Active vs. Passive

by Craig Basinger, CFA

“It was the best of times, it was the worst of times,” Charles Dickens penned so many years ago.

Well, for active managers this appears to be the worst of times based on the S&P SPIVA reports and fund flows. For all U.S. domestic equity funds, 92.9% have been outperformed by the index over the past three-year period. Suppose the good news is, with only 7% of funds winning, this can’t get much worse. Canadian managers have fared better, but not by enough. With only 17% of Canadian equity managers outperforming the TSX in 2016, the three-year period has dropped to only 19% outperforming. Pouring some salt on the wound, U.S. equity funds have seen substantial net redemptions over the past few years while equity ETFs have seen sizeable, albeit sporadic, inflows (first chart). According to Baron’s, investors pulled $574 billion from active funds over the past two years and plowed $924 billion into passive funds.

Since 2010, this has been a tough environment for active managers. In each calendar year, less than half of the large cap U.S. managers outperformed the S&P 500. And in 2011 and 2014, only 18% and 13% outperformed. Yikes! The last two years have been better, with roughly one-third outperforming the index. As we mentioned, Canadian managers have had greater success, but last year didn’t help. Materials and Energy were the best-performing sectors during that period in Canada, which contain more companies that are smaller and riskier. As a result, we would be weary of any manager that did outperform the TSX last year – or at the very least dig in to see how they outperformed and how much risk was taken.

Even with a soft showing for Canadian managers in 2016, it still does appear easier to outperform the TSX compared to the S&P 500. The second chart compares the asset-weighted returns for U.S. managers vs. the S&P 500 over the past three and five years. Plus the same comparison for Canadian managers against the TSX. While the Canadian edge over our U.S. counterparts has narrowed, Canadian managers are still enjoying greater success.

When to be Active, When to be Passive

Notwithstanding the great run passive investing has enjoyed over the past half-decade, we believe there are two critical factors that determine which investment style has the upper hand. But before we discuss these, our underlying contention is that neither strategy is necessarily superior. Markets change too fast and evolve too quickly. A great example of change is given the rise in assets in passive ETFs, it is now estimated that over on e third of trading volume s are driven by ETF market makers executing baskets. The basket is based on the index of the ETF that is seeing either in or out flows. This is rather indiscriminate buying or selling.

Active managers have changed too. Fees have been coming down, reducing the cost gap with ETFs. Still, with many active managers not far enough away from the index, many continue to be replaced by an ETF. The only constant in the markets is change.

 

 

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