Actively managed mutual funds performed dismally in comparison with broad market indices last year, according to Standard & Poor’s recently released Indices Versus Active Funds Scorecard. But some participants in the mutual fund community expressed concern that the survey measures mutual fund performance after management expenses while ignoring any fees that would be incurred by an investor attempting to duplicate index performance through participation in an index fund or an exchange-traded fund.

According to the SPIVA report, a scant 13% of Canadian equity mutual funds beat the S&P/TSX Total Return Composite Index during 2005. Three-year average annual returns show only 8% of actively managed funds ahead of the index, although the five-year period is brighter, with 31% of funds ahead of the market average.

“Less than one-third of actively managed Canadian equity funds have outperformed the S&P/TSX index during the past five years,” says Jasmit Bhandal, director of business development at Standard & Poor’s Canadian Index Services.

On the surface, the numbers are not much of an endorsement for active fund management. But David Feather, president of Mackenzie Financial Services Inc. , calls the comparison “a dog’s breakfast.”

He says the survey is comparing an “after-cost” investment in mutual funds to a “pre-cost” investment in an index.

“There is no adjustment for the fact that index investing does not come free,” Feather says. “Index-based funds incur costs and charge management fees. Advisors selling ETFs based on market indices will either charge an annual service fee equivalent to 1.5%-2% of client assets, or a commission for executing the trade. There are real flaws in the methodology of the S&P survey, and the results would be dramatically different if it was adjusted for the costs of index investing.”

But Bhandal says that S&P is careful to disclose the limitations of the survey, including the fact that there is no deduction of index returns to account for expenses, and that the returns for active funds are measured after MERs but do account for front- or back-end loads.

“The fees associated with index investing can vary, and we cannot arbitrarily choose an average fee,” says Bhandal, who points out that the potential costs of index investing could be offset by the also-ignored potential of front- or back-end loads. “The report is absolutely not perfect, it is intended to be a tool, and we are upfront about how we do it.”

Energy and financial stocks have dominated the Toronto Stock Exchange in recent years and currently account for about 50% of its weight, says David O’Leary, senior analyst at Morningstar Canada. Many active managers have sold down these stocks as they rose to what they believed to be fairly valued prices during the past couple of years and have not reaped the benefit of continued gains.

In the interest of risk management, few fund managers running a diversified core equity fund would allow their funds to become lopsided in any one sector, but the index has no such constraints, O’Leary says. There will, therefore, tend to be a widening of the gap between active management and index performance during periods when particular market sectors are hot and keep getting hotter beyond the point of reasonable valuation. Downside risk increases as stocks become overvalued, and O’Leary points out that 64% of Canadian equity funds have lower volatility than the TSX.

“Active funds mitigate risk much better than an index, especially in Canada,” O’Leary says. “The S&P/TSX is highly concentrated in a few sectors, and during the past few years it’s been largely energy driven. Canadian equity fund managers tend not to take big bets on any one sector.”

The SPIVA survey showed a better performance for U.S. equity mutual funds, which are competing against the more broadly diversified S&P 500 index. In 2005, 42.2% of active fund managers beat the index (measured in Canadian dollars) while the three-year period showed 32% of active managers ahead of the index and the five-year period showed 25% ahead.

The SPIVA report points out that funds in the Canadian equity category may have had as much as 30% of their assets in non-Canadian stocks; in practice, much of this allocation was in U.S. stocks. If actively managed Canadian funds are compared with a blended index of 70% S&P/TSX and 30% S&P 500, the funds fare better, with 48% of managers outperforming the blended index during one year, 43% during the three years and 50% during five years.

@page_break@Small-cap managers did considerably better in outperforming their benchmark, with 63% of Canadian small-cap funds surpassing the returns of the S&P/TSX Small Cap Index in 2005. For the three-year period, 65% of active fund managers beat the index; for the five-year period, 38%.

“The small-cap market tends to be less efficient, as the companies are not as widely followed and stock prices may not reflect all of the information available,” says Bhandal. “Big companies are pored over by the analysts, and there is less opportunity for a manager to find undiscovered value.” IE