Are actively managed mutual funds better in a bear market than ETFs and index funds?

CanadianCapitalist said:

I disagree with the notion that active management adds value in so-called "less efficient" markets. A passive investment strategy is not dependent on whether (or to what degree) markets are efficient. Instead, it is based on arithmetic: investors, on average, earn market returns less expenses. Therefore, passive investing is a winning strategy even in less efficient markets.

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I agree and disagree. It comes down to the exact wording used. Can active management add value? Yes. Can you figure out which active manager adds value in advance? Not in efficient markets. In less efficient markets it would become easier to identify a skilled investor in advance, but the market would have to be very inefficient. Notwithstanding, on a dollar weighted basis, no matter how efficient the market is, and no matter if we are talking about bull markets or bear markets, holding a lower cost portfolio replicating the index will mathematically always be superior than the actively managed dollar in aggregate.

Yes, I already know a follow up question would be: at what point does a market become sufficiently inefficient? I don't know. It's a moving goal-post in an equilibrium-accounting view of the capital markets. Most likely, that point will only be identified post-hoc. Which lends further ammunition for going with the passive strategy.

The real confounding factor with respect to the adoption of this investment zeitgeist is psychology. Too many people miss-attribute past successes to skill versus luck. There is also the marketing and sales aspect. A lot of people make a lot of money trying to convince you that they have superior insight. There is not a lot of money (comparatively) being earned by those who are trying to convince you of the facts.

FYI my portfolio is roughly 80% indexed, and 20% is actively managed (by myself and or others on occasion). The indexed portion uses index mutual funds (trailers rebated, and I use my firm's index funds to support the company), and the active portion has an unlimited scope in what products I can use (leveraged ETFs, managed funds, individual securities, options, futures, etc.) The active portion is viewed as a gambling account.

I use passive investing products (index funds/ETFs) when I want to gain exposure to a broad sector that has either too many quality companies or an industry I don't understand.

For BRIC exposure I use an ETF (ADRE), European exposure (VGK) and US Technology (XLK).

Otherwise I invest directly into equities I want to own over the long-term. My concern is not the best return possible vs. active management, simply I would rather save the cost, own quality companies directly and benefit from sound investing practices.

A MF manager has two knocks against them:
1. Fees contribute to drag down returns
2. Forced selling that is required to meet redemptions

Take MF Manager John A. Smith (ficticious). He runs a mutual fund that focused on deep value stocks. He invests for the long-term, charges a 2% MER and focuses on companies that are considerably undervalued.

Now if John kept his own money invested actively in this practice on his own for a long period of time (say 10+ years) he could generate a CAGR of 20%. The problem being that he experiences two market declines during that 10 year holding period where fees (2%) erode his performance and redemptions force him to sell not because he was wrong, but because investors in the fund want their money back. He has to now sell at a more depressed price than he bought and performance of the fund falls accordingly.

An article at IndexUniverse.com covers a recent study by Fama and French who investigated value added by MF managers. The article states the following:


The article covers a similar study by Barras, Scaillet, and Wermers who presented the following numbers:

The article can be found at here.

Paasive, yes. But index?

An index (or index fund) is just one possible portfolio of infinite portfolios.

While I agree with passive investing and low costs, I don't necessarily agree that an index fund is an appropriate portfolio. With a cap-weighted portfolio in a smaller market like Canada's, you end up with the Nortel effect.

I remember when active managers were complaining that they wanted the 10% cap lifted on Nortel when the dot.com bubble was inflating. Limiting single stock exposure to 10% meant that they had to keep selling Nortel as the price skyrocketed; and were under-performing both the index and index funds.

When the bubble burst, and active managers outperformed the index, this was trumpeted as a triumph of their brilliance and the value of active management - instead of a flaw in the index.

Cap weighted indices address part of the issue; but there are also tracking error and reconstitution costs....

Arcaneind said:

Sorry but I'm speaking from inexperience and ignorance. I feel that I'm playing catch-up.

If I'm readying this thread right, the gist is that Mutual Fund managers in *most* cases are not providing returns to justify their commissions (which I feel is probably true given how some of our funds are doing).

With the change in Ontario to the HST and it's effect on increasing the cost Mutual Fund MER's, are you advocating ETF's instead? Or will the HST push the trading commissions up as well?

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Just to clarify terms, commissions are what is paid to the distributors of mutual funds; and may be paid in one or more of four ways:

1. Front end loads may be charged, as a percentage of the amount invested. This is taken right off the top.

2. Back end loads may be charged based on a declining percentage basis, depending on the amount of time the fund is held.

3. Trailer fees (commissions) may be paid to the distributor on an ongoing basis, from the management fees.

4. Trading commissions (or switch fees) may be charged and paid on transactions.

Management fees and expenses, expressed as MER, are charged on an ongoing basis for running the fund. They may pay for the trailing commissions mentioned above, as well as the management of the fund, trading and general operating expenses.

Actively managed funds usually have management fees from 1-2% higher than passively managed funds.

The question is whether the higher management fee paid for active management pays off in either higher returns or lower risk than passive funds, in excess of the fee charged. The consensus is no.

A different question is whether paying commissions is worthwhile. This is an open question depending on the amount charged versus the services provided and the value thereof.