In the never-ending debate between the proponents of active vs passive investing, many active-management advocates have disputed the use of market indices as legitimate yardsticks for passive performance. They contend that because indices are not directly investible and don’t have portfolio-management and other costs associated with them, indices unfairly overstate the track record of actual passive investing.

There is a kernel of truth to this critique; however, the extremely low fees of many exchange-traded funds (ETFs), coupled with the index replication expertise of their portfolio managers, means market indices often represent reasonable proxies for passive performance. For example, from the Vanguard S&P 500 ETF’s launch on Sept. 7, 2010 to June 30, 2015, the ETF earned a return of 16.55% in the U.S. – only 0.03% less than the 16.58% of the S&P 500 composite index.

Fortunately, this point of contention now is obsolete. In the U.S., Chicago-based Morningstar Inc. has launched the active/passive barometer (APB) to compare the returns of active portfolio managers in a size and style category against a composite comprising relevant passive index funds. Real-world (net of costs) comparisons now will be the gold standard in the active/passive debate.

Morningstar’s first APB report will hearten advocates of passive investing. In general, actively managed funds have underperformed their passive index counterparts, particularly over longer time frames. Over the 10-year period ended Dec. 31, 2014, based on an overall average, almost two-thirds of active funds underperformed their corresponding passive index composite. In only one of 12 categories – mid-cap value funds – did the majority of active funds outperform their index fund composite, and that outperformance was slight.

There is, however, a ray of hope for active management aficionados. When the comparison is between the lowest-cost quartile of actively managed portfolios and the passive index composite in a category, the degree of active funds’ underperformance is materially reduced.

Over the same 10 years, on average, about 55% of low-cost active funds underperformed their comparative passive index composite – an improvement of 11 percentage points vs the total group.

In five of the 12 categories, the majority of low-cost, actively managed funds outperformed the passive index fund composite. This outperformance was particularly strong in value funds: 66.3% of large-cap value funds and 68.2% of mid-cap value funds beat their passive index composites.

There are a number of low-cost, actively managed equity mutual funds in the U.S. with annual management expense ratios from as low as 0.13% to about 0.50% that are available to retail investors. Canada clearly needs more actively managed funds with similarly low MERs. Regardless, the message: if you are going to stray from low-cost ETFs, stick with the lowest-cost active portfolio managers.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. Tacita, its principals, employees and clients may own the securities mentioned herein.

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