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The decades-old active versus passive investing debate has turned into a mud fight where it’s hard to know which side is which.
The first shot was fired in the 1990s when passively-managed index-linked exchange-traded funds (ETFs) hit the market. Those ETFs gave investors indirect access to stocks trading on all the major global indices such as the Toronto Stock Exchange and Nasdaq, and even specific sectors within them - all for a fraction of the cost of an actively-managed mutual fund.
Generally, active investing puts investment decisions in the hands of professional money managers and passive investing puts investment decisions in the hands of every single market participant.
When it comes to which method reaps the greatest rewards, results vary depending on how the data is sliced and diced. Actual returns from objective trackers show actively-managed mutual funds have the edge overall; but, in a cruel catch-22 for investors, they underperform once fees are applied.
There is no single definition of active or passive management these days but there are degrees that can help you determine if the fees you pay are for the services you get.
THE ACTIVE MANAGER
In its purest form, active managers are professionals who invest on behalf of a client based on the individual’s goals and tolerance for risk. They are part of a team that determines the best investments to buy, hold or sell.
Active managers, such as the team led by Warren Buffett, are trained to identify a company’s earnings potential along with potential risks by pouring through quarterly corporate earnings statements, and often establishing direct relationships with management.
They assess the broader sector, market, and economy on a macro level and determine if the company’s earnings justify its current price levels.
Active managers can employ a countless number of methods for determining value but the one thing they share in common is that they actively invest.
The most common way for retail investors to get access to active management is through mutual funds. Annual fees for hands-on management can top three per cent of the total investment.
In its purest form, passive management attempts to replicate broader indices by tracking individual holdings based on their weighting in the index and adjusting them daily as they change in value. No arbitrary decisions are made. They set it and forget it.
As a result, price changes in S&P 500 ETFs - for example- will reflect price changes in the actual S&P 500 minus a small fee. Annual fees on ETFs could be as low one-tenth of a per cent.
SOMEWHERE IN THE MIDDLE
Index-linked ETFs were quickly followed by other passive investment products such as equal-weight ETFs aimed at putting more emphasis on smaller holdings with more growth potential in an index.
It is still a preset formula, but it paved the way for a flurry of complicated preset formulas, which generally fall under the heading “smart-beta” ETFs. In many cases, the act of including or combining different passive investing strategies seems like active management. So do the higher fees that come with the more complicated “passive” strategies.
ETFs have gained in popularity as retail investors become more aware of the destruction active management fees inflict on their portfolios. The demand has given rise to discount brokers offering ETF portfolios, and robo-advisors that automatically determine which combination of ETFs are right for individual investors.
Oddly enough, discount brokers themselves often market passively-managed ETF portfolios as actively managed.
At the same time, many actively-managed portfolios bear a striking resemblance to their benchmark indices. Look at the biggest holdings in just about any Canadian equity fund and compare them with the top holdings in the S&P/TSX Composite Index.
The term is “closet indexing” and it essentially means paying a lot to an active manager to pay much less for a passive investment. In other words, that expensive active manager is doing little more than replicating a cheap ETF.
To make matters worse, mutual fund investors could have to pay an additional annual fee - usually one per cent of the amount invested - if they buy a fund through an adviser.
It’s called a trailer fee and is designed to compensate the adviser for their layer of active management, which begs the question: is an adviser who sells pre-packaged portfolios an active adviser?
Many Canadians opt to pay the higher fees for professional management and it often pays off. It would help to know you’re not paying more for something less.