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By Catherine Mulroney
Canadian Investment Guide 2005
Index funds mimic the market, while actively managed funds shoot for the stars. Both have appeal.
Nader Tehrani recalls the heady days of the late 1990s, when he would watch the evening news to see which high-tech stocks were soaring. Occasionally, he would put in a trade the next morning, then sell later that same day at a profit.
“My investments were up and down with the market,” he says.
Adrian Mastracci, ‘fee-only’ investment counsel at
Vancouver’s KCM Wealth Management, says,
"Ups and downs are inevitable. You can’t control what
happens in the market. The only thing you can control is how you interact with the market.”
But his investments in the high-tech sector were modest – his “play” money – which protected him from the fate suffered by some of his friends. They found the lure of high-tech stocks so tempting they filled their portfolios with them and they took a severe beating when the bubble burst.
For the bulk of his portfolio, his “serious” money, Tehrani took a simpler approach: he plowed most of his US$600-a-month investment budget into an index mutual fund that
mimicked the Standard & Poor’s 500 composite index, a proxy for the U.S. blue-chip equities market. He joined the world of passive investing with its market-mirroring returns.
Today, Tehrani wonders if he made the right decision. Would he have had bigger returns if he’d stuck to individual stocks and actively managed mutual funds? Is one approach better than the other?
Tehrani’s debate echoes the choices investors face when choosing an investment strategy. They can opt for the so-called “passive” approach – investing in products that buy all the stocks in a single index, such as the S&P 500, and simply holding on – or an “active” approach, in which they, or their chosen fund managers, strive to outperform markets by buying individual stocks and/or bonds and trading them as appropriate.
“If I were smarter about it, I may have made more money, “Tehrani says wistfully.” It was a question of lack of time, lack of experience and, to a certain degree, of risk aversion.” After all, it was 1997, he was fresh out of college and starting a demanding career in financial risk management consulting in New York.
I travelled a lot, and I didn’t have the time to monitor my investments constantly,” says Tehrani, who’s now working on his MBA at the University of Toronto and who describes himself as “a fairly conservative guy.”
Both approaches to investing have advantages – and disadvantages. For every point an aficionado of passive investing makes, an advocate of active investing has an answer. And there is no doubt some active managers do outperform the markets for periods of time – some of them consistently.
Take recent returns. According to Standard & Poor’s Corp., benchmark indices outperformed a significant portion of actively managed U.S. equity funds for the first three quarters of 2004. S&P’s scorecard shows the S&P’s 500 ahead of 62.6% of funds containing stocks with large capitalizations; the S&P mid-cap 400 leading 57.7% of mid-cap funds; and the S&P small-cap 600 outpacing 84.4% of small-cap funds.
From a longer-term point of view, for the 10 years ended Sept. 30, 2004, the average annual compound return for the median Canadian equity fund was 8.7%, according to Morningstar Canada, indicating that half the funds in the category had returns about the 8.7% and half had returns below that level. For the same period, the S&P/TSX composite index returned 9.4% on an annualized basis. As the returns suggest, in an actively managed strategy, choosing the right fund can make all the difference.
Unlike an actively managed mutual fund, whose manager selects investments to fit a specific purpose, an index fund mirrors the index in its tracking. An index fund shadowing the S&P/TSX 60, for example, would offer a basket of the same 60 stocks with the same weighting for each stock in the index. Because trades take place rarely and the selection is preordained eliminating research costs, expenses are kept to a minimum. As a result, index funds have lower management expense ratios (MERS) than actively managed funds.
The passive approach is based on the belief that, over time, it is extraordinarily difficult for an active manager to beat a broad market indicator, particularly given the higher expenses of an actively managed fund.
Indeed, closer examination suggests mimicking the market is a wise move. In his article, “The Arithmetic of Active Management,” first published in Financial Analysts Journal in 1991, Nobel-prize-winning economist William F. Sharpe, professor emeritus at California’s Stanford Graduate School of Business, argues that, before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar. Therefore, once costs are factored in, the return on the average actively managed dollar will be lower.
Sharpe’s theory is based on basic math, elaborates Howard Atkinson, head of public funds at Barclays Global Investors Canada Ltd., which offers a selection of index-tracking exchange-traded funds, or ETF’s. “Everyone’s in the same market. If the market return is 8%, logic dictates that the average active investor also earns 8%,” he says. But they will pay more in investment management fees and transaction costs, for a lower overall return.
