When constructing portfolios for their clients, advisors are often faced with two dilemmas: the choice between active and passive management and the choice between strategic and tactical investing.
Some managers argue that good active management can beat the index, while others contend that investors are better off with low-cost exchange-traded funds or index funds. In the other debate, tactical managers advocate taking advantage of short-term market anomalies to make asset-allocation shifts, while strategic managers take a long-term approach.
So, which approaches work best?
In the active vs passive debate, most industry experts lean toward active management, although they also see some merits in the passive approach.
Active management is a superior approach, especially when it comes to difficult downturns, such as the last bear equity market, says Gordon Pape, a Toronto-based fund commentator and publisher of the Internet Wealth Builder newsletter. He cites fund managers such as Peter Cundill, Kim Shannon, Irwin Michael and Francis Chou, who survived if not flourished.
“These are all value investors, and it’s known that that style performs better in down markets than does growth investing,” says Pape.
It comes down to proper selection of actively managed funds, Pape adds: “Advisors are in a better position to identify who these good managers happen to be. The advisor should be saying to clients, ‘You want to ensure that your assets are being managed by people who can preserve capital and make money even in bad times.’ That’s the real test: performing well in a bad market.”
Even in good times, as we’ve experienced lately, active management seems to have a slight upper hand over passive management, says Michael Higgins, senior investment communications manager at RBC Asset Management Inc. in Toronto.
“Looking at the 14 biggest Canadian equity funds over the past five years, seven funds outperformed iUnits S&P/TSX 60, and seven underperformed,” he says. “But 13 funds were less volatile than the index product. This is a pretty good case for active management.”
For some advisors, however, the choice of investment approach is left to clients, says Robert Broad, vice president at T.E. Investment Counsel Inc. , a Toronto-based fee-only investment counsellor and financial planning firm. “Some people are more comfortable indexing the portfolio and are not willing to take the risk of being wrong relative to the market,” Broad says. “We’re agnostic when it comes to a passive or active approach. But the majority of clients prefer the latter.”
T.E. Investment Counsel has an internal pooled program, which incorporates passive and active management. Half of the fixed-income portfolio is managed passively, is low-cost and generates a benchmark-like return. The other half is actively managed by an outside firm, Addenda Capital Inc. , which has a record of beating the benchmarks. On the equity side, all seven domestic and international managers use an active approach.
“Canada is a great example of a market in which an active manager can do better than the market,” Broad says. Based on data from Mercer Investment Consulting‘s manager performance analytics, 36 actively managed funds had an average annual return of 13.5% for the 10 years ended March 31, and beat the S&P/TSX composite index by 2.3%. (That rate of return is before fees.)
High net-worth clients pay about 1.5% for portfolio design and asset management. As that is less than the typical 2.5%-2.75% that mutual fund clients pay, T.E. Investment Counsel can rationalize the use of active managers.
“In most of the core asset classes, especially in Canada and international markets, we’ve been able to identify managers that have successfully outperformed the index,” Broad says. “These managers earn their fees. They have justified the extra cost for choosing active management relative to passive.”
But Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. , argues that active management has a much tougher time in some areas. “The more conservative the asset class, the more difficult it is for managers to add value,” Hallett says.
Bond funds, he adds, are caught between the proverbial rock and a hard place: bond yields are 4%-4.25%, and management expense ratios range from 1% to 1.6%, leaving little for clients. “Your starting point is a lot lower. That means your ability to add value is more limited.”
Pape echoes that view: “Bond MERs are too high, given where interest rates are these days. You’re better off going with some good ETFs.”
@page_break@Markets such as the U.S. also present challenges. “Managers have had such a difficult time keeping pace, let alone beating the indices, whether it’s the Standard & Poor’s 500 composite index or the broader Wilshire 5000 index,” says Pape.
The average U.S. equity fund had an average annual compound return of minus 2.1% for the five years ended March 31, according to PalTrak. Of the 121 funds in the group, Pape notes, 52 beat the S&P 500, while 69 trailed the index. Over a 10-year period, only nine out of a group of 46 U.S. equity funds beat the benchmark.
Is indexing or using ETFs the way to go when investing in the U.S.? “You could do much worse,” Hallett says. “In a way, it makes sense. When you have the biggest, most liquid market in the world and so many participants competing against each other, it’s very tough. That’s an area, on the equity side, for which there is the strongest argument for indexing.”
But, Pape contends, that argument is weakened by investor psychology, which has a perverse way of undermining the best intentions. “Investors don’t think long-term. Most people switch around their investments, reacting to news as it unfolds,” he says. Many investors took heavy losses in 2000 and 2001 and then missed the stock market rebound in 2002.
Because many people fall victim to their emotions, “the idea of long-term investing goes out the window,” Pape says. “If the passive investor can hang on for the long term, fine. But how many people can actually do it?”
When it comes to choosing between a tactical and a strategic approach, you can argue that both have their merits, but much depends on the advisor’s own philosophy and comfort level.
“Some advisors are more comfortable with a strategic approach, while others prefer a tactical one,” says James Gauthier, fund analyst at Dundee Securities Corp. in Toronto. “I’m not saying one is superior to the other. It depends on timing, and the ability of the advisor to take advantage of opportunities. It’s not cut and dried.”
Still, the consensus sides with strategic investing. “Tactical investing comes down to market-timing, and I’ve been uncomfortable with that,” Pape says. “People often ask me, ‘Should I buy in now, or wait for the market to correct?’ The market may go higher before it corrects. Who knows? Even the pros don’t know.”
Over the long term, tactical investing offers no real advantage, Pape says. He points to the marginal difference between Canadian balanced funds, which operate within fairly strict parameters, and tactical asset-allocation funds, which have the freedom to make large asset-class shifts: for the 10 years ended March 31, the average annual return for the Canadian balanced fund group was 7.37%, compared with 7.23% for the tactical asset-allocation group.
“This suggests that the professionals can do this reasonably well, but not much better than if they just stuck to tighter parameters,” he says. “There is no significant advantage to using a tactical approach.”
T.E. Investment Counsel’s Broad expresses a similar argument. “More damage is caused by ‘activity’ over time than by sticking to an investment policy,” he says.
Each client should have a customized investment policy that allocates investments across a spectrum of markets, capitalizations and securities, he adds: “People have a tendency to out-think themselves. They have the potential to chase returns or focus too much on an area that has done very well.”
Conversely, when markets work against clients for a period of time, “people have an overwhelming urge to rethink the process,” Broad says. “But having the discipline of a well-thought-out investment policy and being able to recognize that, over 50 years, this approach will create wealth is a key element. We can say: ‘Yes, we have seen negative market returns, but so far we have always recovered from those negative periods. There is no reason to believe it won’t happen in the future’.”
On that note, Hallett shares a similar view. “I’m not going to say to a client, ‘Here’s your 60/40 and stay there forever.’ Where things get out of whack and there is more risk in one asset class, it’s smart to make some shifts,” he says. “That’s in keeping with the strategic approach: you structure the assets based on an individual’s needs in terms of return, risk, time frame, liquidity and income.” IE