Are truly active managers more likely to beat the market than those who stay closer to their benchmark index? In my latest podcast, I discuss this idea with Christopher Davis, a strategist and researcher at Morningstar Canada.
The idea of active share was introduced in a 2009 paper called How Active is Your Fund Manager? A New Measure That Predicts Performance, by Martijn Cremers and Antti Petajisto. For example, a large-cap US equity fund that holds only half the stocks in the S&P 500 would have an active share of 50%. An index fund, by definition, has an active share of zero.
The researchers presented evidence that the most active funds “significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.” A year later, Petajisto published a follow-up paper called Active Share and Mutual Fund Performance, which included more support for the idea that the most active stock pickers can be expected to add value.
Both papers take aim at so-called closet index funds, which charge the higher fees one expects for active management yet differ little from their benchmark. Closet indexing is a recipe for underperformance: it might be worth paying more for truly active management, but it’s never worth shelling out 2% to track a broad-market index when an ETF will do it for a few basis points. As Christopher and I discuss in our interview, closet indexing is rampant in Canada, in large part because our small, poorly diversified market doesn’t give stock-picking managers many options.
Davis’s research looked at data from 2001 through 2015 to see if Canadian equity funds with high active share went on to produce higher returns in subsequent years. During the first period he examined (from 2001–2010), funds with the highest active share significantly underperformed their benchmark, while in the subsequent sample (2006–15), the most active funds did outperform—at least before fees. As might be expected, the most active funds were also the most expensive.
Davis concluded that active share does not seem to have any predictive power. Indeed, Morningstar’s research has consistently found that the best predictor of a fund’s future performance is cost.
If you’re interested in other criticisms of active share, see the following:
Dissecting The Active Share Myth, Larry Swedroe: “Although much has been made by the active management community regarding active share, it appears to be much ado about nothing.”
The Search for Outperformance: Evaluating Active Share, Vanguard: “Vanguard’s study found no relationship between high levels of active share and subsequent fund outperformance for the period studied.”
Deactivating Active Share, AQR Capital Management: “Our conclusions do not support an emphasis on active share as a tool for selecting managers or as an appropriate guideline for institutional portfolios.”
How to invest in the rear-view mirror
In the Bad Investment Advice segment of the podcast, I pick some low-hanging fruit, courtesy of a recent Q&A column by Gordon Pape. Reading the whole article may require a subscription to The Globe and Mail, but here’s the gist: a reader asked why he should care about mutual fund MERs. After all, isn’t an expensive fund worth the cost if it outperforms? You betcha, answered Mr. Pape:
“I’m glad some people understand what I’ve been saying for years. The only number that should matter when judging mutual funds is the net return to you. If a mutual fund with a 2.5 per cent management expense ratio returns 10 per cent a year after expenses and an ETF with a 0.5 per cent MER gains just 8 per cent, which would you choose?”
This is a classic example of outcome bias, the same logical error people use when they call a low-probability bet in poker and then get lucky when their miracle draw arrives. Unfortunately, investors need to choose their funds before they know what their returns will be. And the rational choice is to choose lower-fee funds, since we know cost is a reliable predictor of future performance, while past returns have no predictive power.
Mr. Pape has a huge audience and a mutual fund newsletter that charges $79.95 annually, so I feel justified in pointing out that this is dreadful advice for investors. Unless, of course, you have a crystal ball that allows you to predict future returns, or a time machine that allows you to buy them.
Are markets really overvalued?
Finally, in the Ask the Spud segment, I address a question from a blog reader who is nervous about investing a large lump sum during a period of “historically high valuations” for stocks.
Are valuations really historically high? While US stocks are expensive according to traditional measures, the same isn’t true for most other markets. The German firm StarCapital publishes a summary of current valuations in all major stock markets, focusing on the cyclically adjusted price-to-earnings (CAPE) ratio. According to their most recent data (as of December 30, 3016) the US and Japan are the only major markets that appear “expensive” according to their CAPE ratios.
OK, you say, but indexes like the S&P/TSX Composite and the S&P 500 are near their all-time highs. Shouldn’t we be nervous about that? The implication seems to be that an all-time high signals an imminent downturn—maybe even a bubble.
But stock indexes don’t move up and down according to a fixed reference point: they’re designed to grow with the stock market, so we should expect them to touch all-time highs pretty frequently. And they do, as this blog by financial planner Jason Lina points out. “The S&P 500 Index has closed at an all-time high on 6.9% of all days,” he writes. That’s about once every couple of weeks, on average. “More tellingly,” Lina says, “the index has been within 5% of its all-time high on 46% of all trading days since 1950.” So if you’re concerned about investing when the market is near an all-time high, in turns out that’s true about half the time.
