UFC Premiere Event: Active Manager Versus Passive ETF Investor Smackdown

Photo by Vie Vie CC BY 2.0 via Wikimedia Commons

I remember as a kid, all of the neighborhood boys congregating to act out our favourite WWF wrestlers. It usually involved highly stylized body-slams, pile-drivers, and flying manouvers off the “top rope” (basically anything we could climb up onto). Naturally, we did this on someone’s front lawn because in our young minds the grass was “soft”.  As a physician I now look back on this with an appreciation for all of the ways that we could have been paralyzed and for just how springy and forgiving our little bones were.

As an adult looking at our finances, wrestling isn’t hardcore enough. We need something more realistic with no pulling of the kicks and punches. Something where the fighters can’t dodge or run – we need a cage.

We need UFC (Ultimate Financial Comparisons)!

This will be the first in a series of posts comparing approaches to some common financial debates.  Are you ready to rumble!?!?!!?!

Let’s meet our fighters:

In the white trunks, hailing from a swanky tower on Bay Street, I give you Active Portfolio Manager. Weighing in at 225lbs of muscle, he obviously works out and eats clean. With his Tattoo:Tooth Ratio coming in at a daunting 3:1, you know that he is tough and won’t quit the fight. Even if he loses the fight, he still takes home a good-sized purse for showing up. He has a black belt in several martial arts, including technical analysis, financial report analysis, and knows multiple market valuation techniques. Immersed in the fight world, he is surrounded by other fighters to test himself against. He has the lightening reflexes of an algorithm based trading computer. He doesn’t fight alone – in his corner is a crack team of trainers and promoters. He is an expert at mindgames and his entrance is intimating with his shiny hooded bathrobe and the thundering beat of a gangsta rap song.

When asked about his strategy in the markets, his monosyllabic answer…… “Beat them. Beat them real gud.”

Seen here limbering up for the match, wearing the black mawashi with the hungry bum, I give you Passive ETFs (exchange traded funds). Don’t let his lack of bling, tattoos, and funky entrance music fool you. His simple, yet functional wardrobe, keeps his fees ultra-low. He is also immersed in the world of his craft and with all of the ETFs to choose from, competition is fierce to give the lowest fees possible. Underneath the soft looking exterior is thick well-marbled muscle – you don’t want to offend this guy’s honour. We asked via translator about his strategy with the markets. His answer…..

“Stay in the middle and don’t get pushed out of the circle.” [alternative translation: “Stay in the middle and match them.”]

Let’s compare our combatants in a little more detail.

Basic Techniques:

  • Active Manager: Active managers can use a variety of tools and strategies to try and give returns better than the market, termed “Beta”. They have the flexibility to buy stocks, bonds, ETFs, or just about anything else, based on what they think will give the best returns in the current and predicted future market conditions. They can also hedge against losses using fancy techniques like short sales and stock options. They can even exit an area of the market if they feel it is too risky at the moment.
  • Passive ETFs: Passive ETFs aim to match the ups and downs of the market rather than trying to achieve Beta. They can try to track an index, like the TSX or the S&P 500 for example. They do this by proportionally buying the main stocks that drive changes in those indices. When a main stock is added or dropped from the index, they do the same. More specialized ETFs may track a segment of the market, like healthcare for example, or even different asset classes, like preferred shares, real estate investment trusts, or bonds.

Basic Strategies:

  • Active Manager: If a market is perfectly efficient, then assests will always be “priced right”. Active managers try to capitalize on times when the market isn’t 100% efficient to buy assests that are underpriced and sell them when they get overpriced. Markets can be inefficient when there is some important variable that hasn’t been factored into price, like a poorly known current situation or an unexpected new event.
  • Passive ETFs: Market inefficiencies can be small and fleeting – especially in really large liquid markets. There is very little information that one group of investors knows that another does not (that can be legally used). Unexpected new events are quickly processed and baked into the price by everyone, leaving a very narrow window to capitalize on.

