The Great Debate: Active vs Passive Investments

onathan Simeone | Assante Capital Management Ltd.

November 26th, 2019

While most prominent investment advisors understand that roughly 90% of the variance of returns of an investment portfolio will be determined by a portfolio’s asset allocation, instead the most common theme of debate by the water cooler has undoubtedly been the war between active and passive management:  Should investors invest in a portfolio of low cost ETFs that track the index or should investors pay the extra management fee to have their money managed actively through some form of fund.

I would love to tell you that there is one straightforward simple answer. Unfortunately, that couldn’t be further from the truth. However, in our experience as advisors, our team has developed our own hypothesis that will attempt to guide investors as best we can with a true objective opinion. There will be some proponents – industry experts, that might agree or disagree with the following arguments. But of course, that uncertainty in itself, is the defining characteristic of our industry. There are infinite variables and situations that will challenge our hypothesis. But here are some basic truths.

There is overwhelming support and literature proclaiming that the low cost passive approach to index investing through ETFs is indeed the way to go. Just looking at the cash flows over the recent years into the ETF market and out of the fund market supports the idea that investors have been listening to the media and are ditching the good ol’ mutual funds for the new fad of ETF investing. But is it all “FAKE NEWS” created by ETF giants like Blackrock’s iShares or Vanguard to spur interest in their new-ish products and increase sales? – No, not exactly. Let’s look at a few basic charts;

Large Cap US Equity Mutual funds vs the Benchmark

US large cap equity active managers have in fact had a tough time lately beating the index. In other words, they are underperforming the passive index-mirroring ETFs. Reasons for this have been sighted due to the higher management fees, and that markets are by nature, efficient. Meaning, there is little room for adding alpha ( excess returns over the benchmark) from stock picking, since the stocks are priced fairly to begin with. 

While the data is hard to argue against, supported by the idea that there is a small likelihood investors will be consistently choosing  the select few funds that do in fact beat the index, it still might not be a slam dunk for the passive index ETF. Not for us Canadians, anyway.

Let me explain.

As a Canadian, when we invest in US stocks or bonds, or any US financial instrument, we are subject to fluctuations in the exchange rates between the CAD (Canadian Dollar) and the USD (US Dollar). As a Canadian investing in US equities, we can benefit from an appreciation of the USD, while losing out on a depreciation as well. When using passive ETFs for a portfolio’s US equity exposure, an investor can choose to hedge away – eliminate the currency risk by buying the XSP – iShares Core S&P 500 Index ETF (CAD- Hedged) or choose to be fully exposed to the fluctuations in currency and buy the XUS – the non-hedged version. When investors invest in active US equity funds, the fund manager might have an active approach to hedging away the currency as well. Only a fund manager does not have to settle for either 100% hedged, or 100% not-hedge like the ETF investor must settle for. This allows the fund manager to reduce the hedge ratio to benefit from an appreciation of the USD and increase the hedge ratio when they estimate the USD will depreciate throughout the cycle. For the ETF investor to realistically do the same, they will have to manually sell one version and buy the other. Add the possibility that the account is non-registered with potential capital gains tax, and that the whole notion of passive investing is to be just that – passive…the likelihood of the investor or even financial advisors making the switch at the appropriate time is very hard and most unlikely. 

The gains from a proper active currency strategy more often outweigh the benefits of a reduced management fee for the ETF. The majority of retail investors over the last decade would have most likely opted for the XSP ETF (CAD-Hedged) , as it eliminates the risk and volatility of currency effects, but they would have missed out on returns for doing so, as the USD appreciated significantly against the CAD over the period. 

 

Figure 2. The Currency Effect: USD Appreciating and adding returns.

XSP- iShares Core S&P 500 Index ETF (CAD-Hedged)

 

XUS – iShares Core S&P 500 Index ETF (Non-Hedged)

 

What about investing in Canadian Equities? Since we are Canadian and there are no effects of currency fluctuations, should we invest in the passive ETF, the XIC – iShares Core S&P/TSX Capped Composite Index instead of a managed fund?

Not necessarily. You see, the Canadian stock market is not as well diversified in terms of sector weighting as the US market for example. Unlike the US market, the top three sectors,  Financials, Energy and Materials make up roughly 65% of the Canadian S&P/TSX Index. These sectors are highly cyclical sectors, which means they go through periods of good or bad performance based on the economic cycle. This phenomenon benefits Canadian equity fund managers a great deal as they are able to increase and decrease their exposure to these cyclical sectors throughout the cycle.  These sectors represent a significant weight of the index and therefore a significant effect on the relative returns compared to the S&P/TSX. Cyclical trends tend to repeat themselves as well in similar economic conditions, so managers have pretty reliable insight when those same conditions repeat themselves. For at least these reasons, we have a much easier time finding multiple active Canadian funds that have beaten the index and outperformed the passive ETF counterpart over the last 10 years. 

 

Fixed Income

The challenge with passive bond investing is the ever present concept of duration. Simply put, duration is a measure of the effect that a change in interest rates will have on the price of the bond. Bonds with longer duration (usually longer term bonds holding all else constant) will drop more in value when interest rates rise than bonds with shorter duration. When interest rates drop, long duration bonds will see their price increase more than short duration bonds.

In these times of heightened interest rate manipulation by the world’s central banks, the need to switch from short duration to long duration bonds has never been more imperative. Active bond managers will be increasing or decreasing their average duration within the fund during these times,  while the choice of the average portfolio duration of the bond ETF will have to be done at the initial investment. When rates change direction, it will be up to the investor or advisor to manually make the necessary changes. In this case, it is much harder to replicate this duration management using passive bond ETFs than employing a fund manager.

In a world where Fed fiscal policy is not as active and interest rates are normalised, holding a portfolio of individual bonds with different maturities would also be a good strategy. In this case there is certainly a greater need to reduce management fees or eliminate completely, especially if interest rates remain lower than usual, and the yield to maturity on the bonds are low to begin with. 

 

Take away

In the right conditions, history has shown that a passive ETF investment can indeed perform better than the active managed counterpart for certain asset classes. However, as discussed, there is still some form of active management at the marco level needed to manage the individual passive index investments optimally. In a perfect world where markets only rise, low cost ETFs would be a good choice. But markets rarely move in one direction and having an active manager helps reduce volatility during market downturns. Relying on fund managers with more efficient and more timely active asset allocation strategies will often reward investors who are not able to replicate for the most part, the risk management strategies themselves using ETF portfolios. ETF Investors are simply at the mercy of the market.

While there has been much debate over the choice between active or passive investments, there is no debate for the need for an active disciplined approach to asset allocation. This is precisely why widely known studies suggest that roughly 90% of the variance of returns from one portfolio to the next will be driven by asset allocation decisions and only  5% from security selection. Investors should therefore develop and focus more on a proper asset allocation strategy, rather than on the investment vehicle itself. This is what will yield greater long term results.

Disclaimer

Assante Capital Management Ltd. is a Member of the Canadian Investor Protection Fund and Investment Industry Regulatory Organisation of Canada. This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances. Commissions, trailing commissions, management fees and expenses, may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing.