Indexing still outperforms: S&P

A much higher proportion of active mutual fund managers were able outperform their respective benchmarks during the worst of the downturn, but the man in charge of Standard & amp; Poor’s indexing committee says that over time, the odds remain in favour of indexing.

David M. Blitzer, S&P’s managing director and chairman of the indexing committee was in Toronto recently to discuss the latest Standard & Poor’s Indices Versus Active Funds Scorecard (SPIVA), which showed mixed results in the ongoing battle between managers and their benchmarks.

Active management advocates have been making a strong case that it has proven its value in the downturn, protecting investor capital during an extraordinarily deep downturn. The idea is that preserved capital should compound to bring future returns which will offset both fee-drag and the benchmark underperformance most funds exhibit during bull markets.

Both Canadian and U.S. funds have posted decent performance against their benchmarks during the bear market. According to the last SPIVA Scorecard, 53.2% of actively managed Canadian Equity funds outperformed the S&P/TSX Composite Index in the final three months of 2008. They did lag the index for the first quarter of 2009.

For the first quarter of 2009, only 27.4% of actively managed Canadian Equity funds outperformed the S&P/TSX Composite Index. However, outperformance rates rose outside of the broad mandate category:

• 70.4% of active funds in the Small/Mid Cap Equity category beat the S&P/TSX Completion Index; and • 76.9% of active funds in the Canadian Focused Equity category beat a blended benchmark of 50% S&P/TSX Composite + 25% S&P 500 + 25% S&P EPAC LargeMidCap Index

U.S. equity fund managers had a great first quarter. The majority of active mutual funds investing outside of Canada were able to outperform their benchmarks:

• 56.6% of active U.S. Equity funds outperformed the S&P 500; • 73.3% of International Equity funds outperformed the S&P EPAC LargeMidCap Index; and • 82.0% of Global Equity funds outperformed the S&P Developed LargeMidCap Index

While active managers arguably won this battle, history would suggest fund investors who go with active managers will not win the war, Blitzer says. The longer an investor sticks with an active mandate, the greater the likelihood it will underperform its index benchmark.

“If you look at performance for a period of at least year, or look out at three year time period, two things will standout. At best, two out of five managers will outperform the index — so three out of five won’t. Once you get out to a five years you’re probably looking at one out of three managers,” he says. “Equally important for [investors], trying to figure out which two out of five managers are going to outperform the index is virtually impossible. It really is true that past performance is not indicative of future returns — it’s not just something the regulators tell you to say.”

Blitzer says there are strong disciplined managers who will have periods of excessive outperformance sticking to a rigorous investment style, but being disciplined also means there will be times where returns will be out of favour with the market. Over time, their occasional outperformance doesn’t make up for their lean periods.

“You can find bottom fishing value managers, who are very good at finding those stocks. The stock market can change and they’re making 3% while the index is making 9% and the growth managers are making 15%,” he says. “Then there are managers who think they can predict what type of market cycle is coming up, be it value, growth or small cap etc. Every time the market changes they have to relearn the game. I don’t think they do particularly well [over time] either.

He adds, “A manager has to be skillful. I have to be lucky enough to pick him. Those are two long shots back to back.”

Finding managers who consistently outperform the index is a difficult feat in itself. Blitzer says fees remain the primary reason the bulk of active management lags the index.

“For a typical investor, fees for an individually managed active mutual fund tend to be higher. It is very difficult to find an actively managed fund that is going to outperform the index,” he says.

This is particularly so in Canada, which S&P says has the second highest mutual fund fees in the world, next to Norway. Theoretically, to beat an ETF, managers don’t just have to outperform the index, they have to outperform the index by more than 2%, compounded annually.

“The U.S. market has roughly a historical 8% total return, the index guys are making 7.5% annually, while the same return of an active fund, after fees, is probably around 6%. You compound the difference between 6 and 7.5% over ten years and it adds up to be some real money,” Blitzer says.

The limits of Canadian indexing Comparing a mutual fund to an index is not necessarily a fair measurement of a manager’s alpha, though. The Canadian equity space is a good example of an investment space where clients probably want a manager with somewhat non-correlated returns. At times in 2008, more than 50% of the index was in resources. Managers who tried to keep up with this would have lost their clients a lot of money in the downturn.

Blitzer concedes that from a portfolio perspective, investors need to be aware of what the weightings of indices are, so they can create non-correlated diversified portfolios.

“I think investors are generally aware of the cyclical risks in an index. If I were Canadian, I would play with the numbers and see what the correlations are. Canada compared to the U.S. has a bigger weighting to natural resources and materials, and compared to the U.S. it has a bigger weighting to financials,” he says. “Instead of putting a chunk of money in the U.S. for diversification, you could look at a broad-based index like the S&P 500, but maybe I would like to underweight materials, because they are heavily overweight in my Canadian exposure.

He adds, “In the U.S. market, I’m going to maybe overweight technology to offset that. I’ll take some of my money and put in an index fund that is technology and then I’ll put the rest in the S&P 500.”

(06/11/09)