The fourth quarter will not be remembered fondly by many people in the stock market. But for active fund managers, at least the carnage spawned some small vindication.
The Standard & Poor's Indices Versus Active Funds Scorecard, which measures the performance of actively managed mutual funds relative to S&P's benchmark stock indexes, showed that in one of the worst quarters for stocks in the past 60 years, active managers of Canadian equity funds trumped the S&P/TSX composite index by almost any measure. (Actively managed funds are those where the managers buy and sell stocks based on their own investing wisdom, rather than following a passive strategy such as mimicking an existing stock index.)
More than 53 per cent of active managers beat the S&P/TSX composite on a total-return basis (i.e. including dividends) in the quarter. Based on average asset-weighted fund returns, actively managed funds lost 20.8 per cent in the quarter, while the index lost 22.7 per cent.
Keep in mind that the fund returns are calculated after deducting fund management fees and costs, which average more than 2.5 per cent on actively managed Canadian equity funds. On a straight-up basis, the average fund manager outpaced the index by more than four percentage points in the fourth quarter.
The numbers imply that in extremely trying times, active fund managers used their skills to shield their investors from the full brunt of the market meltdown. It's a sorely needed feather in the caps of active managers, who over the past few years have developed the kind of public scorn normally reserved for ambulance-chasing lawyers, door-to-door natural gas salespeople and (dare I say it) journalists.
Detractors routinely argue that most active managers don't earn the high fees they collect from investors, and the historical numbers bear that out. Over the past five years, annualized returns (after fees and costs) for actively managed Canadian equity funds are 2.4 per cent, compared with total returns of 4.2 per cent for the S&P/TSX composite. Only 11 per cent of actively managed funds have outperformed the index over the past five years.
Those are pretty damning numbers, given that the whole point of active management is to beat benchmark indexes. Still, active managers have argued that in raging bull markets - especially overblown ones such as the one that came crashing down last year - they tend to underperform indexes because they are unwilling to expose their investors to the excessive and unjustified risks built into many overpriced stocks and sectors. It's when the market turns sour that their analytical skills shine most and they save investors money, they argue.
Since S&P has only been producing the index-versus-active scorecard for five years, it's difficult to fully assess the accuracy of that assertion; the market had been on a bull run for most of that time. The older and more overheated that bull got, the fewer the active fund managers who beat the index on five-year returns (from more than 25 per cent in 2005 to just 11 per cent today).
But last summer, S&P produced a report examining active management's performance during the most recent bear market - 2000 to 2002 - and the results support active-management proponents. Asset-weighted average annualized losses for actively managed Canadian equity funds were 12 per cent, while the S&P/TSX composite lost 34 per cent on a total-return basis. Two-thirds of active managers beat the composite.
The data do suggest that in bear markets, active management bears fruit. If you think the market still has further to fall, active management looks attractive right now.
But over the long run, actively managed funds, in general, are hard to justify. As one index-fund proponent recently pointed out, any good index by its nature will reflect a market's average performance, and statistical reality dictates that the best the large pool of active managers as a group can expect to do is match the average, with roughly half outperforming it and half underperforming. But once you toss in management fees and costs taking a 2- to 3-per-cent bite out of those returns, you end up with the majority of active managers failing to beat the index, routinely.
Sure, there are astute active managers who are smart enough to beat the Street over the long term, and for those who can, they have earning the accolades, the big fees and the faith of investors. But the trick is identifying, over the long term, which managers and fund companies can deliver. Each year, investors give up a considerable chunk of return up front in hopes that their fund manager is smarter than the pack.
For the time being, it has been worth the price. But given the drubbing investors have suffered over the past few months, giving up any return feels like a daunting risk - especially if you need the long-term returns that active management simply hasn't delivered.
© 2007 The Globe and Mail. All rights reserved.
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