In the end, I advise the reader to consider moving into the market gradually if that would make him less anxious. The evidence is clear that dollar-cost averaging with a lump sum does not increase expected returns, but that’s not the point here. Investing gradually—according to a fixed schedule, such as 25% of the lump sum every three or four months—is far better than procrastinating or trying to time the market.
Another great article Dan. Your blog cannot be beat for solid research and data, and an accurate understanding of investing.
Was there a flaw in Cremers’ and Petajisto’s analyses? – their conclusions on active fund performance run contrary to the vast majority of legitimate analysis that’s been done on the active vs passive debate. Were their conclusions about returns before fees?
Good article! This just reassures me further that index investing is the way to go. I’m yet to see any proof that active funds beat the market regularly even without considering fees. Of course some people use the flawed logic of “getting lucky” and picking the 1 or 2 active funds that outperform. Of course some will, but most won’t. In the long run this pattern is unlikely to keep happening.
I have been following Canadian Couch Potato for years and I give it my top rating. Great work.
Pointing out that the S&P 500 index is frequently within 5 % of its all time high seems like another way of saying that the US stock market has historically performed very well. The US economy is strong and diverse, and its markets are very liquid and more or less well regulated. So I find this very plausible, BUT as they say “Past performance is no guarantee of future returns” no matter how good it has been.
There are two economic factors for the USA economy which have to be considered though:
1) The enormous amount of money that “Quantitative easing” and ultra low interest rates has put into the market, supposedly without causing inflation. But can this go on much longer?
2) The enormous amount of US corporate money which is sitting outside the USA, presumably waiting for some kind of action by the US government to encourage companies to repatriate it.
Keep an eye on these two !
@CCCP 1972: First off, nice Soviet hockey reference. :) Swedroe’s article linked below does a good job challenging the methodology of the original papers.
Those Jason Lina quotes are terrific and a great tool if explaining the CCP to anyone…
As usual, excellent information. Thanks for providing your insight. I share this sort of thing with my high school students all the time. I’m hoping 20 years from now, at least a few of them will have benefited from your advice.
“In the end, I advise the reader to consider moving into the market gradually if that would make him less anxious. The evidence is clear that dollar-cost averaging with a lump sum does not increase expected returns, but that’s not the point here. Investing gradually—according to a fixed schedule, such as 25% of the lump sum every three or four months—is far better than procrastinating or trying to time the market.”
This is one of the perennial stumbling blocks I run into when I preach conversion (to well diversified non clairvoyant passive index investing) to my running buddies. Rationality dictates that there is no probability downside to liquidating all your irrational poorly invested assets and re-investing immediately into your well-considered permanent allocation mix as soon as you have convinced yourself of the superiority of the Couch Potato approach.
Your advice for a painless graduated entry into CP investing seems like a harmless enough sop to the nervous nellie who acknowledges intellectually the mathematical correctness of the CP analysis, but still has high adrenalin response to all the irrational reptile brain fears of market factors that you have enumerated for us many times in this blogsite.
It may indeed be helpful advice to one who is rational enough to confront his fears and see where they are coming from, and is disciplined enough to understand that flinching at the wrong moment actually increases one’s chances of a slip and fall.
Unfortunately, for the person who has never really let go of his reptile brain dependence, he/she is still vulnerable to some unforeseen (but perfectly plausibly likely) glitch in the market part way through his 25% every 3 months plan, which, augmented by the usual accompanying Financial Section headlines, might make him delay or divert from his plan “because of this unique situation that has unfolded.”
I don’t have a good answer to this problem. If a person is still too nervous to commit all his investments immediately to the CP method once he sees the light, maybe he hasn’t got the intellectual rigour to stay the course once his funds are fully committed anyway. But telling him to think smart and be rational isn’t likely to be helpful. Perhaps the 25% every 3 months entry strategy should be accompanied by the advice that it is likely to still be difficult because of random market movements plus irrational fears, but that it is essential to finish the investment process once started.
This lump sum investment problem seems to come up a lot. I think it’s really a question of risk tolerance. If you’re comfortable with your strategy for your existing investments, then you should also be comfortable with it for new investments. This should be true for both passive investors and those who think they have a scheme to beat or time the market (or pay someone to do it for them). The only exception would be if your lump sum is so large that it allows you to change your strategy. However, even then it should only result in an adjustment to your asset allocation and you should still invest the entire sum according to the new asset allocation.
I’d suggest that if people aren’t comfortable investing a lump sum according to their existing investment strategy, then they likely have too much risk. Perhaps this would be a good exercise to go through in determining your overall risk tolerance, rather than trying to imagine how much money you’re willing to lose in a market downturn.
