Opinion: Active investing works

Rarely a week goes by when we don’t read that passive investing through ETFs and low fee index mutual funds is a much better way to go than investing in actively managed mutual funds. And we can count on the authors reminding us that the average mutual fund has lower returns than the benchmark index.

But nowhere have I seen the weighted-average performance of all funds within an index category. For anyone who owns or sells mutual funds for the long term, relatively consistent performance is a prime requisite.

A fund which underperforms comes under scrutiny. If there is a reasonable explanation like, a value style fund underperforming in the growth phase of a market, no action will be taken. Two, three, or four years of underperformance and that fund would see significant transfers of assets out to other funds. The top-performing mutual funds are generally the ones with the largest assets under management, but this reality is ignored by the “passive option” promoters.

In the S&P/TSX Composite Index, the Energy and Financial sectors together account for just under 60% of the index. In the past five years such concentration has helped the TSX post positive returns, while the S&P 500 had negative returns in a range-bound market. A disproportionate concentration in technology in the year 2000 was a painful experience for Canadian investors.

You may be surprised to know that a Morningstar study of fund returns for the period ended August 31, 2001, and published in True Wealth, by Thane Stenner, found 91.2% of funds in the Canadian Equity category outperformed what was then the TSE 300 for a one-year return. The three year number was 56.1%, the five year number was 44% and the 10 year number was 47.1%.

While the three, five, and 10 year percentages do not include the funds which were wound up or merged over the course of time, neither do they reflect the relative weighting of the funds, or client/advisor driven switches out of under-performing funds. Yes, the data are nine years old, but reflect a time when there was much more diversity and balance within the sectors of the index.

Among the Canadian Focused category at February 2010, there are 154 funds with a minimum of 10 year returns reported. In the bottom 77 funds, only four have assets over $1 billion, none are over $2 billion. In the top 77 funds in the group, 12 have assets in excess of $1 billion; five of those are above $2 billion, and four over $3 billion. Three of those four are in the top seven funds, with one of those reporting over $5 billion in assets. That fund was in seventh place.

I would ask investors, and even some advisors, to challenge the simplistic approach pundits take deprecating mutual funds. Actively managed mutual funds contribute in a positive way to making the market in various stocks. By their nature, passive investments do not differentiate between good and poor companies. That’s not their mandate. Passive investments do not participate in market making decisions. Investors are disenfranchised, and stock markets are less efficient as a result.

Don Macfarlane is a Mutual Fund Advisor with Assante Financial Management Ltd. in Thornhill, ON. Please contact a professional advisor to discuss your particular circumstances prior to acting on the information above. The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.

(03/30/10)