The debate among investment pundits about whether active strategies are better than passive — or vice versa — is generally puzzling to the rest of us.
But for the better part of 20 years, a war of ideas on the matter has raged all the same.
One side argues active management provides better value.
In other words, an investment manager buying and selling stocks leads to returns exceeding the performance of its benchmark (like the TSX Composite Index).
On the other side is passive investment, which argues that rather than paying someone to pick investments, just buy a fund — like an exchange-traded fund (ETF) — that tracks a broad-market index like the TSX. Whatever the index does, so does your investment.
And you’ll be better off in the long run.
Indeed, evidence largely supports this strategy.
For the ninth consecutive year, for example, most active managers failed to beat their benchmark, a recent report by S&P Dow Jones Indices shows.
Still a common argument among active investing boosters is "just wait and see."
The past decade of a bull market has favoured passive investing because a rising tide lifts all boats — so the saying goes. But active management will prove its value heading into the next recession because active managers position their portfolios to reduce exposure to risk.
Yet that claim also falls short of the mark, according to a recent study released by Vanguard, called "Prevailing myths and misconceptions of the active/passive decision in Canada."
The report lists seven commonly believed falsehoods. And among them is the aforementioned idea that passive management will underperform active management in bear markets (falling prices).
"We often hear an active manager can position the portfolio ahead of a market decline to insulate the portfolio," says Todd Schlanger, Canadian senior investment strategist at Vanguard, who authored the report.
That may be true sometimes — but not consistently so.
"There doesn’t seem to be any pattern to when managers will out- or underperform."
Schlanger says one reason for variability is "most things that change market direction in a significant way are unanticipated, so repositioning a portfolio ahead of those movements is extremely difficult."
Overall, the myths listed in the report focus on how active management is superior to passive strategies. Yet that doesn’t mean active management is a false investment god either.
In fact, the report also tackles the misconception that passive strategies are better.
Certainly, active strategies can be very effective, but they have long been offered in the format of mutual funds, which charge fees several times higher than an ETF using a passive strategy for the same market, Schlanger says.
Even Winnipeg portfolio manager Alan Fustey, who has long been among investment pro-fessionals in the passive camp, admits active management has value.
"It’s not one over the other," says Fustey, from Adaptive ETF, a division of Bellwether Investment Management Inc.
"It’s the combination of the two."
He points to how professional money managers often use index — a.k.a. passive — ETFs as core portfolio holdings because they are low-cost, diversified and easily tradable. Then they add active strategies like value (finding undervalued companies) to enhance returns.
Yet Fustey notes technological advances are quickly making the old way of delivering active strategies — mutual funds — dinosaurs.
"Now almost every kind of strategy available in a mutual fund is available in an ETF."
Only they’re less costly, meaning they’re less challenged to outperform the market.
And let’s still not forget active management strategies can outperform even with higher fees. Indeed, one of the more robust approaches is investing in companies growing dividends over the long term.
Certainly, Toronto-based Bristol Gate Capital Partners has carved its niche for itself using this strategy for private clients. And it recently launched two ETFs so everyone else can do the same.
The firm’s senior portfolio manager Izet Elmazi says it chose ETFs over mutual funds because ETFs have lower fees.
"We can’t wait for the day that... advisers (who only can sell mutual funds) can start buying ETFs because we think they are being disadvantaged by not being able to do so," he says.
He adds regulatory changes are underway to allow most advisers to trade ETFs — something many can’t do now. But change takes time.
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In the meantime, advisers can still prove their worth, especially when that bear market comes. He argues many passive investors could be in for a shock simply because they don’t work with advisers. And investment professionals often help steady clients’ resolve so they don’t panic and sell at a loss.
Elmazi further argues active strategies — especially those focused on dividend growth — are particularly helpful in calming clients because losses are generally not as steep.
"If the market is down 10 per cent, this strategy is often down only seven or eight per cent."
Regardless of choice, active and passive strategies each have their pros and cons. And Schlanger says investors shouldn’t get hung up on choosing one over they other. Rather, they should focus more on "keeping fee costs low, maintaining a diversified portfolio and staying disciplined."
As he notes, research shows these three traits are better predictors of long-term success than any one strategy.
"So if you’re building a diversified portfolio that’s low-cost, and you stick with it, you are likely to be successful, regardless of whether you’re passive, active or a combination of the two."
Seven common myths of active versus passive
Here’s a quick look at the investment misconceptions that can be deadly to your invested dollars, as outlined in the Vanguard report.
Passive only works for average investors: Even pension-fund managers use exchange-traded funds (ETFs) that track broad-based indices to provide low-cost diversification, author Todd Schlanger says.
Indexing only works in efficient markets: Buying an ETF that tracks an emerging market index — considered inefficient because it covers volatile, fledgling market economies — is likely to work just as well, if not better than active strategies, data show.
Active managers outperform in the bond market: Again, data reveal most bond managers don’t beat their benchmark.
The higher the price, the higher the quality: Paying higher fees is likely to lead to poorer performance — no matter how skilled the manager.
Passive strategies only work well in the bull markets: Data show active strategies don’t consistently do better in bear markets or worse in bull markets than passive ones.
Concentrated portfolios outperform diversified ones: While smaller portfolios can lead to outperformance, they are equally at risk of underperformance for the same reason (they lack diversification).
Passive is better than active: Active strategies do enhance returns. But the high fees they charge often stand in their way.