SPIVA challenges active management

Hot on the heels of a Russell Investments report touting active managers, Standard & Poor’s has released its own active fund findings, and the results aren’t as rosy. S&P has found that 47.7% of Canadian equity funds outperformed the S&P/TSX Composite Index, while only 47.6% of Small Cap funds fared better than their benchmark.

Steve Rive, vice-president of Canadian index services at Standard & Poor’s, wasn’t surprised by the weak performance of more than half the active funds. “What we’re seeing in Q1 is pretty consistent with what we’ve seen historically,” he says.

Over a five-year period the situation is even bleaker, with only about 10% of active funds beating the benchmark. For Small Cap, that number is higher, with nearly 50% reaching the S&P/TSX Canadian Small Cap Total Return.

Rive attributes the low numbers to various factors, including the costs of running an active firm and management expense ratios. “If an MER is 2.5%, you’re starting the year in a hole. You need a 2.5% return to break even on the money you’re managing.”

Another reason these funds are underperforming is the hot Canadian market. “Canadian markets have been on fire,” says Bhavna Hinduja, an analyst with Morningstar. “Three-quarters of the index are in three sectors.” She says many active managers don’t overweight the high performing sectors, so it’s nearly impossible to beat the benchmark.

Making matters more difficult, says Hinduja, is that the Canadian markets’ focus is narrowing, so active managers can’t find as many opportunities in the Canadian space. The high Canadian dollar hasn’t helped either. “The currency effects have negatively affected some of these blend Canadian equity funds that have increased their global exposure.”

Russell Investments, which looks at institutional managers rather than mutual funds, found that active managers didn’t have as much trouble beating the benchmark, with more than 65% of large cap equity managers outperforming the S&P/TSX Composite Index.

One reason for the disparity is that Standard & Poor’s takes into account survivorship, or the percentage of funds that have merged or closed in the last five years.

“You don’t have the luxury of choosing only among the managers across the finish line,” says Rive. “You had to make your decision five years ago, with who was offering their wares at the beginning.” Considering that 38% of funds didn’t live to see the five-year mark, survivorship rate played a significant role in the poor performance of active funds.

One other factor accounting for the low numbers is that S&P’s data doesn’t exclude closet indexers — funds that hug the benchmark while still charging an active management MER — which results in an underperforming fund. “If somebody is running an active fund,” says Rive, “we don’t attempt to measure how closely their portfolio matches the index.”

Hinduja says counting closet indexers makes a big difference in the results because “there are a lot of hugging index managers who are thought to be active. When you count for fees, it’s not surprising that they would underperform.”

With only 10% of funds outperforming the index over five years, is it even wise to invest in active funds? Rive thinks so. “Active management exists and can be successful. What these stats say is you shouldn’t take it for granted.” He says people tend to think that comparing an index fund with an active fund is risk free. “But it’s just like anything else,” he says. “You’re taking on some risk and potentially reaping the rewards as well.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com