“The only exception would be if your lump sum is so large that it allows you to change your strategy.”
This is interesting — I didn’t understand at first, but you mean something like..
I’m 50 have an RRSP of 600k which is slowly growing but is allocated at 40%Bonds, 20%CanadianEquity, 20%USEquity, 20%Rest of World Equity. This is mildly conservative because I need to have enough investment when I retire, so I can’t take large risks now.
I suddenly get an inheritance of 2 Million dollars. If I invest 1 million into the same strategy I will have 1.6 million now, which even at conservative 4% withdrawal now will get me 64k annually before tax. Without any withdrawals now, with continual contributions that amount will be even greater by retirement.
Therefore the remaining 1Million can be invested without any fear I will be drawing on my RRSP prematurely. So I can afford to be more risk taking. But that would also have to lie within your comfort zone, too.
Or, perhaps you mean that because the invested amount is so large, even invested safely and conservatively with an overall of 80% bond allocation it allows you to have more than adequate income without needing to take more risk than you need to.
But such a large sum would likely exceed your RRSP contribution thresh-hold, so there is that complication.
But is your point that the lump sum is large enough to distort the factors of your original formula and you now have to re-think your acceptable allocation formula?
Yes, that is what I meant. Personally, I would tend to lower my overall risk if I suddenly had a large, unexpected windfall, but I suppose that some people might see this as an opportunity to comfortably take on more risk. Maybe one day I’ll have the pleasure of having to deal with this problem.
My overall point was that everyone should have an overall investment strategy that they’re comfortable with. It should apply equally well to existing investments and a new lump sum. Even if you’re a market timer and your crystal ball tells you that markets are about to drop, your existing allocation should reflect this belief. Whether this involves lots of bonds, treasury bills or mattress stuffing doesn’t matter. If you’re not comfortable investing the lump sum the same way, then you likely have too much risk.
Regarding your point that a large lump sum would likely exceed your RRSP limit: Dan has mentioned many times that asset allocation and asset location are two entirely different things. Your overall strategy should reflect your risk tolerance. Where you put the money to minimize taxes is a different issue.
Once again thanks for a great podcast. Your podcasts are some of the clearest (audible) ones I have heard.
Your point on investing all at once or over a period of time is spot on in terms of feeling overwhelmed when investing. I have a buddy that is trying to convert his portfolio to 3-4 EFT’s. I mentioned to him about purchasing each one in 2 tranches, but every day he comes back to me saying, “what if it goes lower tomorrow, or what if it goes higher tomorrow”. Subsequently he did not invest. Hopefully after hearing this particular podcast he will start.
Dan, another great podcast.
Your blog is clearly the reference for Index Investing in Canada, and is still getting better and better.
I’m in a similar boat as the Ask the Spud questioner. I’ve been sitting on a pile of cash, watching the market pass me by. The answer has convinced me to jump in. Thanks!
I’m struggling with tax optimization though. Now at 40, my RRSP is maxed, and the aforementioned pile of cash will overflow my TFSA and push me into the need for a taxable account. I’ve been scouring this excellent blog and other resources to try formulate rules of engagement. Clearly this is complicated. :)
Based on the “Assert Location for Taxable Investors” PWL whitepaper, I’m clear on the fact that I’ll hold Canadian equities in my taxable account, due to their light taxation. What I’m not clear on is whether I should hold bonds in my TFSA, or higher risk (and potentially higher reward) US and other foreign equities.
In other words: is it better to keep all my fixed income funds in my RRSP and use my TFSA for foreign equities, or is it better to max my TFSA with bonds keep foreign equities in my RRSP?
Check out the portfolio proposal for John Smith compiled by Justin Bender.
I really like what he does with the TFSA, holding equal weights XEF, VUN and VCN. His reasoning is that no one knows which region will do better going forward so why not hold all three for max growth potential.
There is some bonds in the RRSP (premium bonds such as VAB or ZAG) and the lions share in the non-registered to faciliate growth in tax deferred and tax sheltered accounts. Justin also mentions another benefit of having ZDB in the non-registered: Unexpected capital calls.
Thanks for that reference. It’s certainly conspicuous that the vast majority of fixed income is held in taxable accounts. This approach has also been recommended by MoneyGeek when bond yields are moderate to low. Even in this case, Dan has still recommended to prefer registered accounts for bonds for various reasons (https://canadiancouchpotato.com/2014/04/24/do-bonds-still-belong-in-an-rrsp/), but this was back in 2014, so perhaps the introduction of the far more tax efficient ZDB has turned this all on its head?
