– July 2013
Let’s not mince words. The topic of passive versus active investing is a
contentious one, with staunch, passionate supporters on both sides.
Often media sound bites are heard disparaging either viewpoint:
“Active managers aren’t worth the fees they charge.”
“Passive investing is investing in mediocrity.”
Before we get into a he said/she said situation, we should explain
why this is such a prevalent topic. There has been a lot of change in
the mutual fund industry over the last few decades as the industry
has evolved. Much to the chagrin of the proponents of active
management, passive investing is on the rise. Just six years ago, there
were only two Canadian providers of Exchange Traded Funds (ETFs)
with $15 billion in assets, but by the end of 2012, there were seven
providers managing in excess of $56 billion.1 The range of products
has also exploded. In December 2006, there were only 32 Canadian
ETFs on the market, but entering 2013, there were 208…and counting.
In the U.S., 2013 ETF inflows are on pace to break the 2012 $191
billion record2 and Vanguard, an American mutual fund company
specializing in traditional passive investing, currently has $2.4 trillion
in assets under management.3 The growth of passive investing since
Vanguard launched the world’s first index mutual fund in August 1976,
has been nothing short of phenomenal.
As an active manager, we have to ask ourselves why this trend is
happening. The simplest reason for passive investing’s rise in popularity
is due to the general public’s focus on cost – notably so since the 2008
financial crisis – and it is true that index funds and ETFs are often
cheaper than actively managed funds. If an index fund is cheaper than
an actively managed fund but the actively managed fund produces
higher returns, investors will choose the active strategy, correct?
The problem, as Charley Ellis, a legend among index fund investors,
recently declared in an interview with CNNMoney, is that “some 80%
of [active fund managers] would slightly beat the market, but after
fees, their returns end up being below the market.”4 Investors also are
flocking to passive mutual funds and ETFs for the sake of simplicity
and convenience. With so many actively managed funds available, it is
difficult for the average person to properly research them all in depth.
If passive investing is on the rise due to the belief that it produces
better net performance with more convenience, the big question for
us is: should Mawer just pack it in and close its doors? Absolutely not.
The following discussion will highlight why actively managed funds do
have the potential to provide superior returns over passively managed
funds and can be the better option for many investors.
THE CONTENDERS
Imagine a tourist visiting an exotic locale. She has never been there
before. Does she:
a) Sign up for a pre-determined tour of the most popular
attractions?
b) Hire an experienced guide to lead her to the hot spots, but
also hope he helps her find some hidden gems?
Tour “a” represents the passive fund investor. A passive index fund
manager’s goal is to closely match or mirror the returns of a market
or benchmark. ETFs either track an index, a commodity or a basket of
assets in a similar way to an index fund, but unlike an index fund, they
are securities that trade like a stock on an exchange. Passive investing
holds to the theory that markets are basically efficient (Efficient Market
Hypothesis) and because existing stock prices have incorporated all
relevant information into their value, it should be impossible to beat
the market. Just as the tourist will see all the popular spots and there
will be no big surprises, the passive investor will mimic a predetermined
benchmark and can only expect to perform as the market performs.
But there are no guarantees. The tourist could find a popular site
closed for renovations, the weather could provide poor visibility or the
bus she’s on could get a flat tire. Likewise, the passive investor must
weather the ups and downs of the markets.
Tour “b” represents the actively managed fund investor. An active
fund manager’s aim is to beat the return of an index or benchmark
through security selection and/or market timing. Active investing
asserts that the market is inefficient whereby securities are not always
priced accurately and tend to deviate from their true value. Just as the
tourist expects the experienced guide to not only take her to all the
regular tourist spots, but also to find some hidden gems, an investor
in active management expects their manager to use their knowledge
and expertise to uncover, and act on, mispriced securities. A great tour
guide may even tell the tourist to shun the more popular attractions
completely, as they can be overrated and ruined by large crowds. An
active manager that is not afraid to be different from the market,
can shun those securities he believes to be over-hyped and has many
more opportunities to discover top notch, undervalued companies.
But buyers beware. For the tourist, it is of utmost importance that she
researches the background of the guide she chooses, or she could
end up penniless, in the seedy part of town. Similarly, the investor in
active funds should perform their due diligence prior to selecting an
investment manager.
THE PRICE OF PASSIVE
Individuals in favour of passive investing argue that the fees and
operational expenses are lower. When most people hear “lower
fees” they quickly translate that into meaning more money in their
pockets at the end of the day (or less of a loss). In a much cited
August 2000 Journal of Finance article, Russ Wermers researched
stock holdings from 1975 to 1994 and concluded that active fund
managers outperformed the market by an average of 1.3% per year.
But he also found that on a net basis, or after fees were taken into
account, the same funds lagged the market by approximately 1%.5
The information that investors are not inundated with is that passive
funds and ETFs do not “beat,” or even equal, the market because they
are not free, after all, and their fees will almost always cause them
to lag behind their corresponding index. Critics of active investment
management often mistakenly overlook the fees associated with
passive investing and make apples to oranges comparisons.
