Active vs Passive Investing

July 29, 2015

As the debate rages on around the water cooler and in the media about management fees, the most important question is not being asked. The focus has become all about how much you are paying versus how much you are making. You do not retire early by paying less; you retire early by making more. Do not get me wrong, I understand why fees should be looked at but it should be the second question asked; not the first. Keeping in mind that performance numbers are reported after fees, the question should be would you rather earn 5% or 7%; not did you pay 0.2% or 1.5% in management fees. If you are making more money after fees, you should be happy. And if you are not making more money after fees, then you have choices. When you are planning for your retirement, what is your investment objective? Is it making 6% per year or is it paying 0.2% per year in fees?

An Exchange Traded Fund (ETF) is essentially a mutual fund that trades on a stock exchange and most ETFs are designed to track an index, such as the S&P/TSX. The returns on most ETFs are correlated to the index tracked and the constituents of that index are generally based on the size of the company. For example, Royal Bank is the largest company in Canada in terms of market capitalization and therefore is the S&P/TSX’s largest holding. Its index weight has almost nothing to do with any analysis of Royal Bank or its future growth prospects. It is the biggest weight in the ETF because it is already big. If Royal Bank goes up 50%, it will just have a bigger weight. There is no judgement applied as to whether it is still a good investment despite a significantly higher valuation. It is the biggest company in Canada therefore it is the biggest company in the fund; no analysis. We believe that this is one of the drawbacks of index ETFs. We need only look back to mid-2000 when Nortel Networks was the biggest company in Canada and comprised almost 35% of the index weight, despite its lofty valuation (we know how that turned out). One last thing to point out is that, generally, a true index fund (one not employing other investment strategies) will always underperform its underlying index by the amount of the management fees charged by the fund manager, even if fees are small.


"The process of determining the current worth of a company. There are many techniques that can be used to determine value, some are subjective and others are objective. For example, an analyst valuing a company may look at the company’s management, the composition of its capital structure, prospect of future earnings, and market value of assets. "

*source: Investopedia

There is virtually no chance that an ETF will outperform its index on the basis of security selection - simply because an ETF is designed to mirror the index.

A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. A passive mutual fund mirrors an index, whereas an active mutual fund deviates from an index through careful security analysis in an attempt to add value. Both passive and active mutual funds tend to have higher fees than ETFs. Much like an ETF, a passive mutual fund will almost certainly underperform the index it is tracking by the amount of the manager’s fee; an active mutual fund is managed by a team of investment professionals who analyze stocks to determine whether they are a good investment for the fund. In other words, an active fund manager applies judgement in an attempt to add value over and above a passive manager. There are many different styles of active management but they are typically broken down as one of growth, value, or momentum. An active manager has the potential to outperform the index but, of course, that also means the potential to underperform the index. You cannot have one without the other, which is why looking for the right manager is important. If you find the right active manager that consistently outperforms after fees, then they are worth paying a little extra for.

With all that in mind, now comes the million dollar question: "Can a mutual fund, in most years, consistently outperform its index and therefore add value to my overall portfolio?" If yes, then buy an active mutual fund. If no, then buy an ETF. I believe that the better answer lies somewhere in between. It depends on the country, the year, the asset class, and the fund. Probably the best solution is to own a combination of both actively managed funds and ETFs. Own a low fee ETF to get slightly less than index performance and own an actively managed fund to add some value over and above the index. It takes a lot of work to find and monitor strong actively managed funds and then put them together with the rest of your portfolio. This is why a strong and trustworthy advisor is needed to look after your investments.

The next question should be: "For the active part of my portfolio, how do I know if the fund I own is being actively managed or whether it is a closet indexer?" One of the ways to determine this is to look at a statistic called active share, which was first popularized by Martijn Cremers and Antti Petajisto. (2006, "How active is your fund manager? A new measure that predicts performance", Yale School of Management working paper).

Active Share is a measure of the percentage of stock holdings in a manager’s portfolio that differ from the benchmark index. It is useful in identifying "closet indexers", or managers who claim to be active but whose portfolios are very similar to the benchmark portfolio. Identifying "closet indexers" is extremely important because active management fees can be significantly higher than passive management fees, and so an investor would be better off, for that portion of their portfolio, owning a low fee ETF.

Active Share is calculated by taking the sum of the absolute value of the differences of the fund weight of each holding versus the index weight of each holding and dividing by two. See the below example of a four stock index, five stock fund.

Stock Index Weight Fund Weight Active Share
A 30% 10% 10%
B 30% 0% 15%
C 30% 20% 5%
D 10% 30% 10%
E 0% 40% 20%
F 0% 20% 10%
Total 100% 100% 70%

With 70% active share, and just from eyeballing the holdings, it should be clear that the above hypothetical fund is significantly different from the index. If the above fund or its management team has a proven, long term track record, it should be considered for inclusion in your portfolio as a good complement to an index fund or ETF. Not only does it provide diversification, it provides the opportunity for performance over and above the index. Of course, one needs to remember that even a good active manager does not outperform its index every year, and so one must be willing to accept the risk of underperformance. However, outperforming in a majority of years can add a lot of value to your overall portfolio.

There are some important things to know when looking for active share:

  • Active share > 60% in large cap Canada is very good
  • Index funds have an active share of approximately 0%
  • Closet index funds have an active share < 50%
  • It is easier to generate active share in funds with less total assets as the big funds are essentially limited to buying the big companies due to liquidity constraints
    - The ten largest Canadian Equity Funds average an active share of only 44.6%*
  • Having high active share does not mean that you will necessarily beat the index but owning a passive fund or a closet index fund generally means that you will underperform by the amount of the manager’s fees
  • Certain asset classes such as small cap and countries such as Canada are more conducive to generating high active share in a fund

While past performance does not guarantee future performance, finding a team with a strong track record of success is certainly not a bad place to start when trying to improve your overall portfolio performance. Unfortunately, like other industries, the finance business has become more and more about speculation and fast money rather than old school patient, long-term investing. Chasing one year returns has become commonplace as has selling poor one year returns. Throwing out the concept of active investing due to one year of strong index returns (and thus strong ETF returns) is a mistake as is embracing it fully due to one year of outperformance. Active investing can and has provided significant value (after fees) in the past and I expect it will in the future. There is an opportunity for both ETFs and active managers to co-exist and they should be looked at as complements rather than rivals.

In conclusion, I would like to circle back to one question, "What is the main objective of investing?" The answer should be to make money first with the minimization of fees as a secondary issue. A combination of passive investing through ETFs and active investing through a trusted and proven asset manager can better help you reach that investment objective without paying too much.

*source: Morningstar (as at May 31, 2015)

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Keith LesliePortfolio Manager

Keith Leslie is a Portfolio Manager at NCM Investments. Keith leads two of the firm’s alternative investment strategies, with a focus on Canadian equities. He has over 17 years of investment management experience and is an award-winning Portfolio Manager. Prior…

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