@Jason: Yes, the introduction of tax-efficient bond ETFs such as ZDB and BXF have certainly changed the situation. GICs, too, can be a good choice in taxable accounts. However, traditional bond ETFs, filled with premium bonds, are still a poor choice. And in many portfolios it still makes sense to hold bonds in RRSPs.
The fact is, there just aren’t many hard-and-fast “this goes here, this goes there” rules. A lot of the choices depend on the individual’s situation and the specific products you’re going to use.
I’m certainly not an expert but from what I’ve been reading international developed and emerging markets should be the last to be kicked out of tax sheltered accounts due to their relatively high dividend yield (I think they’re around three percent).
US equities have a lower yield of around 2% so they may be a good option in a taxable account if you want to keep bonds in the RRSP. It always appears to be very specific for the individual (i.e. pension considerations, mortgage liabilities etc).
Another great resource I’ve found online is Reddit Personal Finance Canada. There are some very knolwedgable people that post on the forum and they always keep it mature and classy. Dan even did an AMA (ask me anything) a few months ago that you can check out.
@Josh, @Dan, thanks terribly for your replies
I’m gradually wrapping my head around this. Consolidating all I’ve read into a general rule of thumb for tax optimization, as far as that can even be done, it looks like for RRSPs I will (in order of priority) prefer funds with the highest dividend yields (notably, foreign and emerging markets), then premium bonds such as ZAG, then Canadian equities. For TFSA, I should prefer Canadian-listed equities regardless of market (based on Justin’s argument that we can’t predict which market will do best). And for taxable accounts, I should prefer Canadian equities, discount bonds such as ZDB, and finally Canadian-listed US equities (where at least foreign withholding tax can be recovered).
Justin’s model portfolio for “John Smith” was very enlightening. It sounds like rising interest rates could swing the tides back to preferring to hold bonds in the RRSP, presumably at the expense of shifting US equities into a Taxable account, but from what I can tell, bonds will have to start yielding about 7% for that to be worth it.
Meanwhile, with the rather low yield bonds we’ve had for some time, it does at least look like it’s not completely crazy to hold the lion’s share of your fixed income as discount bonds in a taxable account to make room for equities.
I agree that investing a lump sum is always challenging. I’ve been there and now that I want to repeat it, the same irrational questions pop back into my mind. The advice offered by Dan is sound. Jim Collins offers similar advice on his blog where he states that “that the [US] market always goes up but it is a wild ride and no one can predict what it will do in any given day, week, month or year. The other thing to know is that it goes up more often than it goes down. Consider that between 1970 and 2013, the [US] market was up 33 out of 43 years. That’s 77% of the time.” He also argues against dollar-cost averaging. Source: http://jlcollinsnh.com/2014/11/12/stocks-part-xxvii-why-i-dont-like-dollar-cost-averaging/
You may also find his related article about “Investing in a raging bull” interesting: http://jlcollinsnh.com/2013/05/22/stocks-part-xviii-investing-in-a-raging-bull/
I’ve found this podcast to be as informative and stimulating as the prior ones. Can’t wait until the next one comes out! I love the Bad Investment Advice section with its proper intro. Hilarious!
I have recently discovered your website. I enjoy your articles and podcasts. I have some questions regarding ETS.
I understand the logic of low MERs. I also understand diversification. What are your thoughts regarding valuations? Say we are looking at a EFT that tracks the TSX and say a gorilla occupies one of the top spots on the TSX (Bre X or Notel like) and say that this company is vastly overvalued. An ETF manager simply buys shares of all TSX companies in the same capitalization. The fund can easily be overexposed to overvalued companies. Presently our GDP to PE is running around 130% – historical average is 100%. The investor is simply caught in the merry go round?
In terms of taxation and capital gains – as an EFT is traded and not held in units as a mutual fund I a assuming a cap gain only applies when a purchaser realizes a gain once she has sold her shares assuming there was a gain? If the EFT tracks the TSX will there be cap gains within the fund? Can there be flow thru cap gains or taxes with an ETF?
Last are their funds or ETFs that short an index or segment of an index?
@Ross: Thanks for your comment. These are big questions that I cannot answer in full in the comments section, but to start:
– It is true that traditional cap-weighted index funds will be overexposed to overvalued companies and underexposed to undervalued companies. The problem is believing that is a simple matter to identify mispriced companies. That is, after all, one of the primary goals of active management, and we know it usually fails. There are other index strategies that seek to address this issue:
– As for individual companies dominating an index (such as Nortel once did), many major indexes now have a cap of 10% for any individual company, so this is no longer a danger.
– Capital gains can be passed along to unitholders of an ETF if they are realized within the fund. As with a mutual fund, the gains are distributed at the end of the year.
– There are “inverse” ETFs that deliver returns opposite to that of their benchmark index. However, I would not recommend any of these.