Raymond Kerzérho April 24, 2024 Market Research The Passive Fund Revolution “Passive” or “index” funds—marginal products at the turn of the millennium—have become a dominant force in the global investment marketplace. The ascent of passive funds is revolutionary in many aspects. First, retail investors have access to the same low-cost investment strategies that were once exclusive to pension funds and other institutional investors. Second, anyone with a few dollars to invest can become a genuine capitalist without being an entrepreneur or a stock market expert. Third, the fund management business is being turned on its head as active funds lose market share at an appalling rate. In this series, we explore why passive funds are superior, what types of passive investment vehicles are available and how investors can use them to their advantage. Actively Managed Funds in Trouble The poor performance of actively managed funds—which generally seek to outperform stock market indices—is widely documented. Research firm Standard and Poor’s (“S&P”) recently released a report confirming their disastrous results. Indeed, most actively managed funds available in Canada (typically nine out of ten) have been unable to outperform their benchmark over ten years in every category listed. Table 1 – Percentage of Active Funds that Underperformed their Benchmark Indices[1] Canadian Equity97%Canadian Focused Equity98%Canadian Dividend & Income Equity88%Canadian Small-/Mid-Cap Equity76%US Equity98%International Equity[2]96%Global Equity[3]98% Source: Standard and Poor’s As documented in Table 2, the average actively managed fund underperformed the index by 0.5% to over 4%, depending on the asset class. Table 2 – Ten-Year Return for the Average Active Mutual Fund vs. Benchmark Index CategoryAsset‑Weighted Average Fund ReturnBenchmark Index ReturnDifference: Fund minus BenchmarkCanadian Equity6.05%7.62%-1.57%Canadian Focused Equity6.27%9.30%-3.03%Canadian Dividend & Income Equity6.57%7.05%-0.48%Canadian Small-/Mid-Cap Equity4.41%5.68%-1.27%US Equity10.45%14.48%-4.03%International Equity5.64%7.06%-1.42%Global Equity7.02%11.39%-4.37% Source: Standard and Poor’s Investors’ Migration In Canada, the market share of passive funds has increased from 10% to 16% since 2014. In the United States, the rise of passive funds has been meteoric, with their market share growing from 26% to 47% over the past nine years. Finally, this market share increased from 14% to 31% for the world ex-North America. Even more astonishing, active funds have been hit by net cumulative outflows over ten years worldwide. Meanwhile, passive funds benefited from colossal inflows. In short, masses of investors around the world are quitting actively managed funds in favour of passive funds. If the trend continues, passive funds will hold most of the global retail fund market within a few years. Do Passive Funds Always Outperform? To answer this question, I have identified all passive mutual funds with at least ten years of history available in Canada. Their returns will be compared to the asset-weighted average return of actively managed funds documented by Standard and Poor’s.[4] I chose the most expensive (so-called “commission-based”) class of passive mutual funds to make the fairest comparison possible. Most actively managed funds documented by S&P are also commission-based mutual funds. In the Canadian equity category, the CIBC Canadian Index fund produced an annualized return of 6.5%, the RBC Canadian Index fund DZ delivered 6.8%, the Scotia Canadian Equity Index A fund delivered 6.6%, and finally, the TD Canadian Index fund returned 6.9%. During the same period, actively managed Canadian equity funds produced a return of only 6.1%; therefore, the gap is between 0.4% and 0.8% in favour of passive funds. For high-dividend Canadian stocks, the Invesco Canadian Dividend ETF Class Series A returned 5.3%, compared to 6.6% for the average actively managed fund, a 1.3% advantage in favour of active funds. For US equity, the CIBC US Index fund provided an annualized return of 12.8%, the FDP US Equity Portfolio A fund produced a return of 12.3%, the RBC US Index DZ fund made 13.4%, the Scotia US Equity Index A fund produced 12.8% and finally, the TD US Index I fund produced 13.5%. Meanwhile, actively managed US equity funds returned an average of just 10.5%. Thus, passive US equity mutual funds outperformed the average actively managed fund by a margin between 1.8% and 3%. Finally, in the international equity category, the CIBC International Index fund delivered a return of 5.3%, the Scotia International Equity Index A fund produced 4.9%, and the TD International Index I fund delivered 5.7%, compared to 5.6% for the average of actively managed funds. Thus, passive international equity funds produced a