CE Module. Benefits of Combining Active and Index-based Investing Strategies

Transcription

1 Benefits of Combining Active and Index-based Investing Strategies Active and index-based investors often appear to be adversaries in an ongoing investment battle between those who believe it s possible to beat the market and those who believe it isn t. Many investors fall into one of these two schools of thought, with a firm conviction that their chosen strategy is the superior choice. Those who subscribe to an active management style attempt to exceed the performance of index-based investments through superior market selection and timing. Because active investors veer away from typical index securities and weightings, they have the opportunity to outperform (as well as underperform) index benchmarks. On the other hand, those who believe it is not possible to beat the market typically choose to invest in the same securities, often in the same proportions, as a particular market index. This is index-based investing, and it is sometimes called a passive style of investing because investors don t make any active decisions in regards to individual security selection. Although it s often presented as an either/or choice, mixing both active and indexbased asset management within one portfolio can be a very effective tactic. Let s take a look at each style in detail, as well as the benefits of a hybrid strategy that combines active and index-based investing strategies. CE Module

2 Active Investment Management What is active investment management? Active investment management, also known as active investing, refers to a portfolio management strategy in which the investor makes specific investments with the intention of outperforming a benchmark index. Managers of actively managed mutual funds often use fundamental and technical analysis to exploit inefficiencies in the stock market, purchasing undervalued securities and selling overpriced securities. Fundamental analysis involves studying the fundamentals of a particular company to determine if the company is a good investment. This may include gathering quantitative evidence from financial and earnings statements and balance sheets, as well as exploring qualitative factors, such as a business s competitive strengths, barriers to entry within the sector and the experience of the management team. Fundamental analysis strives to answer many questions about the company s future prospects, including: What are the chances that the company will go bankrupt? What are the company s projected future earnings? How certain are future dividend payments? Is the management team aligned with shareholders value? Technical analysis, in contrast, is the practice of studying the history and past direction of a particular stock in an attempt to predict its future price. Investors using technical analysis techniques often study charts, graphs and indicators (for example, moving averages, money flow and relative strength) of a particular stock to determine the direction the stock price is likely to take. What are the advantages of active investment management? For most investors, the primary attraction of active management is that it allows for the selection of a basket of chosen investments as opposed to investing in the market as a whole. This increased control offers two key benefits: the opportunity for outperformance and the opportunity for reduced volatility, as an active manager has the opportunity to rebalance the portfolio to reduce volatility in any market condition. Any given actively managed portfolio may aim to achieve both or either one of these benefits. The opportunity for outperformance exists every time an investor makes an investment mistake based on emotion or wrong information. When an investor makes a poor investment decision, regardless of the reason, someone is capitalizing on it because every transaction has a buyer and a seller. For example, at any point in time, any number of investors may act irrationally, trading securities at prices that don t match their intrinsic values. In addition, individual investors have different levels of skill when it comes to digesting and interpreting data. Some are less disciplined than others, and some have less insight than others. Investor behaviour and wide variances in investor sophistication can create huge inefficiencies in the stock market. Active investment managers can potentially capitalize on these market inefficiencies and deliver superior performance. Likewise, knowledgeable managers can reduce the volatility in a portfolio by rebalancing various security weightings to achieve optimal diversification. Although market-based index investments are often considered to be well-diversified, this is not always the case. We need look no further than the recent surge in crude oil prices: soaring energy prices saw the S&P/TSX Composite Index become heavily overweight in the energy sector. Active investment managers can rectify this situation through regular rebalancing realigning securities in the portfolio back to their desired weightings to reduce overall portfolio volatility. What are the challenges of active investment management? Cost is often cited as the primary disadvantage of an active investing approach. Most visibly, actively managed mutual funds have an associated management expense ratio (MER), which is a measure of the cost of operating a mutual fund. Operating expenses bundled into an MER usually include the fee paid to compensate the fund s manager for his or her expertise in active stock selection (often the most significant component), as well as charges related to recordkeeping, custodial services, taxes, legal expenses, accounting, marketing and auditing. The MER is deducted from a fund s assets and therefore lowers investor returns. For this reason, higher MERs are considered a major downside of investing in actively managed funds. 2 CE Module Invesco Trimark

3 Note that a fund s trading expense the cost of buying and selling securities within the fund is part of the Trading Expense Ratio (TER). Although the trading cost is not included in the calculation of the MER, it can also diminish the return available to investors. Looking beyond cost, one of the more obvious challenges of active management is that as managers attempt to outperform an index, they may end up underperforming it instead. Although fund managers are professionals, they may still pursue questionable theories, or simply make poor investment choices while managing the portfolio. Paying a mutual fund manager to underperform is a hard pill to swallow for many investors. However, because an active manager s funds tend to look different than their benchmarks and have longer time horizons, their investment theories may be unrecognized in the short term but be rewarded in the long term when given the chance to play out. Table 1 Percentage of U.S. equity mutual funds underperforming relevant indexes from 1997 to Value Blend Growth available. The challenge is identifying in advance those managers who will outperform. Perhaps the most important attribute to evaluate when selecting an active fund manager is consistency. Superior managers often strictly adhere to a well-defined and clearly articulated investment philosophy through all market conditions. Of course, this can make good managers appear wrong in the short term in order to be right in the long term. That is, even the best managers will sometimes be out of favour when following rigid investment guidelines. It is important to assess the long-term performance a manager has achieved in relation to the performance of that manager s peers with a similar investment approach, as well as in relation to relevant index benchmarks. Because it s often hard to differentiate between manager talent and good luck, placing a high priority on a consistent investment philosophy may result in a more effective active manager selection process. 1 Derived from data provided by Lipper Inc. and MSCI. The following indexes were used: MSCI US Prime Market Value, MSCI US Prime Market 750, MSCI US Prime Market Growth, MSCI US Mid Cap Value, MSCI US Mid Cap 450, MSCI US Mid Cap Growth, MSCI US Small Cap Value, MSCI US Small Cap 1750 and MSCI US Small Cap Growth Indexes. Source: The Vanguard Group, Inc., Issues & Perspectives, Number 2, Large-cap 81% 72% 47% Mid-cap 100% 51% 40% Small-cap 71% 62% 52% And, as Table 1 demonstrates, underperformance is quite common among actively managed mutual funds. In fact, the majority of U.S. value and blended style equity mutual funds failed to outperform their respective benchmarks between 1997 and The growth style fared better, but still produced lower results than the benchmark nearly half the time. Choosing an active mutual fund manager When investors buy an actively managed mutual fund, they are essentially buying the manager. The question therefore becomes, how can an investor or advisor identify good active managers? Past performance is not necessarily an indicator of future performance, so we can t identify good active managers through an analysis of past performance data alone. Top 10 lists of outperforming mutual funds are, of course, readily CE Module Invesco Trimark 3

4 Index-based Investment Management What is index-based investment management? Passive investment management, commonly referred to as passive investing, refers to a portfolio management strategy in which an investor makes as few portfolio decisions as possible in order to minimize research and transaction costs. Index-based investment management is a type of passive investment management in which the investor attempts to mimic the performance of a specific external index, such as the S&P/TSX Composite Index. Index-based investing has exploded in popularity in recent years, and today there are thousands of index funds tracking a wide variety of market indexes. Some of the largest equity mutual funds in the world employ indexbased investment strategies the Vanguard 500 Index Fund with $92.6 billion in assets 2 under management is a good example and most asset management firms offer index-based investments in one form or another. The concept of index-based investment management is sometimes summed up as, Don t just do something, sit there! This is counterintuitive to many investors. But the rationale behind index investing is rooted in a sound concept. Many index investors support the idea that, over time, the average investor will have an average beforecost performance equal to the market average. It s a zerosum game: the performance of the market takes into account the performance of all investors, including mutual funds, and therefore, on average, mutual funds must underperform the market by the MERs they charge. For this reason, index investors generally believe they can benefit more from reducing investment costs than from trying to beat the market. What are the advantages of index-based investment management? Several benefits explain the growing appetite among investors for index-based investment management. In particular, investors searching for a way to achieve lowcost market exposure to a specific asset class cite two key advantages of an index-based investment fund over an actively managed fund: cost and simplicity. Index investing is an easy way to achieve diversified asset class exposure at minimal cost and maximum efficiency. In general, index funds are far cheaper than their actively managed counterparts for a few reasons. Indexing is essentially a buy-and-hold strategy, with securities held in the fund as long as they remain in the index. This usually results in low portfolio turnover, and therefore low transaction costs and associated capital gains taxes. Beyond that, the criterion for many index funds is very straightforward: if securities are included in the index, they are included in the fund. As a result, the costly research associated with active management is basically eliminated. This keeps MERs for index funds extremely low in comparison to actively managed funds. In addition, index funds typically contain a large number of securities to mimic their corresponding benchmark, offering investors broad diversification within an asset class with little risk of performance differential relative to the benchmark. That is, index-based management shouldn t result in either severe underperformance or spectacular outperformance compared to the benchmark. Conversely, active managers risk severe underperformance (the flipside of their potential for spectacular outperformance) relative to their respective benchmarks. Many supporters of index investing point to statistics (such as the ones in Table 1) that show active managers have an inconsistent record of outperforming the index, particularly after the fees they charge. Index-based investing can also be useful for structuring extremely large portfolios. As a mutual fund gets bigger in terms of its assets under management (AUM), an active fund manager may experience increasing difficulty buying meaningful positions in a small number of securities. This can force the manager to hold positions in a larger number of securities. As the number of different securities in the fund increases, the fund moves more in sync with the market (or market sector) as a whole, and therefore performs more like the index. The end result is that large actively managed portfolios can sometimes resemble index funds, even though they still charge active management fees. For this reason, index-based investing can sometimes serve as a more efficient strategy in the management of large portfolios. 2 As of February 28, CE Module Invesco Trimark

