Active or passive

The mutual fund industry is inundated with misleading numbers. In particular, you’ve likely read an article or two that refers to some study that has shown how most actively managed funds have failed to beat their benchmarks over the long term. The inevitable conclusion would have been that everyone should buy low-fee, index-tracking exchange-traded funds (ETFs) because you’re unlikely to pick a mutual fund that will give you a higher return.

The premise of the argument is tough to dispute. Without going into details, our experience has indeed been that the average mutual fund has tended to provide a lower return than comparable ETFs. But while there are a lot of uninspiring mutual funds available that bring down the average, it would be a mistake to dismiss active management altogether.

For some strange reason this topic tends to polarize people; they become staunch supporters of either active management or fiercely loyal index-fund and ETF enthusiasts. It is considered sacrilegious in some circles to use both approaches in a portfolio. But where was it ever written that you have to choose one side or the other?

Investors should purchase the best available option in a given category, whether it is managed actively or passively. If you can’t find an actively managed fund that you’re confident will add value in some way, then simply revert to the best low-fee, index-tracking mutual fund or ETF alternative.

Note that we say “add value in some way,” which deliberately implies there is more to think about than a fund’s rate of return. Here are a few things to consider when choosing between an active or passive fund:

Is the fund truly active? The trouble with the whole activeversus- passive debate is that most studies that attempt to tackle this subject have a very black-or-white view of the fund universe, where a fund is either active or passive. In truth, the distinction between the two is often blurry at best. And it is this ambiguity that can render statistics on this subject misleading.

Investors would do well to think of funds as being placed along a spectrum ranging from more active to less active. Truly active funds are run by professionals who scour their eligible investment universe to find the securities they believe will perform best, regardless of the benchmark. At the other end of the spectrum, completely passive funds are run by professionals who use various techniques to ef- ficiently copy an index.

On the surface, the difference seems easy to identify, but in reality there are a whole host of funds with strategies that lie somewhere in between. For instance, there are many so-called actively managed funds whose strategy is to ensure that they take only small, measured deviations from the benchmark. These funds tend to be easy for fund companies to sell because their performance never really stands out in a negative sense.

But in a country where 2.50% MERs are common, this is clearly a loser’s strategy. If the fund is tied too closely to the index, it should come as no surprise if it underperforms that index once fees are deducted. It is this group of funds that skews the statistics and makes the average fund perform consistently worse than the index.

By narrowing your search to truly active funds, your odds of selecting a winning fund improve. You can accomplish this by comparing a fund’s sector and geographic allocations relative to its index, as well as the top holdings. Also, performance correlations can be very telling.

Does the fund suit my risk profile? One of the key misconceptions about passive funds is that they are less risky than active funds. Often, the very opposite is true. Passively managed funds are not designed to mitigate risk over and above that of the index they track; they simply imitate an index. Actively managed funds, on the other hand, consciously attempt to provide superior risk-adjusted returns (or at least they should). Of course, just what that level of risk is depends on the manager and the investment objective of the fund.

In some cases, an index may be riskier than what is appropriate for certain investors. In Canada, for example, funds that closely track the S&P/TSX Composite Index have, in recent years, shown a high degree of volatility due to the index’s high concentration in resources and banks. And of course we all remember the Nortel fiasco.

In Morningstar Canada’s database, there are 48 mutual funds in the Canadian Equity category with a 10-year history, and all but five of those funds have exhibited lower volatility than the S&P/TSX Composite over that time—not to mention one of the five is itself an index fund. Many managers in this space have taken advantage of the flexibility to deviate from the index meaningfully.

Does management employ a distinct, sustainable strategy? Some mutual funds are managed with little or no regard to benchmarks, which is refreshing. In these cases, comparisons to popular index funds and ETFs don’t tell the whole story.

Two extreme examples are Mackenzie Ivy Foreign Equity and Chou Associates, both of which are Morningstar Fund Analyst Picks. For the former, management has built a portfolio of 20-odd leading businesses with clean balance sheets that can perform well through all phases of the business cycle. This strategy won’t shoot the lights out, but should provide a solid return over the long haul with relatively low uncertainty.

Chou Associates, on the other hand, employs a much more aggressive approach of buying up deeply undervalued (and in some cases, distressed) assets in the hope of achieving outsized returns. A strategy such as this will inevitably suffer extended periods of underperformance relative to benchmarks and peer groups. But over the long term, unitholders have enjoyed huge success.

A fund’s historical performance relative to some benchmark shouldn’t be the only consideration in determining its suitability. Instead, decide whether its strategy might be a better fit than an investment vehicle that tracks an index whose construction is based entirely on its underlying constituents’ market capitalization, as is the case with popular benchmarks such as the S&P/ TSX Composite, S&P 500, and MSCI World.

David O’Leary is manager of fund analysis with Morningstar Canada; Brian O’Neill is a senior fund analyst.