In the U.S., actively managed domestic equity mutual funds have suffered nine years of consecutive outflows as investors have poured money into index domestic equity mutual funds and ETFs. The contrast is glaring - from 2007-15, US$835 billion exited actively managed domestic equity mutual funds while $1.2 trillion flooded into index domestic equity mutual funds and ETFs.
Investors have glommed onto the fact that high management fees are a deadweight on portfolio performance. Faced with the choice of an actively managed equity fund with an average 0.84% management fee or an index fund with an average 0.11% management fee, investors are opting for the passively managed options.
Canadians are awakening to this reality. ETF assets under management (AUM) have exploded, growing by almost 25% in the first 11 months of 2016 and have now passed the $110 billion mark.
Are actively managed funds inexorably headed for the dustbin of history? No, but for active portfolio managers to compete head-on with index funds or ETFs, those portfolios' fees will have to be cut dramatically, probably by 50% or more. However, absent the high cost, there are studies that show skilful active managers can deliver excess returns.
A study recently published in the online Financial Analyst's Journal examined the performance of 143 global equity funds through 2002-12 and found that the average global equity portfolio manager outperformed the benchmark by 1.2% - 1.4% a year before fees. The study concluded: "...the findings support considering active management in global equity markets, at least for institutional accounts that pay annual fees of less than 1%."
An analysis, corrected for survivorship bias, by Russell Investments Canada Ltd. of 90 institutional Canadian large-cap portfolio managers found that 64% of active management outperformed the S&P/TSX composite index before fees for the five years ended September 2015. A more recent analysis, although not corrected for survivorship bias, found that in the 10 years ended June 2016, the median small-cap manager outperformed the S&P/TSX small-cap index by 1.15% per year before fees.
Active portfolio managers have to close their funds earlier and hold smaller amounts of AUM. A study of U.S. equity funds from 1984-06 found evidence of skilful portfolio managers who deliver superior returns relative to passive benchmarks before fees. Portfolio managers of small funds with AUM of US$5 million-US$250 million exhibited the highest skill levels: the top 30% of managers in this size category delivered monthly returns 0.08%-0.49% higher than their peers before fees. In contrast, only the top 10% of portfolio managers of funds with assets of more than $1 billion in this size category delivered monthly returns of 0.11%-0.21% higher than their peers before fees.
With less AUM, portfolios can be concentrated, focusing on industries in which the portfolio manager has specialized knowledge or investment process advantages.
Active portfolio management has a great future, but it is a much cheaper, leaner future than today's model.
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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