Say goodbye to closet indexers
by Rob Mikalachki, Chief Investment Officer, Trimark Investments, Invesco Canada
I’m writing here in response to questions I’ve received from advisors and to piggyback on comments I’ve made at our recent due diligence events. First, I’m going to dispense with the strict “active vs. passive” construct of the current debate. I’ll make my case for the value of true active management and introduce you to the elements of a portfolio that I believe make it truly active. I’m going to cover a lot of ground here, but I’ll do my best to keep it concise.
Goodbye “active vs. passive”
The debate as it has been argued to date is oversimplified. In my opinion, it’s framed in a way that doesn’t take into account all of the various products available to investors. It’s more than simply active or passive, so let’s look at it in a different way.
Based on data from FactSet Research Systems Inc., as at June 30, 2017.
On the far left of the chart above are vanilla index funds that track broad indices and are generally lower cost. By investing in a market-cap weighted ETF, the one thing you are guaranteed is that it will underperform the index. The fee may be small, but it is a fee nonetheless and it’s taken off the top of any returns gained by whichever index the ETF tracks. There is absolutely a place for these in a well-diversified investor portfolio, but it’s certainly not the place that aims to bring long-term outperformance. There is also a small, but growing portion of assets invested in smart beta strategies, which I believe can also play a targeted role in a portfolio.
The middle is where things are often misrepresented. Fifty percent of invested dollars today are in what I would call closet index funds. These are the funds that focus on where holdings are, plus or minus, versus their benchmark index. Managers of these funds typically don’t want to make big decisions, or veer far from the index, but charge fees as if they do. These funds are dinosaurs, and in my opinion, they don’t fit into today’s competitive marketplace. My view is that closet index funds that charge as if they are actively managed can’t and won’t last. Period.
Finally, on the far right side are high-conviction, active portfolio managers, like us here at Invesco, who aim for significant outperformance versus our benchmarks over the long term.
The rhetoric we’ve heard for years is that active can’t beat passive – that it never has, never will. History tells us a very different story. History tells us that outperformance from active managers has been cyclical. The data points to specific time periods when active significantly outperformed, and others when it underperformed.
Sources: eVestment and Goldman Sachs Global Investment Research 2017. The chart provides median excess returns vs. the benchmark; it includes actively managed large-cap, long-only U.S. mutual funds. Past performance is not indicative of future results.
When have actively managed funds outperformed? When the markets sell off in times of crisis. The tech bubble correction, for example, can be seen in the chart above between 2000 and 2002. Active management can be a safety blanket. In times that are toughest for investors, history shows that active management can help you by outperforming an index.