Passive investing still wins in bear market: study

A new study challenges the notion that active managers outperform indexes in down markets. According to Standard & Poor’s Indices Versus Active Funds Scorecard (SPIVA) report, which looks at the bear market that occurred between 2000 and 2002, active Canadian equity managers fared better than usual, but the indexes still won.

One of the favoured arguments for choosing an actively managed mutual fund over a cheaper index-based fund is that a good manager will manage risk, so that while that manager may not be able to outperform a certain index in a bull market, he or she will protect the fund’s assets during a decline.

At first glance, this argument appears true. During the bear market that occurred for Canadian stocks between August 2000 and December 2002, Canadian equity managers were able to post an average equal-weighted fund return of -11.95%, an impressive bit of risk management considering the S&P/TSX Index Total Return declined 33.93% and the S&P/TSX Capped Composite Index Total Return was at -18.59% during the period.

The SPIVA study says these numbers are misleading and that it was the outsized returns of a few managers during this period that distorted the average returns for active managers. The S&P study finds that only a minority of managers (38.9%) were able to outperform the S&P/TSX Capped Composite index, which places an upper limit of 10% on the relative weight of any single index name.

More than 66% of managers were able to outperform the S&P TSX Composite Total Return, but the study notes these stats are an aberration due to the heavy weighting of Nortel on the index during that period.

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At its peak, in July 2000, Nortel represented 36.5% of the relative weight of the S&P/TSX Composite index, but most managers were prohibited from having more than 10% of their fund’s money in any one stock. Therefore, managers were not as adversely affected by Nortel’s steady decline during the period examined.

“It was a number of strongly performing managers that pulled up the average, but when you look at the number of managers, it’s still a minority,” says Jasmit Bhandal, director at Standard & Poor’s Index Services.

During the current stock market downturn, far from a bear market at this point, preliminary numbers from S&P suggest that 15% of active Canadian equity managers have been able to outperform the S&P/TSX Composite since January. It’s a select group to be sure, but it is a noticeable improvement over the results of the first quarter, in which only 8.2% of managers were able to outperform. It does seem that as things go south, there are a number of managers prepared to weather a downturn.

Bhandal says the problem for investors during the last bear market, and during the current downturn, is how to find those managers. She says it’s rare that a manager outperforms a benchmark over any given period and even rarer still that a manager does so with any consistency.

“It’s a challenge for investors to find out who those managers are, [and] even if they do outperform, would those managers be the ones who outperform in the future?” she says.

Naturally then, advocates of passive investing are heralding this study as further proof that it’s better for the average retail investor to create a diversified portfolio of low-cost ETFs over higher-cost actively managed mutual funds.

Heather Pelant, head of iShares for Barclays Global Investors, says she’s glad S&P has done the study because she believes the notion that active managers outperform in a down market is a myth, and a destructive one at that.

“It is one of those industry hype things that really bothers me,” she says. “Oftentimes you’ll hear that an active manager has a good downside capture ratio, which means they’ll give you all the upside of a bull market and protect you on the downside. This study is saying active managers cannot beat the market even in a downturn.”

As the head of an ETF firm, Pelant would like to see more investors considering ETFs over mutual funds, but ETFs are not without their own risks. Any investment that tracks an index, will go right down with it during a bear market. In the last bear market, investors would have seen their S&P/TSX Composite index tracking ETF drop more than 30%.

Pelant says for that reason it’s imperative that an ETF portfolio is diversified across a broad range of sectors. In particular, she says Canadian investors have to consider decreasing their holdings of Canadian equities, which represent less than 3% of the world’s equities by assets and are heavily weighted in three sectors.

“You’ve got to be diversified right now. You need to make sure your allocation is correct. If you need to do a strategic rebalancing, do it. If you get asset allocation right, you can weather a lot of storms,” she says. “My personal sense is Canadians are way over-weighted in Canadian equities, which means they are making three big bets on energy, financials and basic materials. If you think about it, [in a] down market, traditionally where do you go? You go to healthcare; you go to utilities and consumer staples. What does Canada have none of? Healthcare, utilities and consumer staples.”

In her opinion, managers faced with a down-market do the opposite of diversifying; they model their portfolios to look more like the index.

“Managers are compensated for beating a benchmark,” she says. “When they get rattled like markets do, oftentimes they start to hug and look more like the benchmark. This is a period where you want a manager to be different than a benchmark.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(08/06/08)

Mark Noble