Volume 40 ­– July 2013
Chart A depicts the management expense ratios (MER) for a few of
iShares most popular ETFs:
3
Chart B
RBC Investor Service’s Risk and Investment Analytics
Rates of Return for Periods Ending March 31, 2013 (gross)
Chart A
iShares ETFMER (%)
(As of May 31, 2013)
DEX Universe Bond Index Fund
0.33
S&P/TSX Capped Composite Index Fund
0.27
MSCI World Index Fund
0.47
Source: www.iShares.com
Many passive investors believe that they get to mimic the market at
practically no cost and this is simply a myth. If someone was to invest
$10,000 over 10 years (assuming a 7% annualized rate of return) in
the iShares ETF, MSCI World Index Fund, they would shell out over
$600 in fees; hardly a free ride.
In addition to MERs, ETFs can also experience less visible costs or
tracking error. Tracking error is the measure of how closely a fund
follows the index to which it is benchmarked. Many people believe
their index fund will perform exactly the same as its benchmark. This
is not the case for a variety of reasons:
1) Cash drag – Unlike an index, ETFs and Index funds hold
cash and the lag of receiving and reinvesting cash can cause variances.
2)
Liquidity – Some indices hold illiquid securities and there
can be a lag or outright discrepancy when an index fund or
ETF manager must purchase or sell these securities in order
to replicate the portfolio’s benchmark.
3) Currency Hedging – Occasionally, an international ETF will
not follow its index due to the costs incurred from currency
hedging.
For example, due to currency hedging, the iShares S&P 500 (XSP) had
a tracking error of over 0.70% in 2012, with a management expense
ratio of 0.24%, making its effective cost 0.94%.6 In a volatile year,
such as the 2008 financial crisis, the results can be much worse. To
illustrate this point, in 2008, the iShares FTSE NAREIT Mortgage REIT
lagged 11.8% behind its benchmark!7
OH, THE POSSIBILITIES
But if, as Charley Ellis approximates, 80% of active fund managers do
beat their benchmarks but lose out after fees are taken into account,
why should an investor choose active management?
Because there are active investment management firms providing
added value, even after fees.
If we examine the gross performance of the 25th percentile managers
in the RBC Investor Services’ Risk and Investment Analytics for the end
of the first quarter of 2013, we see that these “good” managers all
beat their benchmarks over a 10-year period.
Ten Year
Value
Canadian Equity Funds
25th Percentile
11.2
1.2
S&P/TSX Index
10.0
Canadian Small Cap Equity Funds
25th Percentile
13.9
BMO Small Cap Index
11.1
2.8
Fixed Income Funds
25th Percentile
6.3
DEX Bond Universe
6.1
0.2
US Equity Funds
25th Percentile
5.2
S&P 500 (C$) Index
4.6
0.6
Global Equities
25th Percentile
6.9
MSCI World (C$) Index
4.9
2.0
Non-North American Equities
25th Percentile
7.5
MSCI EAFE (C$) Index
5.7
1.8
As fees vary greatly among actively managed funds, some of the funds
represented in these asset classes may have beaten their benchmarks
when fees are taken into account, some not. But this is just a sampling
from the top quartile managers. The top decile performers would have
even greater success.
As you can see in Chart C, Mawer’s three top decile equity strategies
add a substantial amount of value over a 10-year period, even after
fees.
Chart C
Mawer’s Top Decile Equity Funds vs. their Benchmarks
Rates of Return for Periods Ending March 31, 2013 (net)
Total
Ten Year
Value Add
Mawer Canadian Equity Fund
S&P/TSX Index
11.01.0
10.0
Mawer New Canada Fund
BMO Small Cap Index
14.8
11.1
3.7
8.5
5.7
2.8
Mawer International Equity Fund
MSCI EAFE (C$) Index
Source: Mawer Investment Management Ltd.
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Volume 40 ­– July 2013
And a little added value goes a long way. Chart D shows the growth
of $10,000 over a 10-year period for these same Mawer equity funds
versus their benchmarks:
Chart D
Growth of $10,000 over 10-Year Period (net)
$45,000
$39,757
$40,000
$35,000
$30,000
$28,651
$28,394
$25,937
$25,000
$22,610
$20,000
$17,408
$15,000
$10,000
the downward swing, or, at the least, will recover when the irrational
behaviour has passed.
Likewise, an active manager can provide a greater degree of
diversification within their portfolios. Sometimes a particular sector
gets caught up in a frenzy and doubles or triples in value. An active
manager might use this as an opportunity to take profits from
overvalued securities and deploy the proceeds to those that are
undervalued. The passive manager has no choice but to continue
allocating greater and greater amounts of the portfolio to a sector or
security that is trading at excessive valuations. And a passive investor
can get hit hard if that security’s performance takes a dive.