difference between ‑0.7% and +0.1% compared to the average active mutual fund. In short, passive funds largely dominated the Canadian and US equity categories and moderately underperformed in international stocks. Meanwhile, the only passive fund available in the high-dividend Canadian stocks category underperformed by a substantial margin. Why Passive Funds Sometimes Underperform There are various reasons to explain the occasional underperformance of some passive funds. The problem is rarely fees, as passive funds charge less, on average, than active funds to manage your money in all categories. One source of underperformance can be the choice of the benchmark index that the passive fund seeks to replicate. For example, the Invesco Canadian Dividend ETF Class Series A (discussed above) aims to replicate the NASDAQ Select Canadian Dividend Index, which may or may not be optimal to capture its targeted asset class. Another reason could be that active managers collectively drifted away from their mandate. For example, it is common for active international equity funds to hold 5% to 10% in US stocks, which are systematically excluded from passive international equity funds. A third explanation could be that some of the active funds surveyed in the S&P study belong to the less expensive share classes, which biases the comparison against passive funds. Finally, passive funds may underperform simply because active fund managers have successfully “beaten the market.” The Competitive Advantage of Passive Funds Passive funds are well-documented to outperform their active peers in the US. They are also likely to outperform in Canada, especially since their fee advantage is greater north of the border: passive funds are 1.18% cheaper than active funds in Canada, compared to only 0.62% in the US. According to another Standard and Poor’s research report, passive funds benefit from two additional competitive advantages beyond their lower fees. First, the professionalization of investment management shrinks the presence of amateur investors whose mistakes can be exploited by active fund managers to outperform. Another competitive advantage of passive funds is the skewed distribution of stock returns. In the long run, relatively few high-performing securities explain global stock returns at the margin, while most stocks on the market underperform. According to S&P: “The probability that a randomly chosen stock would deliver above-average performance, in other words, was 26%, not 50%. When fewer stocks outperform, active management is harder.” Why I Recommend Passive Funds Beyond their likely outperformance, I believe there are several reasons to adopt passive funds. First, active managers tend to behave “actively,” i.e., to carry out a large volume of transactions. These numerous transactions generate commissions that enrich investment banks at investors’ expense. Second, passive funds are predictable: investors know they’ll earn the market rate of return minus fees. Third, passive funds protect investors against “manager drift.” As I mentioned, many international equity funds contain significant U.S. equity or cash allocations. By contrast, passive funds are bound by a clear mandate that doesn’t allow this behaviour. You know precisely what you’re buying with a passive fund, which isn’t necessarily true with active funds. Fourth, with passive funds, there are no excuses for poor returns. You can discard a fund without hesitation if it doesn’t replicate its benchmark. By contrast, when an active fund underperforms, it is hard to determine whether it is due to bad luck or incompetence. Finally, I find that passive funds are better suited to financial planning. The road to financial freedom is littered with challenges: uncertain job prospects, health problems, the birth of twins, a divorce, a second marriage, the cost of sending kids to university, the relentless social pressure to buy stuff, etc. Life events impact our ability to save, invest and prepare for the future. Active funds add another layer of uncertainty, as their long-term returns are less predictable than those of passive funds. My next post will provide crucial information to design your portfolio according to your needs. I will explain the different classes of mutual funds and review their benefits compared to exchange-traded funds. [1] Based on net-of-fee returns.[2] The “International Equity” category includes stocks from all developed countries except Canada and the US.[3] The “Global Equity” category includes stocks from all developed countries.[4] Annualized ten-year returns are calculated as of December 31, 2023. Sources: Standard and Poor’s, CIBC, FDP, Invesco, RBC, Scotiabank, and TD. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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