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Active or passive? iShares says, why not both?

Rob Carrick's ideas for managing your investments

Wait until index investing purists get a load of this.

The company that pretty well owns the indexing franchise in Canada is reaching out to people who think it's possible to beat the index by judiciously choosing individual stocks or mutual funds. Can passive investing based on relying solely on an index really work hand-in-hand with active management?

The answer is a resounding yes at Barclays Global Investors, the company behind the iShares series of exchange-traded funds. "The active versus passive debate is over - these approaches are not mutually exclusive," says its marketing material.

Barclays makes a reasonably convincing case that combining active and passive strategies can be better than a 100-per-cent indexing approach, although purists won't buy it for a second. But to really understand this initiative, you have to look at what's going on in the today's ETF market.

Competition is intense and the number of products listed on North American exchanges has more than doubled in the past couple of years to about 600. Barclays is a dominant player in this market, and it wants to stay that way. To do so, it's trying to appeal not only to indexing enthusiasts, but also to those who have shied away. The concept of mixing active and passive is a way of soft-selling ETFs to these people.

"The key is that both an active manager and index manager bring complementary skills to the table," said Heather Pelant, head of business development for iShares. "Each is powerful unto themselves, but if you put them together they're even more powerful."

Some advisers have already bought into this approach. "We do it here," said Jim Steel, executive vice-president at Watson Di Primio Steel Investment Management in Ottawa. "My two partners are active managers and, while I don't want to pigeon-hole myself as a passive guy, that's one of my strengths."

Mr. Steel's client portfolios may contain mixes of ETFs, individually selected stocks and quasi-index funds sold by a company called Dimensional Fund Advisors. The rationale behind this approach is that it allows him to build a diversified, low-cost portfolio with a tilt toward value investing, which means emphasizing quality companies that are currently out of favour.

Low fees are the main benefit of indexing, especially where ETFs are concerned. More often than not, actively managed mutual funds will underperform the major indexes because of the impact of their fees. While Canada's largest ETF, the iShares Cdn LargeCap 60 Index fund, has a management expense ratio of 0.17 per cent, the 10 largest Canadian equity mutual funds average 2.25 per cent.

As espoused by Barclays, the argument for combining indexing with active management is not built on market-beating returns so much as it is on creating the sort of portfolios that investors can comfortably hold through all market conditions. Imagine owning a Canadian equity fund with a long-term record of beating the index but poor short-term results. "If your active manager is underperforming, you may stomach it better because you have the index in your portfolio," Ms. Pelant said. "You're more likely to hang on to that manager."

In doing so, you would avoid a trap that many investors fall into where they sell quality funds simply because they're in a slump. Typically, these people buy into a hot fund of the moment, only to watch it revert to its usual, less stellar pattern of performance.

The very idea of believing you can choose a manager who will outperform is laughable to committed indexers. They'll trot out figures like the one from a recent Standard & Poor's report showing that over the five-year period ended March 31, just 10.2 per cent of actively managed Canadian equity funds outperformed the S&P/TSX composite index. And yet, there are fund managers who have quietly managed to beat the index over long periods. We'll look at them in a future Portfolio Strategy column (and today's Number Cruncher), but for now you might try researching names like Saxon Stock, Mawer Canadian Equity, Leith Wheeler Canadian Equity and Fidelity True North.

Ms. Pelant suggests three approaches to combining active and passive strategies in a portfolio.

Core and satellite

This is where you use ETFs to flesh out a portfolio, and then add specific stocks or mutual funds as a complement.

50-50

Split all the asset categories in your portfolio into two even halves and invest one in ETFs and the other in funds and stocks.

Using active funds where indexing is less effective

Some experts believe that skillful managers have an easier time beating the index in certain sectors, notably emerging markets and small-capitalization stocks. On the other hand, the Standard & Poor's numbers suggest that indexing is a better bet than an active fund when it comes to investing in large-cap Canadian stocks.

One objective in mixing active and passive investments is to add what investing pros call alpha, which refers to returns above and beyond what the index delivers.

A more practical objective is to use active funds to reduce a portfolio's beta, which is a risk measure that benchmarks volatility against relevant indexes. A security or fund with a beta of 1 is as volatile as the index, while higher and lower betas suggest greater or lesser levels of volatility.

The appeal of this method is especially relevant today, with the S&P/TSX composite index up around 113 per cent in the past five years. The composite stumbled last month and could plunge again at some point. An ETF tracking the index would go along for the ride, whereas a conservative equity fund might hold up better.

Ms. Pelant said the last thing you want in an actively managed investment is a closet index fund that more or less mimics the index's ups and downs. "If you're going to hire an active manager, you have to be prepared to let them make bets, let them take positions away from the benchmark," she said. "That's the only way they're going to add any outperformance."

Mixing active and passive investing makes the most sense when it's used in a defensive way to protect against the worst effects of a falling index. But the investment industry much prefers to play offence, which is why there will probably be a greater tendency to use stocks and funds to torque a portfolio of ETFs.

Indexing purists will laugh at all of this, and they have a point. The beauty of indexing is that it doesn't need a lot of fiddling around to be effective.

Active, meet passive

Barclays Global Investors, the company behind the popular iShares series of exchange-traded funds, is promoting the idea of combining passive index investments like the ETF with actively chosen mutual funds and stocks. Some investment advisers are already using this strategy, including Brent Woyat and Kent Parker of Parker + Woyat Asset Management, which is affiliated with Raymond James in Vancouver. Here's the sort of portfolio blueprint they use.

Equities-60%

Canada

-10% iShares CDN Dividend Index Fund (XDV-TSX)

-10% in individual stocks such as Linamar Inc. (LNR-TSX), Saputo (SAP-TSX), Finning International (FTT-TSX), Shoppers Drug Mart (SC-TSX), WestJet Airlines (WJA-TSX)

U.S.

-10% iShares Dow Jones Select Dividend Index Fund (DVY-Amex)

-10% in individual stocks such as Chevron (CVX-NYSE), Verizon (VZ-NYSE), and Entergy (ETR-NYSE)

International

-10% iShares CDN MSCI EAFE Index Fund (XIN-TSX)

-10% in individual stocks trading as American Depositary Receipts such as Suez (SZE-NYSE) and ENI (E-NYSE)

Fixed Income-40%

10% iShares CDN Bond Index Fund (XBB-TSX)

5% in individual short-term Government of Canada bonds

5% in Aberdeen Asia-Pacific Income Investment Inc. (FAP-TSX)

5% in Flaherty & Crumrine Investment Grade Preferred Fund (FAC.UN-TSX)

5% in BG Top 100 Equal Weighted Income Fund (BTH.UN)

SOURCE: PARKER + WOYAT ASSET MANAGEMENT

© 2007 The Globe and Mail. All rights reserved.

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