Being active is for the gym, not your portfolio.
“When did you get so clever?”
“When I realized I wasn’t as clever as I thought.”
― John Connolly, The Infernals
Hubris. The fatal flaw. And a common trait of the average actively managed fund manager.
“I will be different!” … is what I envision them saying, as they march onward in the quest for alpha.
Each and every day, throngs of asset management employees spend hours poring over reams of data, performing endless analysis and searching for the golden nugget of information that will give them an edge over their competition. And unfortunately, each and every day, the majority fail.
Day after day.
Month after month.
Year after year.
This isn’t up for debate, it has been empirically proven.
The investment management industry attempts to sell you on their superior expertise to maximize your investment gains.
We have all seen ads similar to this one:
However, they are really spending a lot of money on marketing in vain.
There are 2 factors to consider with respect to their performance.
The most critical aspect of measuring a mutual fund’s returns is their performance against its benchmark.
For example, if you wanted to buy a mutual fund that invested in Canadian stocks, that mutual fund would likely be benchmarked against the S&P/TSX Composite Index. The actively managed mutual fund would then invest in an attempt to outperform that index. It would do this in 2 primary ways:
- Only investing in certain stocks while avoiding others, some examples may include
- investing in banks but not oil & gas;
- investing specific bank stocks instead of all bank stocks
- Timing the market by investing more or less in an attempt to avoid losses and capitalize on upward momentum gains.
There are other ways that certain funds may be able to achieve gains (e.g. options, hedging, etc.), but not all are appropriate for the average mutual fund.
Simply put another way, the best performing sample only saw 37% of mutual funds beat their index.
Funds are often judged based on quartiles. This means that for a given class of funds, such as US Large Cap funds, they are measured against their competition in the group via a ranking from top to bottom. The top-performing 25% of funds would be in the top quartile and the bottom 25% in the bottom. Because they are grouped together in this manner, many fund managers aim to simply not be an outlier amongst their peers. Why do you ask? How do you think a fund manager’s year-end performance review with their boss would be if they were in the bottom quartile for a given year?
This is what gives rise to the concept of closet indexers. What this means is that supposedly actively managed funds are in fact aiming to mimic their respective benchmark so that they can avoid appearing in the bottom quartile of their group. This is relatively easy to do by investing in the entire, or close to it, benchmark. For example: If the TSX was made up of 1/3 Financials, 1/3 Oil & Gas and 1/3 Mining companies, the active manager could invest in 2 or 3 companies for each segment of equal weights. 1/3 of the assets invested each of Financials, Oil & Gas and Mining, and you have likely just avoided the bottom quartile. This would not yield outperformance but would rather perform similarly to that of the entire TSX (in this simplified example).
The other key consideration with active management is expenses. Active management costs more. It costs more in a few ways:
- Higher Management Fees or MERs for mutual funds
- Higher trading costs due to trading in and out of stocks.
- Tax bills for realized gains
The cost argument is always best approached by comparison. If you simply bought an index fund that tracked the TSX, you would pay less in management fees than an actively managed fund. For example, TD offers many mutual funds, but I have included an example below of their cheapest TSX Index Fund and an actively managed fund which intends to outperform the TSX. Below is a summary of their MERs and relative performance (data source 1 and 2).
To be clear, TD is used in this example, but this is something that you would likely find at nearly any mutual fund vendor with respect to expenses on the actively managed side. That said, the e-series offering from TD is one of the lowest cost options of its kind.
Now, consider how many of these actively managed funds may be closet indexers in conjunction with the higher prices that they charge for management… That sounds like a recipe for underperformance, not their promise of outperformance.
If you choose to invest with a portfolio manager who would be purchasing individual stocks, instead of a mutual fund, this is where the trade costs add up. Every time that the asset manager switches into and out of a stock, they have to pay a commission to the brokerage that houses your account. This means, that through being active in an attempt to outperform, there can be substantial fees related to stock trading.
The additional contemplation of active stock trading is taxes. Every time that you trade a stock in a non-registered account (i.e. outside of a TFSA or RRSP) you realize a gain or loss. This could mean that you are stuck with a surprise tax bill at year end because of all the active trading that you are doing. This means that the money owing in taxes cannot be reinvested and compounded for your benefit, but instead will be sent to our good friends in Ottawa.
If you go back and look at the advertisement shown above, you will note that it doesn’t indicate whether the returns are before or after fees. How do you think the return figures might change if you factored in 1, 3, 5 or more years of fees into the equation?
THE BRASS TACKS
Asset managers would like to sell you on their superior intellect and clever ability to pick individual stocks that are winners. History has told us otherwise. Index investing guarantees you the effective market return at a lower cost.
Think of it this way:
You are writing an exam and have 2 potential study methods.
Study Plan A gives you a 20% chance of being average or better and an 80% chance of being below average and the material will cost $600.
Study Plan B gives you a 100% chance of being average and costs $100.
Study Plan B would be a no-brainer.
So I will leave you with one final question:
Who’s clever now?