Every so often, I come across an article that I just can’t ignore. Articles in which the ‘Pearls of Wisdom’ are so flagrantly baseless, I must call foul and point them out.
A recent article in the Globe and Mail claims the COVID-19 pandemic “is tipping the debate between active and passive investing in favour of active money managers who actually make investment decisions.” The Globe article (which unfortunately is only available online to investment advisors) goes on to repeat several myths about active management that are important to dispel.
For one, ETF sales are outstripping active mutual fund sales for the first six months of 2020, as more investors are getting wise to the falsehoods perpetuated by active managers.
The piece’s fundamental premise is that the volatility created by COVID favours active managers over passively managed exchange traded funds (ETFs) that invest in all the securities in an index.
A fund manager argues that market-weighted ETFs are vulnerable because they hold large weightings of the small number of stocks that have driven market returns in recent months.
This person claims active fund managers, by contrast, can load up on shares in undervalued companies that will be winners going forward—health care, and technology, e-commerce and certain real estate stocks that are benefitting from the work from home phenomenon.
Unfortunately for active managers, there is no evidence they’re able to consistently outperform the index, even in periods of high volatility like the pandemic. In Canada, a whopping 88% of active managers underperformed their benchmarks over the year to June 30. That’s consistent with the 90% who have failed to do so over the past decade, according to the S&P SPIVA Canada Scorecard.
The performance of U.S. active managers was somewhat better in the last year but not much. According to S&P’s U.S. scorecard, 67% of U.S. domestic equity funds lagged the S&P Composite 1500 index while 63% of large cap funds underperformed the S&P 500 over the year to June 30. However, over 10 years the index beat 84% of all U.S. domestic funds, much like in Canada.
The Globe article contains a number of fallacious arguments against passive investing. One of them is that active managers may not outperform in developed markets like Canada and U.S. but are able to do much better in emerging markets where company data is often opaque.
Here again, evidence doesn’t support the argument. The S&P U.S. scorecard shows a slight majority of active emerging market funds outperformed the index in the year to June 30. However, actively managed funds were trounced by the index over three, five and 10-year periods. Ten-year annualized returns show 73% of emerging market funds were outperformed by the index.
Of all the misguided statements in the article, perhaps the most pernicious is the suggestion that fees really don’t matter. “If you’re getting the performance you’re looking for, who cares what fee you’re paying?” one analyst asks.
In fact, the high management fees charged by active funds create a performance hurdle that most managers can’t clear. And, as for finding good performance before it happens, we know that’s impossible. Even the pension plan and endowment fund managers with much more resources than you and I aren’t able to do that.
There’s no way to discover the minority of managers who will outperform the index because it’s a different group every year as demonstrated by this article. It shows that just 3.8% of U.S. domestic equity funds that were in the top half of performers in 2015 stayed in the top half over the next four years. That’s below random chance. Only 0.18% of top quartile funds performed the same feat, again below random chance.
Volatile markets are supposed to be the time when active managers shine. The pandemic showed a large majority of managers couldn’t beat the index even when markets were at their most turbulent and returns were highly dispersed (meaning the winners’ performance was drastically better than the losers).
If they couldn’t beat the index under those conditions, when will they be able to?