Passive Indexing vs. Active Management
An Introduction to Investment Planning – Part 7
In the world of investment funds, passive investments that track an index are relatively recent innovations. In the US, John Bogle, the founder of Vanguard, launched a mutual fund in the 1970s that tracked the S&P 500 Index. One could argue that the first passive index-tracking Exchange-Traded Fund was launched on the Toronto Stock Exchange in 1990. Toronto 35 Index Participation Units (TIPs 35) tracked the TSE-35 Index.
Passive index funds did not begin to gain ground with the Canadian public until about 20 years ago. Mutual funds have been the main investment vehicle Canadians have used, and most of them have been actively managed. That is steadily changing, but if you were to go to your local bank or credit union branch in order to open a mutual funds account today, you would likely be offered an actively managed mutual fund.
In this post, I am going to look at three criteria for measuring investment funds that help to distinguish passive index funds from those which are actively managed: 1. Relationship to the index; 2. Portfolio turnover; and 3. Fees.
Relationship to the Index
The Role of Stock Market Indices
Mutual funds and ETFs managed under a passive indexing approach typically follow a broad-based major stock index. In Canada, that would be the S&P/TSX Composite which holds about 250 of Canada’s largest publicly traded companies. In the US, the S&P 500 is the most well-known stock index. As its name indicates, it holds 500 of the largest stocks in the US markets. There are also indices for a variety of other markets. In all these cases there are mutual funds or ETFs that seek to track these indices in a passive manner, simply trying to replicate their performance, less a relatively small fee to cover the costs and provide a profit for the fund company.
Indices are an important consideration for actively managed funds, too. Instead of seeking to replicate an index, however, the managers of actively managed funds use these indices as benchmarks against which they measure their performance. The goal of an actively managed fund is to outperform that benchmark index after fees are deducted.
There are some challenges that actively managed funds must deal with in meeting the goal of outperforming their benchmark. While index funds are always guaranteed to slightly underperform the index they are designed to track due to their management expenses, actively managed funds seek to outperform by judiciously selecting stocks from the index they use as their benchmark. This outperformance can be a challenge due to something known as closet indexing.
Closet indexing is the practice, by active fund management teams, of creating a portfolio of stocks for their fund that closely tracks the benchmark index. Fund managers may do this to lessen the risk of significant underperformance. By sticking close to the index, the fund will probably underperform but it will not be by a dramatic amount and may allow everyone to keep their jobs.
One way to measure whether a fund is a “closet indexer” is a statistical measure of deviation from the index called R-Squared. An index fund will have an R-Squared that approaches 100 whereas a fund that is going its own way, so to speak, will have a substantially lower R-Squared. You can find an R-squared (or R2) measure on Morningstar.ca by searching for the fund you are interested in and then looking for it under the Risk category.
Another challenge that active funds must deal with is the impact of their active strategies on the taxes their fundholders must bear. Please note that this depends on the degree of activity a fund manager has determined for their fund. A fund with a portfolio turnover of 100% has bought and sold every security in the fund in the course of the year. A consequence of high portfolio turnover is that the sales of the positions may lead to substantial capital gains, resulting in significant taxes becoming payable in a non-registered account.
Must an actively managed fund have high portfolio turnover? No. Some funds, even so-called active funds, have very low turnover, as low as 10%. That does not mean they are not actively managed; it just means that the fund has a longer-term investment mandate. It also means that such funds will likely be more tax efficient.
Index funds, since they seek only to track their benchmark index, have very low turnover and therefore tend to be more tax-efficient than the average actively managed fund. For the same reasons, they tend to be low cost.
By far, the most consistent factor in predicting fund performance has been fees, specifically the MER or Management Expense Ratio. This has been documented by fund researchers, like Morningstar, time after time. This has also been among the most significant factors driving investors from actively managed funds to index funds since the latter are so much cheaper.
The challenge for active fund managers is that, unlike index funds, they need to do research, which means spending money, which requires that they charge a higher fee for their fund. Index funds do not do research. They simply pay a fee to an index provider (S&P and MSCI are two of the most well-known) for the right to use their index and set up a computer system so that their funds track that particular index. No expensive research team is necessary.
The higher fees of actively managed funds are often said to be justified if the fund delivers higher returns. The problem is the frequent failure of those funds to deliver consistent benchmark-beating performance over time. Few can do this although this fact is not readily apparent. Funds that are consistently poor tend to be closed or merged into other funds, so they are no longer part of the universe of funds that are compared.
Having said that, there are some actively managed funds that do well, meeting or beating their benchmark over time. Using these three analytical points – relationship to the index, portfolio turnover and fees – is a good place to start.
Active or Passive?
Does this mean that you should go with actively managed funds, if you can pick the right ones? The problem is that the average fund tends to disappoint, to underperform. Oddly enough, it is not that easy to pick the top performer. The reality is that the average investor picks the average fund. One thing that the presence, and indeed, the success of index funds makes clear is that very few of us have above average ability in picking investments. Even having an investment advisor helping you probably means you are going to get the average advised fund.
The simple solution to this search for the higher-ranking actively managed fund is to give up on active management altogether and simply invest in passively managed index funds. I am not ready to write off actively managed funds altogether, though. The tremendous research capabilities of mutual fund firms may yield superior results, but those results are often negated by high fees. If you are willing to investigate your investment options using the criteria described above as well as the other tools that are at your disposal, and you have the patience to tolerate years of sub-par returns, you may realize the potential for index beating results.
In my next blog post, I will investigate what is often considered the decisive factor in investing: Asset Allocation.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.