Passive vs. active fight masks real issue

(November 3, 2004) Sometimes a debate can become so polarized that the real issue at hand is lost to the audience. No, we’re not talking about presidential politics here. This time it’s asset allocation.

The debate between active and passive management is essentially artificial, but both sides have “found religion” and taken an unrelenting stand in favour of their own style, according to Scott Mackenzie, president of Morningstar Canada, speaking at the Peel Institute of Applied Finance Toronto Fall Symposium.

Of course, portfolio construction is about balance and Mackenzie says there is a place for both passive and active management, so long as it is understood what assets they bring to the table.

The fight between active versus passive investing can overshadow the more important issue of proper diversification across style and capitalization. Too often, investors take an all-or-nothing approach, labelling themselves as value investors or growth investors, when a blend of both would serve their purposes better.

Most passive investment products aim to mimic a given index, such as the S&P/TSX Composite or the S&P 500. “The problem is those indices were never designed to rate performance,” Mackenzie said. “The indices were designed to reflect what’s happening in the marketplace. The Dow Jones and the S&P 500 were introduced to describe the market and the NASDAQ was introduced to promote an exchange.”

Investment funds that seek to mimic these indices are inherently skewed toward large cap stocks.

Mackenzie points out that investors looking for broad exposure within the large cap universe can certainly achieve this through the use of low-cost ETFs, but they should be aware that they will miss out on any small or mid-cap rally. Investors who strictly hold index funds will also have to accept they will not likely outperform the index they are tracking.

The prime argument in favour of passive investment has been that these funds come with dramatically lower costs. On the other hand, higher costs do not necessarily indicate active management. Mackenzie warns that many “closet indexers” are charging MERs similar in line with their professed active management.

These fund managers find themselves under pressure to match a given index for fear of losing their job. Once management fees and trading costs are factored in, it is impossible to beat the index by indexing, so managers will tweak their portfolio slightly to compensate.

If an investor wants a fund that follows an index, though, they deserve to pay the lower MER. To help weed out the closet indexers, Morningstar has introduced the industry sector concentration (ISC) measure. The ISC can be viewed as a “TSX similarity” measure, with a score of “0” showing complete similarity and a theoretical high score of “200” indicating no similarity. Active managers tend to fall into a range of 25-35.

As the portfolio diverges from the index, it stands a better chance of beating it, but with that increased volatility comes downside risk. Risk is not necessarily a bad thing, of course, but a bad year can damage a manager’s career more than a long-term investor’s portfolio.

Mackenzie says ISC research has shown a “sweet spot” for funds. Over a three-year time horizon, funds with a low ISC score between zero and 10 (that is, those very similar to the index) beat the index only about 6% of the time. As the ISC score rises to the 10-20 range, funds beat the index about 25% of the time.

By the time a fund’s ISC hits the 30-40 range, which is above the average score for active managers, these funds were beating the index 50% of the time. Of course, they were underperforming or meeting the index half the time as well. As the ISC score went beyond 40, however, the odds of beating the index began to fall again. On a five-year horizon, a similar pattern prevailed, with the 30-40 range remaining the “sweet spot.”

Funds within this high ISC range also posted the higher average returns over the same three- and five-year period. They also carried the highest MERs, however, serving as a reminder that out-performance through active management does not come cheap.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com