In 2014, investors in Canadian-based equities watched while the majority of actively managed funds failed to meet their benchmarks, let alone outperform their passive counterparts such as index funds and exchange-traded funds (ETFs).

According to Standard & Poor’s Dow Jones Indices vs. Active Funds (SPIVA) Canada Scorecard¹, only 32% of actively managed mutual funds beat the S&P/TSX composite total return index over the past three years. [Note: SPIVA compares the performance of actively managed Canadian mutual funds against their corresponding S&P indexes.] Cross-border investments fared even worse: Only about one in 70 Canadian-based actively managed mutual funds investing in U.S. equities beat the S&P 500 Total Return index over the same three-year period. Looking at the past five years, approximately one active fund in 20 outperformed their indexes. [Note: The SPIVA study was based on performance calculations minus all fees and costs through the end of June 2014.]

Active managers in Canada are not the only ones who have had a rough go in the market. According to a study this year by Bank of America², only 18% of actively managed U.S.-based large-cap equity funds beat the market, which it made it the worst performance in over a decade for active management. [Note: The BOA study covered 2014 through the end of October.]

By in Large, Passive Management Outperforms Active
The takeaway: No matter which time frame or manager domicile examined, the overwhelming majority of actively managed accounts in large measure fall woefully short of their goals. This means that most investors in actively managed funds paid more to make less. This fact has not been lost on investors, according to Morningstar³, as we have witnessed approximately U.S. $70 billion redeemed from actively managed funds [last year through September 2014].

While research has shown that stock picking and market timing in general fail over the long term, what makes it worse is that active managers charge premium fees (versus their lower-cost passive counterparts). For example, Canadian investors can choose among several ETFs which typically charge fees (called management expense ratio, or MER) between 0.06% and 0.27% whereas the average MER for the 50 largest Canadian equity fund products is 1.9%⁴. Other studies, including one by Lipper, looked at the entire universe of no-load passively managed funds and found the average expense drag to be 0.83%.

According to SPIVA Canada⁵, based on asset-weighted returns for the period 2008-2012, the majority of actively managed funds failed to outperform their comparative indexes in all seven fund categories covered. On average, active managers underperformed their benchmarks by 2.85% per year across the seven categories during the five-year period studied, said SPIVA Canada.

This is no post-financial crisis phenomenon either. According to A Case for Index Fund Portfolios⁶, an in-depth study covering a 16-year period from 1997-2012, index fund portfolios outperformed 82.9% of actively managed portfolios. [Note: The study looked at three index funds managed by one provider against randomly drawn actively managed portfolios drawn from 5,000 actively managed funds available to U.S. investors.]

Dealing With Advisors and Naysayers
Unfortunately, some investors take this data to mean that they don’t need anyone advising them. While putting a large portion of your portfolio in index mutual funds or index-based ETFs can be a good start, constructing a personally tailored and diversified asset allocation can be tricky. This is where the advisors can earn their keep: helping investors structure their index-based portfolios to reflect their goals, income and liquidity needs, age and investment time frame, and risk tolerance.

Further, an advisor who understands your taxes intimately can advise on U.S. and domestic investments with a view toward tax efficiency and can enhance your returns through the reduction of your tax liability.

Naysayers are quick to point out that that actively managed funds can outperform their passive counterparts. However, carefully scrutinize the time frame cited; you will often find that most active management outperformance occurs on a short-term basis.

And in the exception-to-every-rule department, actively managed funds in select niches, say emerging market small cap stocks, may consistently do very well. When looking at the Active vs. Passive universe, it is normally assumed that the Passive portion (and most of the studies cited) are looking at broadly diversified multi-asset class portfolios and/or predominantly large cap stocks.

Furthermore, some critics will note that there are no true index funds because indices are purely hypothetical, and some funds diverge from the index more than others. In fact, they are right on this count. Not all index funds are identical. Any two may purport to mimic a standard benchmark, e.g., the S&P 500, but almost no fund owns all of the stocks in the index. Instead, they will maintain a “basket” of representative stocks. And no fund, active or passive, can maintain the same weighting as their benchmark index because the underlying values and weightings are constantly changing.

These two arguments, while noteworthy and material, do not convincingly discount the overall better performance of passive versus active funds. Perhaps more importantly, they underscore the value of an advisor who can recommend select niche products as an adjunct to your portfolio. Lastly, your advisor understands that diversified security selection paired with appropriate risk can help achieve a client’s long-term goals.

¹ Tim Shufelt, GlobeAdvisor.com (November 14, 2014). Actively managed funds vs. the index: once again, no contest. Web site: GlobeAdvisor.com
² Bloomberg News (November 15, 2014). Why did active fund managers do a bad job picking stocks this year? Web site: Investmentnews.com
³ Wall Street Journal (November 4, 2014). Investors Flee Active Stock Managers. Web site: www.wsj.com
⁴ Rob Carrick, Globe eBooks (2014). Rob Carrick’s Guide to ETFs. Web site: theglobeandmail.com
⁵ Standard & Poor’s Indices Versus Active (SPIVA). SPIVA Canada Returns. Web site: standardandpoors.com
⁶ Vanguard Research (April 2014). The case for index-fund investing. Web site: vanguard.com

Advisory services are only offered to clients or prospective clients where the independent Cardinal Point firms and its representatives are properly licensed or exempt from licensure. Each firm enters into client engagements independently. Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Investing involves risk and possible loss of principal capital. Copyright © 2015 Cardinal Point. All rights reserved.