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Passive or aggressive? Getting the best of both

Indexers and active managers each claim to be the one true path, ROB CARRICK writes. Maybe it's time to call a truce

A question to the two sides in the investing world's never-ending war over index investing: Can't we all just get along?

Surely there must be some common ground between indexers, who believe the best investing approach is to buy funds that let you make the same returns as major benchmark stock indexes, and adherents of active management, who believe you're better off in the hands of a professional fund manager who chooses individual stocks and bonds.

Each side claims to be the one true path to an ideal investment portfolio, which means they're perpetually trying to discredit the other. On and on, they fight in a war of statistics that can never be won definitively.

So maybe it's truce time. Indexers and active management types, let's join forces and see what develops.

If you think about it, indexing and active management can be mutually reinforcing, not mutually exclusive. Indexing means you'll make the return of any number of major stock indexes through ownership of an index mutual fund or exchange-traded fund, which trades like a stock. Active management is the technical term for what mutual fund managers do in selecting their own stock holdings, rather than passively mirroring an index.

Believers in active management argue that a smart manager can deke around stock market upsets, thereby smoothing out the volatility you'd get in an index fund and delivering higher overall returns. But even if we assume that lots of fund managers can do this, there's still a problem. When a major stock index really takes off, many fund managers can't keep up.

Combining indexing and active management can give you the best of both strategies. When the stock markets are flying, your index funds will allow you to fully participate, and when the indexes are flat or falling your actively managed funds will have the opportunity to deliver.

The largest Canadian equity fund by far is Mackenzie Ivy Canadian, with about $5.3-billion in assets. This is a conservative fund that offers excellent medium-term numbers, uneven recent returns and a compelling argument for partnering active and passive management. Let's put Ivy Canadian together with an ETF that tracks the S&P/TSX composite index, the TD S&P/TSX Composite Index Fund.

Over the five years to April 30, Ivy Canadian was the place to be as it made a compound average annual return of 6.2 per cent. The TD exchange-traded fund hasn't been around for five years, but we can easily estimate its return by taking the gain of the underlying index and subtracting 0.3 of a percentage point to cover management fees and any errors by the ETF's managers in tracking the index. By this reckoning, the TD fund would have made just 1.4 per cent annually.

More recently, the TD fund has delivered one- and three-year returns of 15.3 per cent and 8.6 per cent, respectively, much better than Ivy Canadian's one-year gain of 10.6 per cent and its three-year return of 3.6 per cent.

Fans of active management might interject at this point and say the best approach would have been to hold Ivy Canadian for the past five years and not bother with an ETF. That's a reasonable argument from a numbers-only point of view, but introduce human emotion into the equation and all of a sudden ETFs look a lot more interesting.

Ivy Canadian's glory years in the past half decade came during the bear market, when it stood tall while the S&P/TSX composite was dragged down in large part by its huge exposure to Nortel Networks and other technology stocks. Then, when the markets rebounded in 2003, the TD ETF came into its own and bested Ivy Canadian.

Another way to look at the debate over active versus passive investing -- or Ivy Canadian versus TD S&P/TSX Composite Index Fund -- is to look at the 10-year numbers. Ivy Canadian made a compound average annual 9.6 per cent, while the TD ETF made an estimated 9.7 per cent. Pretty much dead even.

What this tells us is that being in either Ivy Canadian or the TD ETF over the past 10 years would have left you with almost identical returns, but with much different ups and downs that would have combined to keep you on a more even keel than if you owned just one of the two. Psychologically, the benefit would be a more relaxing ownership experience, which might lessen the temptation to make precipitous changes in your mix of investments in reaction to slumps in one security.

Partnering funds and ETFs can work in the U.S. equity category as well, although the S&P 500 index has proven a high hurdle for many active fund managers.

Mixing investments in the global category is tougher because there is no ETF that offers the mix of U.S. and offshore stocks that global equity funds typically contain. An alternative would be to match international equity funds (they invest everywhere but North America) and an ETF tracking the Morgan Stanley Europe, Australasia and Far East Index. You can also match mutual funds and ETFs covering Europe, the Far East and other regions and sectors.

Here are some factors to consider when looking for active funds that might partner well with ETFs (all the data you need can be found on Globefund.com's fund profiles).

Beta: This refers to a fund's tendency to track its benchmark stock index, which always has a beta of one. A fund with a higher beta is more volatile than the index, while a lower beta indicates less volatility. When partnering with the index, you should look for lower-beta funds (see chart).

Down-market performance: An index fund will generally fall as much as its underlying stock index, plus a small bit extra because of management fees. Ideally, then, your mutual funds should exhibit more stability at times when the indexes are falling. Some good reference years are 1998, 2001 and 2002, all of which were negative for the benchmark Canadian index.

Up-market performance: A fund that is a good complement to an ETF will probably not do as well in hard-driving bull market.

Holdings: Some mutual funds are "closet index funds," which means they hold basically the same stocks as the index. Don't partner index funds with funds like these. If you have a mutual fund of big blue chips, consider pairing it with the iUnits S&P/TSX MidCap Index Fund, or iMidCap, which holds medium-sized stocks. If you have a mutual fund holding lots of medium- or smaller-sized companies, think about the iUnits S&P/TSX 60 Index Fund, or i60, which is strictly big blue chips. The TD S&P/TSX Composite Index Fund is a good all-purpose ETF because it represents a range of companies and sectors.

The safest bet in investing is that indexers and active management types will continue to fight their data war, each trying to show the other is demonstrably inferior. You can either choose sides, or get them both working for you.

Reconciling investing's odd couple

Made for each other

Combining index funds and traditional mutual funds can smooth out the ups and downs in your portfolio over the years. Here are some examples of how this can work using a Canadian equity fund, Mackenzie Ivy Canadian, and an exchange-traded fund, the TD S&P/TSX Composite Index Fund.

Example 1

Notice how the two funds excel over different time frames, even while offering similar long-term gains. All periods are as of April 30.

1-year gain3-year gain5-year gain10-year gain
$10,000 invested in Mackenzie Ivy Canadian$11,060$11,119$13,509$25,010
$10,000 invested in TD S&P/TSX Composite Index Fund*$11,530$12,808$10,720$25,239

Example 2

Notice how Ivy Canadian has made money in some years when the index has fallen, but also lagged when the index soared.

200420032002200120001999199819971996
Mackenzie Ivy Canadian8.88.7-4.72.520.43.15.717.625.2
TD S&P/TSX Composite Index Fund*14.126.1-12.7-12.97.131.4-1.914.728.0

*The ETF began trading in 2001; returns for prior years was estimated by reducing index returns by 0.30 of a percentage point to account for fees and errors in tracking the index.

Going their own way

Here's a list of Canadian equity funds that have shown substantially less volatility than the S&P/TSX composite index. The measure used here is called beta and it compares the swings in a fund to a benchmark stock index, which always has a beta of one. A lower beta means a more stable fund and a better partner for an index fund.

FundBeta1-year return5-year return10-year return
AIC Diversified Canada 0.724.60%3.50%13.5%
AIC Canadian Focused 0.7216.6N.A.N.A.
CI Canadian Investment 0.7017.611.913.3
CI Harbour 0.5917.39.8N.A.
Mackenzie Cundill Canadian Security C 0.519.210.6N.A.
Mackenzie Ivy Canadian 0.5010.66.29.6
TD Canadian Blue Chip 0.6516.59.010.8
Trimark Select Canadian Growth0.7210.68.68.9

SOURCE: GLOBEFUND.COM

© 2007 The Globe and Mail. All rights reserved.

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