How do these techniques and strategies look in practice:

  • Active Manager: On each side of a market inefficiency is a winner and a loser – someone has to sell an underpriced stock for someone else to buy it. Everyone is trying to win obviously and the problem is that whether a stock or other asset is underpriced today really is a function of what it is going to do in the future. It is a lot like trying to predict the weather. You can use all sorts of science, pseudoscience, and instruments to try and predict what is going to happen with the weather, but there are many variables involved.  In actual combat, it is hard to predict the exact course of a Hurticane as demonstrated here by Master Ken. Bet you never saw that coming. Also like in meteorology, the instruments of an active manager are expensive. There is also more turn-over of holdings and each time that happens there are brokerage fees and the triggering of taxes on realized net capital gains. They need to win more often and win by enough compared to the losers to cover those extra costs.
  • Passive ETFs: If an active manager is like a meteorologist using their science, complex models, and expensive instruments to predict the future of markets. Then, passive ETF investing is more like the weather rock. Cheap and 100% accurate. You tend to buy and hold your passive ETFs and only trigger a capital gain or loss when you sell to either take money out or rebalance.

How do they stack up to each other when put head to head in the cage match?

Like any good fight, there are blows exchanged back and forth, and in any given year active managers or passive funds may outperform each other. We are interested in longer periods like a whole round of combat. There a number of reports spanning 10 year periods that we can use for reference. The most recent performance report from Morningstar, ending December 2016 is here if you want the details.

Round 1: US Markets Over  the Last 10 Years

Aggregate Fund Performance 10yrs Trailing 2016
Asset Class Annualized Return (Asset Weighted :: Equal Weighted) Winner
Active Passive
US Large Caps 5.7%  ::  5.4% 6.9%  ::  6.7% Passive by 1.2-1.3%
US Mid Caps 6.1%  ::  6.1% 8.1%  ::  7.9% Passive by 1.8-2%
US Small Caps 6.9%  ::  6.3% 7.8%  ::  7.1% Passive by 0.8-0.9%

Well, in the first round, despite flashy moves and a lot of energy expenditure, Active Manager was unable to move the bulky Passive ETFs. This is not surprising since the US market is large, liquid, and efficient. It would also make sense that in a bull market, everything is rising, and an active manager may perform better in a less bullish or bear market where they can sidestep carnage or find bargains in the fear-driven market. The period 2006-2016 did include a nasty bear market, but also a raging bull market for the past 8 years. So, this round clearly goes to Passive ETFs. Let’s look over a longer time period.

Round 2: US Markets 1985-2016

Years that Active Manager beats Passive ETFs (net of their fees) was 15 of 31 years. Most of those were clustered around 2000 and 2008 – times of major market volatility.

Data Source: Morningstar

Average annual return over that time period for the S&P 500 Passive ETFs was 12.11% and Active Manager was 12.30%. I would call this round a draw.

Round 3: Non-US Developed Markets (Europe)

While the US markets have been on fire for the last decade, Europe has been more stagnant. This is another large developed and liquid market.

Aggregate Fund Performance 10yrs Trailing 2016
Asset Class Annualized Return (Asset Weighted :: Equal Weighted) Winner
Active Passive
Euro Large Caps 1.3%  :: 0.4% 0.6%  ::  0.5% Active by 0.7% or a draw

I would point out that, really, both fighters were pretty dead on their feet this round with returns less than the rate of inflation. With the less bullish environment over the past decade in Europe, Active Manager may have managed to edge out Passive ETFs. Both fighters were pretty pathetic this round with Active Manager being marginally less pathetic. Step it up for the next round you wussies!

Round 5: Emerging Markets

Emerging markets are volatile, risky, less liquid, and full of opportunities for attack. This is where a skilled active fighter should shine with their adaptability, variety of techniques, and killer instinct.