5 Last but certainly not least, index investing allows investors to have a life. On the surface, active investing may appear more appealing, and perhaps even more profitable, but it takes a lot of time and effort to construct an actively managed investment portfolio. Many investors possess neither the time, skill nor temperament to meet this challenge. Furthermore, active management requires ongoing portfolio maintenance in addition to portfolio construction. In other words, even after performing the proper research and due diligence to make investment decisions, investors have to monitor their holdings closely. How is company A measuring up against company B in terms of sales and earnings? Has their management team or product offering changed? These questions, and many more, must be considered on an ongoing basis for each position in an actively managed portfolio, and this can turn out to be a full-time job in itself. Index investors, on the other hand, often experience fewer demands on their time when it comes to investing, leaving more room for other aspects of life. What are the challenges of index-based investment management? While index investing has many benefits, there are also substantial drawbacks to this investment approach. In particular, settling for market performance is just not good enough for many investors. This may be especially true in bear markets, when index funds offer no protection from severe market downturns. To achieve the benefits associated with an indexbased investment management style, investors must give up the one thing only active management offers the potential for outperformance. This is a very sticky point for many investors who simply aren t satisfied with settling for market returns. And, in reality, investors will be settling for less than market returns. An index fund is not the market, and index-based investments are almost guaranteed to provide sub-index returns. Although typically much less significant than the overhead and cost associated with actively managed funds, any index-based investment is going to have at least some administrative cost, and therefore charge some level of fee to its investors. In addition, unlike the market itself, index funds have trading costs that will inevitably create a drag on performance. Furthermore, since managers of index-based funds have no mandate to deviate from the benchmark index s returns, the fund s performance typically follows the index in good times and bad. That is, an index fund s performance will inevitably be both up and down over the course of market cycles. Not so for actively managed funds, where managers can intervene if necessary. Active mutual fund managers can use their skill, foresight and common sense in an attempt to reduce the impact of severe market downturns on client portfolios. There is no such protection available for index fund investors. Also, note that although index investing greatly reduces an investor s risk of underperformance relative to the benchmark, the potential still remains for underperformance relative to the median active manager for any given asset class. Another complexity index investors face is that there are different methods of index construction. These different methods each have their own challenges and can mean significant variation in performance among index funds that are apparently following a single market segment. Market-cap indexes Let s consider traditional marketcapitalization index construction, where security weightings in the fund mimic the market capitalizations, or weightings, of the index. The problem with this method of construction is that overvalued securities dominate market-cap indexes, and undervalued securities are underrepresented. As any given stock becomes overpriced, its value grows correspondingly and it becomes a larger part of the index. Therefore, the index funds tracking that particular index must buy more and more of that stock. How many millions of dollars went into buying Nortel at $120 a share, simply from index fund investments? The converse is also true when a stock is falling in value, a fund tracking a market-cap index by definition has to sell it. This buy high, sell low result leads to trend-following, and is a significant drawback of market-cap index funds. Equal-weight indexes An early attempt to address the challenges of market-cap indexes was the construction of an equal-weight index as a benchmark for an equalweight index fund. This approach attempts to deal with the over-concentration of large-cap securities within an index. In an equal-weight index, all securities have an equal weighting, regardless of their actual market capitalization or representation on any given stock market exchange. Compared to a market-cap index, an equal-weight index method of construction produces a higher weighting of small-cap and mid-cap stocks and a lower weighting of large-cap stocks. Fundamental-weight indexes More recent developments in index construction centre on the concept of a fundamental-weight index. Like an equal-weight index, a fundamental-weight index is not based on market values and current stock market prices. Instead, this approach focuses on a company s fundamental values, such as sales, book value, revenue, dividend rates and earnings. Fundamental-weight indexes have the potential to avoid CE Module Invesco Trimark 5

