I remember as a kid, all of the neighborhood boys congregating to act out our favorite WWF wrestlers. It usually involved highly stylized body-slams, pile-drivers, and flying maneuvers 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)! Are you ready to rumble!?!?!!?! Let’s meet our fighters…
Active Portfolio Manager
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 lightning 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 mind games 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.”
Passive Index-Tracking Investor
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 honor. We asked via a translator about his strategy with the markets. His answer…..
“Stay in the middle and don’t get pushed out of the circle.” [alternative translation: “match the market minus miniscule fees.”]
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 “alpha”. 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 alpha. 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 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. They can even track different asset classes, like preferred shares, real estate investment trusts, or bonds.
Basic Strategies:
- Active Manager: If a market is perfectly efficient, then assets will always be “priced right”. Active managers try to capitalize on times when the market isn’t 100% efficient. They try to identify and buy assets that are underpriced. Then, sell them when they get overpriced. Markets can be inefficient when there is some important variable that hasn’t been factored into the 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 them.
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. Obviously, everyone is trying to win. 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 sa
w that coming. Also like in meteorology, the instruments of an active manager are expensive. There is also more turn-over of holdings. 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.
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 for him.
| 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. However, 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 judgment.
- Outside of the large liquid US market: draw. Not shown in this article was Canada. 2021 SPIVA Canada data shows a clear loss for active management in Canada.
- 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 judgment:
- 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. The problem is that you can’t pick who the good one will be moving forward. In fact, SPIVA persistence data from 2021 shows previous winners underperform moving forward.
- The data used here included funds that died (they term it “obsolete” in the paper). That helps to avoid survivorship bias in their data. That 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
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.
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.
Hey, LD, another late comment! A couple of points about this topic. Now that we have 15 years of data from the latest SPIVA Report, in all markets (emerging markets, small caps, bonds, you name it) around 90% of active managers fail to beat their risk adjusted benchmarks. So it seems that the longer the time frame the less likely an active manager can beat the market, no doubt due to the relentless compounding of costs. The latest report also commented that the 15 years of data showed that ex US markets did worse than US markets, again likely due to the higher costs. It will be interesting to see the 20 year data, which some authorities (Larry Swedroe) feel will bring the outperformers down around 2%. While true some active managers can outperform over shorter periods, the only time period that matters is the long term, where the results are very poor.
The other issue that Is worth noting is that some managers are using inappropriate benchmarks to claim victory. Eg. Some will buy small cap/value stocks, compare their results to a broad market index and claim they are outperforming the market, when in fact they are taking more risk, loading on the size/value premium, and getting better results (assuming a time period when the size and value premium is positive). If an apple to apples comparison with the appropriate risk adjusted bench mark were made their outperformance would almost certainly disappear. Not to mention that less expensive ETFs tracking small cap/value indexes are available in most markets. Justin Bender looks at the this issue here.
https://www.canadianportfoliomanagerblog.com/active-funds-exposed/
Great points Grant! The more time I spend around data (both in medicine and in finance), the more I see how the nuances can be massaged to alter the message. Despite nuances, the message from the evidence with passive vs. active managed investing is pretty consistent and getting stronger with time as you say. I wish that I had realized that 15 years ago, but oh well!
-LD