So if average returns are the ultimate result, why doesn’t everyone simply buy an index fund? Because, while it may be easy, it requires enormous discipline, say the experts. If market dips make you panic, for instance, index funds may not be for you, says mutual fund commentator Gordon Pape. Panicky investors “zig and zag” he says, attempting to cut their losses, which tends to make things even worse. A panicky investor who bailed out of an index fund tracking the S&P/TSX composite index at the beginning of 2003, after it dropped an ugly 13.5%, would have missed out on that year’s gain of more than 25%. In 1992, the same index dropped about 6.8%; but it bounced back the next year to the tune of almost 31%. It can be quite the ride.
Investors in actively managed funds, on the other hand often find it easier to stick with the discipline and philosophy that’s most appropriate for them, says Don Reed. For example, an investor who believes in taking a “value” approach – that is, buying shares in a company that trades at less than its underlying assets – is less likely to switch styles and chase hot markets, knowing that when those high-fliers fall back to earth, the value fund will still be chugging away. A professional value-fund manager, says Reed, will continue to make investments based on the overriding philosophy and investment mandate of the fund.
The low MERs of index funds, on the other hand, give them a definite one-up on actively managed funds and make them a favourite of financial advisors who charge their clients a straight fee for their services and do not accept mutual fund sales commissions.
Adrian Mastracci, an advisor and investment counsellor with Vancouver-based KCM Wealth Management Inc., is one of those, and he is a big believer in index funds. “You know what you have. Over 10 years, most markets don’t lose money,” he says.
Because there are a variety of index funds available, ranging from equity to income, it’s possible to hold a diversified portfolio that suits the investor’s risk tolerance and required asset mix while keeping expenses down, he argues.
“In a low-return environment, costs matter,” Mastracci says.
Atkinson agrees that index fund unitholders can protect themselves by diversifying their holdings to reflect the asset allocation they need, given that the range of index funds available includes such choices as bond, resource and equity funds. But they need to be careful not to negate the benefits of a widely based index fund by narrowing their choices too much. It pays to remember that the broader the index, the lower the risk. Therefore, investing in a fund that mirrors the S&P/TSX 60, for example, will probably carry less risk than a fund that reflects a specific sector, such as S&P/TSX capped gold or the S&P/TSX capped energy indexes.
On the other side of the debate, Fraser Horne, an investment counsellor, firmly believes that active managers add value to a portfolio, and it’s a mistake to make investment decision based only on costs and fees. “You have to ask yourself: ‘What am I paying for? Am I getting something for my money?’” he says.
Pape, too cautions that passive investing is not suitable for everyone. Older investors, in particular, might not be able to recover from a bear market – making index funds unsuitable in a RRIF, for example. They would also be unsuitable for funds that are earmarked for short-term goals.
As well, investors never attain the exact results of the index their fund is tracking because the fund earns what the market earns less the overall cost of operating the fund. MERs for index funds are around 1.1% (vs. the average MER for an actively managed equity fund, which can hover in the neighbourhood of 2.6%). Pape suggests comparing MERs carefully and steering clear of index funds with fees of more than 1%.
Reed points to another limitation of index funds – particularly in Canada’s relatively small equity market, in which a handful of large companies can grow to dominate an index. Toronto Stock Exchange-linked index funds took a major hit after Nortel Networks Corp. grew to reflect about 30% of the S&P/TSX index before plummeting. Peaking at $124.50 a share in mid-2000, Nortel now trades in the single digits. Because it was so dominant, Nortel’s dramatic correction dragged the entire index down.
Index funds were at their most popular during the 2000 RRSP season. Investor Economics Inc., a Toronto-based financial services research firm, notes that new sales have slowed since then, although the Canadian index funds sector is still growing at a steady rate. As of Sept. 30, 2004, assets of Canada’s 191 index funds were up 12.6% year-over-year.
Although overall interest in index funds may have cooled, one segment of the category – ETFs – is showing consistent gains. As of Sept. 30, 2004, $7.9 billion was invested in ETFs, representing 37% of the index investment funds market, ETFs’ highest market share to date.
Like other index funds, ETFs represent a basket of securities reflecting a specific index. Certain key difference, however, make them resemble stocks. For example, they are bought and sold on stock exchanges, so they can be traded throughout the day, offering investors greater liquidity. They can also be bought on margin, and trade records and paperwork are handled by the brokerage conducting the trade, which helps keep fund expenses low.
“ETFs are a better delivery mechanism for a portfolio,” says Barclays’ Atkinson.
Boosters of the passive approach argue that understanding the philosophy behind mimicking the markets will help avoid needless losses. “Ups and downs are inevitable.” Says Mastracci. “You can’t control what happens in the market. The only thing you can control is how you interact with the market.”
That interaction, he notes, includes having a stated investment plan that includes investment goals, risk tolerance and time horizons. It also involves ascertaining the right asset mix to arrive at those goals. “Performance is a very elusive thing,” he says.
And that is a statement on which everyone – regardless of what side they take in the active vs. passive debate – can agree.
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