6 What is an ETF? Exchange-traded funds (ETFs) are a common way to achieve index-based investing. An ETF is similar to a mutual fund in that it tracks an index or basket of assets. However, unlike a mutual fund, an ETF is an individual security that trades like a stock on an exchange. Also, mutual funds are bought and sold at their Net Asset Value (NAV), the price at the end of each trading day, whereas ETFs experience price changes throughout the day as they are bought and sold on the open market. Essentially, ETFs offer the advantages of traditional index funds with the trading flexibility of individual stocks. Because ETFs trade like stocks, investors typically have to pay a trade commission when they make a purchase or sale, just as they would with a regular stock order. Investors have embraced ETFs enthusiastically over the past decade, and they now appear in many investment portfolios. Some of the different types of ETFs include: Canadian equity ETF Canadian equity ETFs usually track a major Canadian equity market index, such as the S&P/TSX Composite Index International equity ETF Investors seeking equity exposure beyond Canada s borders may choose an international equity ETF tracking a foreign equity market index, such as the MSCI Germany Index Fixed-income ETF Fixed-income ETFs may focus on international, government or corporate bonds, or any other segment of the fixed-income market Foreign currency ETF Foreign currency ETFs give investors exposure to foreign currencies without the hassle of complex transactions on foreign exchanges; investors can track a single foreign currency or a basket of currencies within a single investment Sector ETF Sector ETFs generally track an index representing a certain industry, such as Canadian financials, giving investors access to that market sector Commodity ETF Commodity ETFs also target a specific area of the market, in this case, commodities such as gold or oil One other type of ETF is worth considering in more detail: an inverse ETF. When markets turn sour, savvy investors still look to turn a profit, but short-selling can be dangerous due to the unlimited potential for loss. Inverse ETFs, which move in the opposite direction to the underlying index or asset, are designed to allow the investor to take a short position while making a long purchase. the overweight/underweight distortions of marketcap indexes. But a potential downside of this indexing strategy is that the line between index-based management and active management can become blurred, and there is an additional cost compared to market-cap indexes to account for the time and effort required to research company fundamentals. Some investors refer to this type of strategy as intelligent indexing a new frontier that blends the benefits of index-based investing with professional asset allocation. Combining Active and Index-based Management A mix of active and index-based management styles within a single portfolio gives investors access to the advantages of both strategies, while mitigating the challenges associated with each one. The indexbased portion of the portfolio can help to maintain appropriate asset allocation at a minimal cost, while actively managed components provide investors with the potential to reduce volatility and outperform. What is the ideal mix? The precise answer will depend on each investor s unique personal situation, including goals, time horizon, preferences and risk tolerance. After deciding on the best active and index-based weightings for a specific investor, it s very important to choose managers wisely to achieve optimal long-term results from a blend of active and index-based investments. Several established active/index-based blending strategies are worth exploring. The first approach is to use index-based investment management for the domestic portion of the portfolio, and active management for international holdings. Historically, returns for domestic index-based mutual funds have been very competitive with their actively managed counterparts. This is possibly due to the degree of efficiency in the Canadian market. Market efficiency depends on the ability of investors to access and interpret information about securities, and Canadian equity markets are significantly more efficient (with information much more readily available) than, for example, emerging international markets. In general, greater market efficiency means less opportunity for active managers to outperform relative to the benchmark index. Another approach is to take index-based positions for the fixed-income and large-cap equity components of a portfolio, while employing active management for small-cap and mid-cap equities. Despite the 6 CE Module Invesco Trimark

