Sometimes, the active versus passive debate is a bit like the movie Rashomon, in which different characters recall wildly different versions of the same incident. Take the S&P Passive versus Active (SPIVA) report card on mutual fund returns during the last bear market from August 2000 to December 2002. The report points out that just 39% of active funds beat the TSX Capped Composite Index but concedes:
A bright spot for active funds was equal weighted and asset weighted returns over the period. Active Canadian Equity funds exceeded the S&P/TSX Capped Composite returns. This would imply that a few funds were able to beat the index by a large margin thereby pulling the average equal and asset weighted returns higher. However, given that investors are limited to investing in a small number of funds, the outperformance figures better represent replicable performance by the average retail investor.
An indexer wouldn’t be surprised even if majority of funds beat the index during a bear market. After all, the cash held by mutual funds provides a cushion in falling markets (and it must be said, a drag in rising ones). But active funds and their cheerleaders make a virtue out of this necessity. In a recent column in The Toronto Star, Rudy Luukko, an investment funds editor for Morningstar Canada writes:
But active managers, according to both S&P’s numbers and Morningstar’s, generally fared better than the Canadian index funds during the 2000-2002 study period. Active managers were able to build cash reserves if they couldn’t find any bargains. And the active funds were less likely to risk holding 10 per cent or more in a single stock.
First, there is no evidence that active managers are any good at building cash reserves in anticipation of bear markets. If anything, evidence suggests that mutual funds cash holdings are low at market peaks and high at troughs. Second, regulations restrict mutual fund holdings in a single stock to 10%, to which Mr. Luukko retorts: “However, in looking at historical holdings, I found that many actively managed funds were either holding much less than 10 per cent in Nortel, or not holding any of it. This risk-reduction decision paid off”. Mr. Luukko’s argument is meaningless because he doesn’t quantify how many of the 90 mutual funds that S&P counts as Canadian Equity he looked at (how many is “many”?).
None of the objections to index funds are valid: yes, a majority of active funds may occasionally beat the index but John Bogle estimates the odds of an index outperforming an active fund at 85% over 5 years, 91% over 10 years, 95% over 20 years and 98% over 50 years. A carefully diversified portfolio holding some bonds and cash will provide the “smoother ride”, if that’s what investors are looking for. And yes, index investors should pay attention to costs too and pick the cheapest available fund with the lowest tracking error.
The trouble with active management isn’t that a few funds beat the index some of the time. It’s picking the fund that will outperform the index ahead of time and telling the difference between skill and luck after the fact. Of course, there is no shortage of vendors to help us pick the good managers. Like, Morningstar, for instance.
