Active vs. Index Management

The Financialist • Issue 84 • October 2004
BY BRYSON MILLEY

Index funds are “passively managed” investment funds. In practical terms, that means the assets held in the fund closely mirror the underlying index, such as the S&P/TSX Composite Index.  Because the portfolio is easily defined and easily managed (the index fund only changes its portfolio when a stock changes in relation to the underlying index), there is no need for a dedicated team of investment analysts or researchers. As a result the management expenses are generally lower than “actively managed” funds, where an investment manager selectively chooses companies in which to invest.

Our firm has the ability to help clients invest in just about any index fund available. Index funds can be a viable investment option in the proper context. Having said all of this, there are two key things to know with regard to index funds.

First, the risk level (volatility) of index funds is generally higher than the average equivalent actively managed fund. Index funds are fully invested (they hold very little cash) and the holdings often include smaller, volatile companies; investors will feel every bit of the market’s ups and downs. Active managers, on the other hand, often try to reduce volatility by holding more cash during uncertain times and by being more selective in the stocks they choose.

Second, the performance of index funds is almost always below that of the actual index itself. This is because the index fund reacts to the market - it can only make adjustments to its holdings after the market has changed. As a result, the performance of an index fund is generally lower than the performance of the index itself. This phenomenon is known as “performance lag.”

Let’s compare the TSX/S&P Total Return Index with the 128Canadian equity mutual funds in Canada that have a track record longer than 10 years. The comparison is for the ten years up to July 31st, 2004.*

Return Comparison

The TSX/S&P Index returned 9.22% over the 10-year time frame. Of the 128 funds, 50 have returns better than the S&P/TSX  Composite Index, after their fees are accounted for (39% of the group outperforming the index).  The average return of all 128 funds was 8.31% (or 90% of the index’s return during the time period).

Risk Comparison

Risk can be defined as volatility – the size and the frequency of fluctuations. Analysts use two methods to measure volatility.  The first is “beta,” which compares the volatility of a given security relative to the volatility of a given benchmark (usually a stock index). A beta of 1.0 means the security in question is just as volatile as the benchmark. A beta of 1.5 means the security is 50% more volatile than the benchmark; a beta of 0.5 means the security is 50% less volatile. Using the measure of “beta”, the index was 27% more volatile than the average of the funds.

Another measure of volatility is “standard deviation.” The higher the standard deviation, the more variable the returns are. Looking at the standard deviation of the S&P/TSX Composite index over our 10-year time period, we can see the index was 10% more risky than the average fund.

Fee Comparison

The average Management Expense Ratio (MER) of the sample group was 2.20%. Index funds can have MER’s of 1.0% or less; some can be as low as 0.20%. I have assumed no commissions, fees, or redemption charges apply, which is usually not the case.

Conclusion

Actively managed funds generally do better in negative market conditions, however index funds generally outperform actively managed funds over the long term. Overall, there is a cost/benefit analysis to be done when choosing investments (as with everything). It’s important to fully understand what you receive for your costs.

As always, it’s important to consider your personal circumstances when determining what investment is right for you.  If you have any questions, contact your Rogers Group Advisor. 

*Source: Bell Globemedia’s Globe HySales Portfolio analysis software