Aggregate Fund Performance 10yrs Trailing 2016
Asset Class Annualized Return (Asset Weighted :: Equal Weighted) Winner
Active Passive
Diversified Emerging Markets 1.1%  :: 1.9% 1.8%  ::  1.5% Active by 0.4% or Passive by 0.7%

Well this round was interesting. Asset weighted returns favoured Passive ETFs and equal weighted returns favoured Active Manager. This suggests that larger funds, with presumably more resources, did worse. This may strike to the heart of the matter – fees/costs. When you look at this data broken down by fund fees, the rate at which Active Manager was able to beat Passive ETF decreased from 42.9% in the lowest fee quartile to 15% in the highest fee quartile. Overall returns in this market were not great during this time period. In an area where I heavily favoured Active Manager, Passive ETFs has caused an upset – miniscule edge Passive ETFs.

Round 6: Bonds

At this point, our Active Manager fighter has expended a lot of energy and is tiring. Passive ETFs has not been budged from the center of the ring, but he is getting a little hungry. I’d be scared, Active Manager, you look kind of tasty and we are heading into bonds.

The bond market is large, liquid, efficient, and diverse. There are some areas with higher risk bonds where Active Manager could shine, but it is not looking good overall.

Aggregate Fund Performance 10yrs Trailing 2016
Asset Class Annualized Return (Asset Weighted :: Equal Weighted) Winner
Active Passive
Intermediate Term Bonds 4.5%  :: 4.0% 4.2%  ::  3.9% Active by 0.1%-0.3%

Well, both combatants stepped up their game this round with better returns. The goal of bonds in a portfolio is to give good consistent returns to dampen volatility. The minimal spread between Active Manager and Passive ETFs attests to this, but Active Manager was able to squeeze out a little bit of value – minuscule edge Active Manager.

With no clear death-blow dealt, this match will go to a judgement.

  • Outside of the large liquid US market: draw.
  • Large liquid US market over the past decade: Passive ETFs win.
  • Over the longer-term in the US market, Passive ETFs and Active Manager are in a draw. One tends to dominate over the other in a cyclical fashion, lasting years each cycle. Most recent has been the Passive ETF dominated cycle.

Some other points to consider in our judgement:

  • This is aggregate data of a large number of managers. I am sure that there are some who are great and some who are not and they average out – I just don’t know that we can pick which one any given manager will be. The data used here included funds that died (they term it a more gentle “obsolete” in the paper). That helps to avoid survivorship bias in their data which is good. However, it also illustrated that the rate of Active Management funds survivorship in time intervals varied from about 55-95% depending on the asset class and interval compared to Passive ETFs having a survival rate of 75-100%. I would hate to pick as my fighter one who didn’t survive. Our Passive ETFs fighter may look like he is going to have a heart attack at any given time, but he is actually a survivor.
  • Performance varies, but cost is a constant. The performance here was net of fees, so it is factored in. When stratified into quartiles by cost, the more expensive an active manager was, the less likely they were to survive and the less likely they were to beat passive ETFs. It was a linear and consistent relationship across asset classes. Fees kill. One would expect this to be even more accentuated in a lower return environment where the returns shrink and the fees don’t. Many suggest that a lower return environment awaits us over the next decade, but again I prescribe to the Weather Rock for my most reliable forecasts.
  • This active manager data is looking at larger firms. How would the smaller active portfolio managers fare? They may have some advantages in being more nimble and some disadvantages of less resources. Unfortunately, there isn’t really any data on that that I could find. Many are using passive ETFs to build their portfolios and strategically balancing them. The lack of knock-out blows from the bigger funds is not particularly confidence inspiring and again I suspect it comes down to fees.

And the winner of this bout and a kiss from Princess Leah…..    Passive ETFs

Everybody loves a winner and money is migrating in droves from the active to the passive side of the house.