7 consistent underperformance (relative to the benchmark) of many actively managed equity mutual funds, smallercap equity active managers have a solid track record of outperformance. One advantage they have is that they can ride a soaring stock out of the small-cap range of the index and realize its full price appreciation. Not so for a small-cap index fund, which must sell these securities as they rise out of the index s capitalization range. Also, a small-cap index fund will typically be forced to include all the securities that are falling from mid-cap or high-cap levels due to stock price declines. Put simply, an active manager of smaller-cap equities doesn t have to sell the winners and buy the losers. As a final example, index-based investing may make sense in areas of the market where relatively few securities dominate and, therefore, where active managers have little opportunity to add value. The Canadian real return bond market is a case in point. It has a market capitalization of $43 billion, and 85% of that amount is invested in just five real return bonds. In a sector like this, there is little an active manager can do to differentiate a fund and deliver superior performance. Meanwhile, index-based investing can offer exposure to this type of market at a significantly lower cost. Active/index-based combination strategies are quite common in large, institutional portfolios. The California Public Employees Retirement System (CalPERS) is one of the largest public pension funds in the United States, with assets totalling $200 billion as of January 31, The CalPERS investment team follows a strategic asset allocation policy that targets the percentage of funds to be invested in each asset class, in both U.S. and international markets. In their quest to efficiently and effectively manage pension assets, CalPERS targets a blend of 63% active and 37% passive investments. 4 3 Source: 4 As of February 28, The Bottom Line Active and index-based investment management are not mutually exclusive, and both styles may have a place in a well-diversified portfolio. In fact, using index-based invest-ments, such as index funds and ETFs, in conjunction with actively managed mutual funds as part of a core/satellite strategy is a great starting point for many investors. The key is to combine carefully selected active managers and index-based investments. Furthermore, deciding how much to allocate to each type of investment is a critical decision requiring detailed planning andproper execution. In the end, by striking a balance between enhanced performance and reduced cost, a blend of active and index-based investments allows investors to reap the benefits of both management styles. Disclaimer: The information provided is general in nature and may not be relied upon nor considered to be the rendering of tax, legal, accounting or professional advice. Readers should consult with their own accountants, lawyers and/or other professionals for advice on their specific circumstances before taking any action. The information contained herein is from sources believed to be reliable, but accuracy cannot be guaranteed. Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the simplified prospectus before investing. Copies are available from your advisor or from Invesco Trimark Ltd CE Module Invesco Trimark 7

8 Multiple Choice Questions 1. Which of the following costs is not included in the MER of an actively managed mutual fund? a. Manager s fee b. Marketing expenses c. Trading costs 2. Which feature is an advantage of index investing? a. Guaranteed outperformance b. Low fees c. Lack of taxation 3. A fundamental index construction approach does not focus on: a. Book value b. Stock price c. Annual revenue 4. Which investment vehicle offers investors the advantages of traditional index funds with the trading flexibility of individual stocks? a. ETF b. MER c. TER 5. Which of the following is a disadvantage of index funds? a. No protection against downturns in the market b. Low fee structure c. Manager error 6. Which feature is an advantage of active investment management? a. Guaranteed outperformance b. Extremely low fees c. Potential for reduced volatility 7. One of the primary disadvantages of actively managed funds is: a. Opportunity for underperformance b. Opportunity for outperformance c. Probate fees 8. Which of the following is often the most significant component of an actively managed mutual fund s MER? a. Fee paid to the fund s manager b. Trading costs c. Accounting and legal fees 9. Index funds typically produce performance figures in comparison to the market itself: a. Exactly the same b. Similar c. Much higher 10. Which is the following is not a characteristic of ETFs? a. Trades like a stock b. Qualities of a fund c. Designated beneficiary 11. Combining active and passive investments within a single portfolio allows investors to enjoy which benefits? a. Potential for enhanced performance and reduced cost b. Guaranteed outperformance relative to benchmark c. Elimination of risk 12. Active managers typically have more potential to outperform relative to the benchmark index in which asset class? a. Large-cap equity b. Fixed income c. Emerging markets 13. Investors and investment managers attempting to add value over market returns often rely on security selection and market timing strategies. This is an example of: a. Passive investment management b. A buy and hold strategy c. Active investment management 14. The practice of studying charts and indicators, such as moving averages, in an attempt to determine future stock price is an example of: a. Fundamental analysis b. Technical analysis c. Passive investing 15. A market-capitalization style of index construction bases inclusion in the index on which attribute? a. Stock price b. Dividend yield c. Earnings Contact Us Invesco Trimark 5140 Yonge Street, Suite 900 Toronto, Ontario M2N 6X7 Telephone: or Facsimile: or inquiries@invescotrimark.com * Invesco and all associated trademarks are trademarks of Invesco Holding Company Limited, used under licence. AIM and all associated trademarks are trademarks of Invesco Aim Management Group, Inc., used under licence. Trimark and all associated trademarks are trademarks of Invesco Trimark Ltd. 8 CE Module Invesco Trimark Invesco Trimark Ltd., 2010