In last week’s column, we distinguished passive management from active management. While it is clear to me that these two strategies can complement each other, some doubt hangs over the question of fees surrounding active management. Remember that, unlike passive management, this one has an additional cost that justifies the work required to outperform the market as a whole.
Proponents of active management are convinced of the relevance of paying for this alpha, while defenders of passive management believe that its very low management fees, which are used to copy the indices, are more than enough. Furthermore, the S&P Indices Versus Active Funds (SPIVA) is an annual report detailing the performance of these actively managed funds. We learn that in 2022, more than half of active fund managers have not achieved the objective of beating their index.
So why does active management still have a place, you ask? This is because thinking about the composition of a portfolio should not be limited to thinking about the costs associated with it and its ability to beat the indices. It is indeed necessary to take an interest in the composition of these famous indices in a broader macroeconomic context. Before limiting ourselves to replicating an index, we must first ask ourselves whether this index represents an efficient or irrational market.
Naturally, the example of the technology bubble at the beginning of the century immediately comes to mind, with the overweighting of companies like Nortel on the TSX. But we should not underestimate the risks associated with the complexity of the current markets and the ongoing correction of many securities which, however, still seemed safe bets a few years ago.
By copying the indices, funds in passive management of course copy the rises, but also the falls. Thus, you will have more of a leaning profile for passive management if you have a good tolerance for volatility and are able to tolerate these declines passively. The use of active management makes it possible to select certain managers whose mandate is to capture market declines as little as possible.
If, in the last ten years, a good asset allocation was sufficient to ensure a good return, in times of turbulence and uncertainty, the selection of securities, specific to active management, will take on more importance in the economic environment. of the market. A manager may not have outperformed the index in 2022 for decisions he made to adapt the composition of his mandate to the new economic and financial context that will take hold for the next few years. We could therefore congratulate him… later.
Indeed, an actively managed fund often struggles to keep up with the performance of indices when growth is dazzling, but it can also show more resilience in a downturn, precisely because these funds are positioned more conservatively. in turbulent markets.
What is the actual price difference?
Actively managed funds command higher management fees than passive funds because managers must undertake stock research and pay trading costs. Their analysis aims to determine the correct market value of the securities in order to provide downside protection and thus reduce risk. Management fees are used to pay for this team and its administrative structure.
Of course, some do not live up to expectations, so choose the best performers. When fund returns are published, they already take management fees into account, which average close to 2%. Note that the more complex the mandate, the higher the costs. For example, an international equity fund costs more than a Canadian fixed income fund. While it is true that in theory you would have more returns in your pockets without these management fees, we could also say that we would all be richer if all the companies that sell goods and services to us kept less profit …
It is not the management fees that should attract your attention, but the net return after fees. This is what confirms whether you are “getting what you pay for”. Fund Facts can be used to validate the returns you would have obtained for a given period. Thus, the comparison between active and passive management should not be limited to the comparison of management fees, but should extend to historical returns after deductions of these.
For example, in 2022, a well-managed active fund would have lost less than its benchmark, even after fees. A fund’s history also allows you to see how the manager behaves during bull and bear markets over a long period of time. Finally, if you have a large non-registered portfolio (personal or corporate), the tax dimension is integrated into the comparative analysis since some active funds offer a tax-efficient structure, which can also justify higher management fees. in some cases.
Concretely, I do not recommend that you limit the analysis of your current portfolio or the construction of your future portfolio to management fees alone. While the majority of funds do not beat the indices, a minority do. A well-constructed portfolio should make room for them, especially in asset classes where the market is less efficient, such as small-cap and mid-cap stocks and international stocks. The last few months have proven to us that good fixed income managers deserve to be taken into account as well.