Active vs Passive Management

Within the investment community, there are two schools of thought. One is that if you spend enough money and hire the right professionals, they can determine not only which stocks to buy, but when to sell them. Brokers espouse this view when they buy and sell individual stocks, and many financial planners and bank employees espouse this view when they encourage you to buy mutual funds. Even portfolio managers, who generally buy a basket of stocks do so in an attempt to out perform the market.

The other school of thought is that over time the vast majority of brokers, advisors, financial planners, and individual investors simply can't beat the market over an extended period of time and therefore the average investor would be better off, over the long run to reduce their ongoing fees as much as possible. 

Because, regardless of the actual results, one thing is certain, and that is this type of trading increases the costs to the client. There are direct fees associated with buying and selling individual stocks, and there are indirect fees, in the form of ongoing management fees that are embedded in the ongoing costs of holding active mutual funds. In some cases these fees are in excess of 3% a year if you are buying specialty funds, or if you start owning funds within funds. 

Naturally given the fees associated with this philosophy, most advisors have a vested interest in hoping active management, or in the case of individual stocks, stock picking, actually works. 

However, the research on this is not overly compelling. According to the research, less than 10% of active large-cap fund managers have outperformed the S&P 500 over the last 15 years. Over the last 20 years, less than 10% of U.S. actively managed funds have beaten the market.

In the small and midcap market range only 35% were able to outperform the index. In the balanced index category, (ie 50% TSX, 25% S&P 500, & 25% world), 46% of active managers outpaced this index. However, over the course of a year, NONE were able to do so. 

Over the last five years, the results have been far less compelling, with only 7% of actively managed funds in the Canadian Equity Category outperforming the index, and only 8.5% did so over a three year period.

Dividend funds showed a similar long-term trend, although over a one year period they did beat the index (Canadian Dividend Aristocrats) in that 79% has superior returns to this index. However over three years, only 21% beat this index, and over five years a measly 4% managed to do so.

Regardless of whether or not you are looking at Canadian equities, US Equities, International or Global, the trend remains the same.

ETFs trade on an exchange. Each transaction is subject to a brokerage commission. Commissions depend on broker, with various "plans" and different conditions, so no simple rule can be given. A "typical" schedule (at least in the United States) is $10 or $20, increasing slowly, or not at all, for larger orders. What is clear, however, due to the quasi-flat charge, amount invested has a great bearing; someone who wishes to invest $100 per month may have 10% of their money vaporized immediately, while for someone making a $200K investment, commission may be, essentially, negligible. Generally, mutual funds obtained directly from the fund company itself do not charge a brokerage fee. Where low or no-cost transactions are available, ETFs become very competitive.

Most ETFs have a lower expense ratio than comparable mutual funds. Not only does an ETF have lower shareholder-related expenses but, because it does not have to invest cash contributions or fund cash redemptions, an ETF does not have to maintain a cash reserve for redemptions and saves on brokerage expenses. Mutual funds can charge 1% to 3%, or more; index funds are generally lower, while ETFs are almost always in the 0.1% to 1% range. Over the long term, these cost differences can compound into a noticeable difference.

ETFs are almost always compared to no-load funds, for the simple reason that, compared to loaded funds, there is no comparison. A person investing $100K in a load fund may have $5K disappear immediately, which is much higher than any conceivable brokerage commission.

Mutual funds may also charge for too short a holding period, which is nonexistent with ETFs. In fact, ETFs can be bought and sold in the same day, although it's not obvious that it's a good idea. This has made ETFs subject of some criticism, since low fees may cause investors to trade more quickly. In this view, traditional mutual funds are doing investors a favor by charging fees such as front loads.

Conclusion

As a result of the above information, we believe that clients should focus more on their asset allocation, (ie ensure they are diversified) and their ongoing costs, and less on trying to time the market or picking the fund manager who may be on a hot streak. This conclusion leads us to believe that if one wants to invest, it's best to invest in investments designed to get market returns. This would include index funds and exchange-traded funds. 

If investing in equities (ie the stock market) it is strongly advisable that you have a time horizon of at least 5 years, and historically equities fluctuate over time and thus their short-term performance tends to be erratic compared to fixed-income products, such as GIC's or bonds.

Frequently Asked Questions 

Question: What exactly is an exchange traded fund?

Answer: Wikipedia has this to say about what they are: 
An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index, such as the Dow Jones Industrial Averageor the S&P 500. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features. In a survey of investment professionals conducted in March 2008, 67% called ETFs the most innovative investment vehicle of the last two decades and 60% reported that ETFs have fundamentally changed the way they construct investment portfolios. 

Question: You're obviously not a fan of mutual funds. Does that mean you never suggest they be included in someone's portfolio? 

Answer: Not necessarily. 
Sometimes mutual funds are the only investment type in a particular asset category, and sometimes there are costs associated with disposing of them, and yes, sometimes their performance is such that they've earned their keep. So if someones mutual fund has performed well, it will be noted. As also noted above, if someone is dollar averaging relatively small sums of money into their investments it may be cheaper to do so through mutual funds than to faciliate this by paying broker fees. 

Question: It appears that you hold a high regard for asset allocation can you explain why? 

Answer: Gladly. 
We can't think of a better illustration of the importance of asset allocation than the current stock market crisis we're experiencing. If an investor currently has all their investments in the stock market they are experiencing a much future decline than those a similar investors who only had 25-30% of their investments held in the stock market.

Question: What is your opinion of bonds and GIC's in a portfolio? 

Answer: We've always considered bonds to be similar to a shock absorber on a vehicle. 
With the exception of the 90's when interest rates were dropping, bonds generally don't provide you with great returns, but if you have individual bonds and GICs rather than bond funds, they are predictible and will only go in one direction, that being positive. 

Question: Besides traditional investments such as stocks, bonds and things of that nature do you provide advice in other areas as well? 

Answer: Yes, indeed. 
We provide advice to those those who own real estate as we consider those investment too. In addition we are happy to provide advice for those who don't hold any investments but may want information on their retirement status, or a review of their estate plan, or some advice on their current debt load, or some tax planning advice or a combination of any of these. 

If you have a question that you would like an answer to, we would welcome your enquiries.