There is no better example of this than when Nortel accounted for over
30% of the TSE 300 Composite Index (now the S&P/TSX Composite
Index) in July of 2000. Passive investors in the TSE 300 Composite Index
woke up one morning to find almost a third of their capital invested
in a single security, while active investors had plenty of opportunity
to take profits from Nortel before its extraordinary decline—to zero.
$5,000
MAWER’S TAKE
$0
Mawer
Canadian Equity Fund MawerS&P
TSX
Composite
Mawer
Canadian
New
Canada
Equity Fund
Mawer International
Fund Mawer New Canada Fund Equity Fund
S&P/TSX
Index Cap Index (weighted)
BMO Small Cap Index
BMO Small
Mawer International Equity Fund
MSCI EAFE (C$) Index
MSCI EAFE index (net)
If a person had invested in the Mawer Canadian Equity Fund, the
Mawer New Canada Fund or the Mawer International Equity Fund, she
would have netted $2,457, $11,106, or $5,202, respectively, above the
performance of their benchmarks over a 10-year period. (Of course,
this is assuming the investor bought the indices for free — which
we have already established is impossible.) This outperformance is
primarily due to an adherence to a sound investment philosophy and
fundamental “bottom up” investment approach that allows investors
to benefit from mispriced securities, or hidden gems, uncovered by
disciplined research. This would not be possible if the market was
efficient at all times.
BRACE YOURSELF…
Most investment professionals agree that the market is fairly efficient.
But sometimes “Mr. Market” falls off the wagon and goes on a
bender. The Tech Bubble crisis of 2000 and the Financial Crisis of 2008
are good examples of why down market protection is a key factor
for investors to incorporate into their portfolios. Investors in passive
funds are at the whim of the forces of the day and are exposed to the
fear and greed that can occasionally drive the market. A good active
manager can provide some degree of protection in down markets
by investing in quality securities that are either minimally affected by
Passive investing has certainly been on the rise over the last few
decades, and this trend does not seem to be going away. Nevertheless,
there are clearly several shortcomings to investing in a passive strategy,
such as being at the whim of a neurotic market and overexposure, at
times, to certain securities and sectors. In addition, passive investors
are not getting the free ride they expect when it comes to fees. In
fact, passive investment fees are often not dramatically less than
those of some active managers. And if the active manager provides
superior returns after fees are taken into account...well, we think it’s
a no-brainer.
And at Mawer, we do believe that there are good managers out there.
To us, being a good manager means following a disciplined investment
philosophy and process that is logical, consistent and time tested.
We are confident in our ability to add value over passive investment
management because we have seen first-hand that security prices
often deviate from their true value due to markets not being perfectly
efficient or rational.
We are proud of being independent tour guides and trust in our ability
to offer an investment experience that exceeds that of our passive,
cookie-cutter competitors.
Joanna Crozier
Business Communications Writer
Mawer Investment Management Ltd.
1 “Canadian ETF Providers,” http://www.etfinsight.ca. Web. June 2013.
2 John Spence: “ETF Inflows May Hit $200 Billion in 2013,” http://www.efttrends.com/2013/05. Web. June 2013.
3 The Vanguard Group, Inc.: Key Facts and Figures, http://www.vanguardcanada.ca/individuals/about-vanguard.htm. Web. June 2013.
4 Penelope Wang: ”How much does your money manager cost you?” http://www.cnn.com/2013/05/01/investing/money-manager.moneymag/index.html. Web. June 2013.
5 Wermers, Russ. “Mutual Fund Performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transaction Costs, and Expenses,” The Journal of Finance: Vol. LV, No. 4.
6 iShares S&P 500 Index Fund (CAD-Hedged) Annual MRFP, 21-Mar-2013. http://www.iShares.com/investor-resources/resource_library/regulatory_document.htm. Web. June 2013.
7 Macdonald, Larry. “ETF Tracking Error: Is Your Fund Falling Short?” http://www.investopedia.com/articles/exchangetradedfunds/09/etf-tracking-errors.asp. Web. June 2013.
August 2000.
Copyright © 2013 Mawer Investment Management Ltd. Readers may forward electronic versions of this article. To order reprints or receive an electronic copy, please contact us at [email protected]
All information contained herein has been collected and compiled by Mawer Investment Management Ltd. All facts and statistical data have been obtained or ascertained from sources, which we believe to be reliable
but are not warranted as accurate or complete. All projections and estimates are the expressed opinion of Mawer Investment Management Ltd. and are subject to change without notice. Mawer takes no responsibility
for any errors or omissions contained herein, and accepts no legal responsibility from any losses resulting from investment decisions based on the content of this report. This report is provided for informational
purposes only and does not constitute an official opinion as to investment merit. Based on their volatility, income structure or eligibility for sale, the securities mentioned herein may not be suitable for all investors.