The contrarian in me is given pause by that movement of the mass herd. Herds have a tendency to run over cliffs at some point. However, it is also generally a bad idea to stand in front of them when they are stampeding. The best strategy would seem be to run with herd with passive ETF investing and then jump out to active management when the cycle is shifting. The problem with that is that it is hard to see ahead of the herd and no one knows when or if that will happen. The winner is only usually clear in retrospect and since it will cycle back again, changing strategies back and forth chasing previous gains is futile at best and leads to losses from poorly timed moves at worst. Best to stick with a single strategy I think.

I personally decided to act as my own portfolio manager and go with the Passive ETFs strategy and minimal portfolio turnover – just rebalancing once or twice a year.

My reasons for that are outlined in my previous post that it is better than dialysis. For me, I think that either active or passive strategies are likely to match the market over time and that the main differentiators are drag on the returns by taxes and fees.

That brings me to taxes. The data that compares active versus passive does not account for all of your taxes. Taxes may vary depending on your location, tax bracket, whether you are trading in a tax sheltered account, and how much you turn over in your portfolio per year. The impact of this can be huge and the more active you (or your personal portfolio manager on your behalf) trade, the worse it is. The more actively you trade, rather than waiting to realize capital gains for when you need the money, the more taxes you pay today rather than deferring them until later. With compound returns, over time the effect of that is huge.

This could, again, favour a more passive strategy since you have less turn-over. On the other hand, an expert personal advisor who manages your portfolio with minimal and strategic investment turn-over may help you avoid mistakes that result in more taxes.

Can you afford to make mistakes?

I think one of the themes, looking at the data as a whole, is that an active manager versus passive ETFs will both generally return very close to the market return over time. The main differentiator is fees, and those with larger fees tend to do worse when you look at returns net of fees. This has been particularly evident over the past decade. So, if you are managing your own portfolio, you could make some mistakes as long as they don’t cost you more than a manager’s fees would. Personally, I use certified financial planner for my overall financial plan advice and manage my own portfolio.

In my last post, I suggested that for me, I could make almost a million dollars worth of mistakes managing my portfolio and break even over the long course of my career.

I came up with that guess using the Manager versus Passive ETFs Smackdown Calculator. We will go through some illuminating exercises with the calculator in my next post – Battleschool: Lessons from the Manager vs Passive ETFs Calculator.

The calculator focuses on the math and finances, but remember that whether to use an advisor or to manage your own portfolio is not purely a mathematical question. It is also not all or nothing, and a good advisor can help your finances and financial health in ways besides your portfolio returns as described in Managing my own portfolio is way better than dialysis!!!

For those considering an advisor, I suggest reading Choosing a Financial Advisor is Like Choosing Lingerie if you haven’t already for some tips on what to consider. There is also a good article and resources in the American context at WCI.

For those now thinking about managing your own ETF based portfolio, but have no idea what that would look like. Fear not, we will explore that on this blog!










  1. I keep finding gold nuggets when I look through your old posts!

    I think the hardest part is discipline when managing your own investments. I did a MBA, read the investment books, but still was susceptible to emotional decisions. If you have the discipline, then it makes sense to do one’s own investments. There are some areas where active management outperform (small cap, emerging, foreign), but I think it’s harder and harder to do so.

    I use a discretionary manager who changes less than 1%. From what they tell me, my net exceeds the index. I guess it is worth it for me because it protects me from myself. Unfortunately, with the new budget, I may have to look at other options to decrease my passive income.

    1. Thanks. I thought I was pretty knowledgeable when I started the blog, but I keep learning new pearls with each article I do and from the interactions with others. Thanks for commenting. Having the right manager is key if you decide to use one. I have learned some expensive lessons both about managers and my own self-discipline . The key for me has been to be mechanical and passive – if not, then my emotions can trip me up. If taking an active approach, I would want a good manager – preferably as part of a team with a good financial planner and tax planner. I also think it is a good idea to pick an approach and not flip back and forth as either active or passive dominates for long periods, and knowing me, I would switch strategies just in time for the balance to tip the other way.

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