Active Management: Drive Carefully
In my previous blog you saw that only one out of three actively managed balanced funds outperformed a low-cost ETF portfolio after fees. But does this mean that all the actively managed components of a balanced fund performed poorly? By examining the various asset classes and sectors you can see where you can keep driving ahead with active management, where you need to exercise extreme caution, and where you should slam on the brakes.
Once again, I am looking from the perspective of investments in a RRSP or RRIF. The results improve for taxable accounts if your investment management fees are tax deductible. I used the RBC Investor & Treasury Services Pooled Fund Survey as of March 2020 to be consistent with my previous blog on balanced funds. The survey covers the performance of actively managed funds for categories such as Canadian Equity, U.S. Equity, Non-North American (International) Equity, Emerging Market Equity, Canadian Bonds (Government and Corporate), and Canadian Corporate Bonds. I deducted a 1% fee from the fund returns, which is typical for high net worth investors.
Watch The Signal
The table below shows, for each category, the ETF used for comparison and the percentage of actively managed funds that outperformed the return of the ETF over the last five and ten years. The percentage of funds outperforming over three years was even worse than that for the five-year period.
Table 1
As you can see the historical performance of actively managed funds has been lousy after fees. I have been generous and highlighted in green when 50% or more of actively managed funds in a category have outperformed the ETF. While 75% of actively managed Emerging Market funds outperformed the ETF over the last 5 years, all the other numbers highlighted in green were in the 50% range. The amber highlights show when actively managed funds in the category outperformed only about 30% of the time. Red highlights reveal the abysmal areas where almost all the funds underperformed the ETF.
We can use the after fee return data from the categories in Table 1 to see how it impacts constructing an investment portfolio. I make the optimistic assumption that you have been able to choose an actively managed fund in the top 25% of returns (1st Quartile) in its category. Even the professionals have difficulty doing this!
Keep Driving Ahead
The only two categories in Table 1 that were highlighted in green over both five and ten years were International Equities and Emerging Market Equities. As Chart 1 shows, after fees over the last ten years the 1st Quartile of actively managed International Equity funds added 2.03% extra return per year versus the ETF, or 22% more in total. That’s a good boost to your portfolio! Emerging Market (EM) 1st quartile funds added 0.93% per year and 10% more in total.
Chart 1
Source: RBC Investor & Treasury Services, Wayfairer Capital Management
Exercise Extreme Caution
Now you need to drive very carefully. Actively managed Canadian Equity and Canadian Corporate Bond funds flashed amber in Table 1. Only about 30% outperformed after fees over the last five years. The ten-year results were better and were in the green zone. Chart 2 shows that over the last ten years 1st Quartile Canadian Equity funds added 1.06% extra return per year over the ETF, or 11% in total. Over the same period, Canadian Corporate Bond 1st Quartile funds did fairly well by adding 0.61% extra per year, or an extra 6% in total. The numbers tell us that these 1st Quartile actively managed funds added value, but generally not as much as the 1st Quartile International and Emerging Market Equity funds over the last five and ten years.
Chart 2
Source: RBC Investor & Treasury Services, Wayfairer Capital Management
Slam On The Brakes
Actively managed Canadian Bond funds and U.S. Equity funds, the remaining categories in Table 1, are firmly in the red. If I say that it is abysmal that only 13% of actively managed U.S. Equity funds have outperformed the ETF after fees over the last ten years, what do I say about only 3% of actively managed Canadian Bond funds outperforming? For bonds, what this really highlights is the impact of fees. With bond yields so low, deducting 1% in investment management fees almost guarantees underperforming the ETF which only charges 0.1%.
Chart 3 shows a sad situation. Even the best actively managed funds, those in the 1st Quartile, significantly underperformed after fees the relevant ETFs. Canadian Bond 1st Quartile funds underperformed by 0.43% a year over the last ten years or 4% in total. Actively managed U.S. Equity 1st Quartile funds were even worse over the last ten years, underperforming by 0.85% year or 9% in total.
Chart 3
Source: RBC Investor & Treasury Services, Wayfairer Capital Management
Planning The Trip
To have the best chance of reaching your financial destination you need to tilt the odds in your favour. It is human nature to think that we can do better than a simple, low cost ETF. Yet the data tells us otherwise: actively managed funds struggle to outperform ETFs after deducting typical fees for individual investors. Using the last 10 years as a guide, the first takeaway is that actively managed International Equity and Emerging Market Equity funds do best and should have a place in a portfolio. Second, actively managed Canadian Equity and Canadian Corporate Bond funds can add value over ETFs, but the risk of underperformance is meaningful. A split between actively managed funds and ETFs could be used, or just ETFs. Third, ETFs should be used instead of actively managed U.S. Equity or Canadian bond funds as even the 1st Quartile funds underperformed.