The double-digit growth of index-based exchange-traded fund (ETF) assets under management (AUM) globally has outpaced that of actively managed portfolios. In 2014, Canadian ETF AUM increased by 21%, a growth rate that is almost 50% higher than that of traditional mutual fund AUM. Clients and their financial advisors clearly are attracted to the lower cost and transparency of ETFs.
However, don’t count out all active portfolio managers yet. A report by Vanguard Group Inc.’s research unit highlights three key criteria critical in pursuing a top active portfolio manager. Vanguard, although best known as a leader in index-based funds and ETFs, has been offering actively managed funds in the U.S. since 1975 and is the third-largest active equity mutual fund manager in the world.
Over the 30 years from 1985 to 2014, an equally weighted average of Vanguard’s actively managed equity funds, net of their management expense ratios (MERs), outperformed their benchmarks by 0.33% a year. An asset-weighted average did even better, outperforming by 0.45% a year. Outperformance also was consistently achieved over the past 10- and 20-year periods. In glaring contrast, the average actively managed equity fund in the U.S. over longer periods has underperformed its benchmark by approximately the percentage of its MER.
The first ingredient in pursuing outperformance is a low MER. As of Dec. 31, 2014, Vanguard’s average actively managed equity fund had an MER of 0.37%. This is almost 57% less expensive than the 0.86% MER of the average actively managed equity fund in the U.S. A low MER reduces the cost hurdle that an active portfolio manager has to exceed in order to deliver a superior return.
The second ingredient is talented portfolio managers with long-term interests aligned with the investors.
Vanguard is independent and can use either in-house or external portfolio-management teams. Vanguard’s selection of managers is not limited to quantitative measures, as past performance alone rarely is a predictor of future returns. Vanguard uses qualitative measures, including: a portfolio-management firm’s culture; the stability, expertise and passion of investment personnel; the firm’s philosophy; and the competitive advantages inherent in the firm’s investment process.
Vanguard’s ability to offer an external manager scale and the potential of a long-term relationship drives down cost. Combined with a compensation model that offers an incentive fee for outperforming a benchmark, there is an alignment of interests with the portfolio manager in the pursuit of excess returns over the long run.
The third ingredient is patience. Vanguard is aware that talented portfolio managers will underperform their benchmarks at times, sometimes for prolonged periods.
Of the actively managed equity funds in the U.S. that outperformed their prospectus benchmarks over the 15-year period from 2000 to 2014, 98% underperformed in at least four years while almost 66% underperformed in three or more years in a row. Vanguard’s focus on long-term results means the firm remains patient when its funds lag.
These criteria provide a checklist for pursuing outperformance by active management. Fortunately, there are a handful of Canadian firms that share these attributes.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.
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