Active vs. passive investing: Which approach wins?
Lower-cost ETFs may appeal to investors, but it’s important to consider cost versus value in the active vs. passive debate
Date: May 11, 2017
Exchange-traded funds (ETFs) are attracting record investment in Canada. As of March 31st, 2017, Canadians were invested in $122.9-billion in ETFs, up 29 per cent from a year ago. But the debate between those who favour the passive approach (typical of ETFs that track an index) and those who favour active management is far from settled.
Kathrin Forrest, portfolio manager at Sun Life Global Investments, says when it comes to the active vs. passive question, it’s a decision that comes down to an investor’s goals.
“To me, it’s not really about active or passive. They both serve a purpose, they both might be suitable [strategies], but let’s not start with that question. Let’s start with: What are you trying to achieve?” says Ms. Forrest.
“In many cases, it’s a combination of a return target and a risk tolerance that includes behavioural biases, and then a set of constraints,” she explains. Return objectives can include capital preservation or capital appreciation, while investment constraints can run the gamut from a need for liquidity to time horizon to tax concerns.
“Once you’ve solved all that, then you can ask which style – active or passive, after fees – has the better odds of delivering on the intended outcome.”
The odds of success of each investing style can vary, says Ms. Forrest, based on everything from asset class and the way markets are moving to an individual manager’s particular skill set.
“In the end, you’ll probably end up with a combination of both, depending on the market [a client is] is investing in, and depending on investment objectives and constraints,” she says.
Ms. Forrest notes that while the passive approach can deliver lower fees, an active approach can help investors be more responsive to changing market conditions by allowing them to move within and between asset classes.
“For example, if you invested $1,000 in the S&P 500 passively on Jan. 1st, 2000, you would be left with $760 ten years later, so you would have lost about 25 per cent of your capital,” she says.
“Is that a great outcome? I’m not sure. Your fees were low – that’s great – but you probably didn’t meet your investment objective. [That objective] probably wasn’t, ‘I want to match the S&P 500.’”
After all, Ms. Forrest points out, investors aren’t investing to match, or even beat, a broad market index. They’re trying to build wealth for their retirement, help pay for their children’s education or afford a down payment on a house.
Active managers, she says, have done well in Canadian equities, emerging market equities and, this year, in Canadian fixed-income. For example, 48.28 per cent of managers within the Canadian-focused equity markets outdid outdid the blended index in 2016, according to the S&P Indices Versus Active Funds (SPIVA) Canada Scorecard.
However, active managers have struggled to beat the index in U.S. equities.
“We’ve seen an incredibly strong equity market, particularly U.S. equity market performance coming out of the financial crisis starting in 2009,” says Ms. Forrest. “Active managers historically have tended to outperform in markets that were weak. When markets are very strong, active managers have tended to struggle.”
For many investors, the downside of the active approach is the higher cost, says Tom Drake, founder of the popular investing site, Canadian Finance Blog.
“I think more and more people are coming around to the math that being average with ETFs and index funds is more reasonable than the expectation of beating the market by more than the high management expense ratio of actively-managed mutual funds,” says Mr. Drake.
Part of the problem, Mr. Drake says, is that judging which approach would have worked better is a lot easier than figuring out which approach will work better in future.
“There have been many past market conditions where active management has surpassed passive investing, but the problem is that we can only see that in hindsight,” says Mr. Drake.
Ms. Forrest notes that mistaking past performance for an indication of future performance is common with investors. It’s human nature to look for patterns, even when there’s small print warning against it.
The question for investors should be one of cost versus value, she says. But while the cost of investing with a specific manager is easy to see, the value that manager brings is harder to judge.
“In the end, it comes down to a well-designed manager selection and oversight process,” says Ms. Forrest. “The key really is to look at factors that allow a manager to deliver on the intended outcome. What are the objectives and incentives? What’s the breadth, depth and continuity of their unique capabilities and insight? It’s a lot of work.”
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