Active Management versus Index Shootout, Part 2

John Bogle likes to call it the “the relentless rules of humble arithmetic”. William Sharpe showed how any purported superiority of active management as a group can only be “justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers”. It doesn’t matter if such arguments are logically sound or that there is a mountain of evidence supporting it — the fund industry tenaciously markets any shred of “evidence” that shows the alleged superiority of active management.

Let’s turn our attention to the “evidence” presented in a chart yesterday that shows 9 out of 10 largest Canadian equity mutual funds outperform the blended index. Sounds impressive, but is it really? Let’s have a look:

1. As a reader pointed out in the comments section, the table compares the 10-year performance of the 10 largest funds today with a blended index. Since investors cannot enjoy past performance, a sensible comparison would be the 10-year performance of the funds that were the 10 largest ten years back.
2. Any list of existing funds is likely to be rife with survivorship bias. The mutual fund industry has a habit of merging poorly performing funds with those showing better performance records. The performance records of the poorly performing funds then simply disappears and the better fund simply gets larger. Therefore, it shouldn’t be surprising that large funds have a good performance history.
3. When a fund shows a good track record, it is heavily advertised. Columns appear in the financial press praising the stock picking skills of the fund manager. Investors reading the columns and advertisements pour money into the fund but the new money is simply chasing past performance and is likely to be disappointed.
4. It is not clear that the comparisons use the correct benchmark. The funds in the list belong to two fund classes — Canadian Focused Equity and Canadian Dividend & Income Equity. I would guess that a 90% TSX Index/10% Fixed income mix and a 70% TSX Index/30% Fixed Income mix are appropriate benchmarks respectively. The 10-year performance of the two asset mixes would be 5.60% and 5.94% — both significantly better than the benchmark used.
5. It is not even clear if the list is accurate. For instance, the list doesn’t mention the gargantuan Investors Dividend fund, which has $9.1 billion in assets under management and charges a MER of more than 2.5%. The fee generated by this one fund alone is reported to be larger than three quarters of all funds in Morningstar’s database! The fund is missing from the list presumably because it doesn’t have a 10-year history but the performance history it does have is nothing home to write about: -1.4% versus 0.6% for the index.

Interestingly, investors wanting to take the active management route might be better off avoiding the large funds because the larger funds cannot take meaningful positions in their “best” ideas and their performance would likely resemble that of an index. Why pay a steep MER when all you can get is beta less fund expenses?

Here’s the second table in the Mackenzie funds marketing material:

Largest Global Equity Mutual Funds vs Index over 10-Years (January 31, 2009)

• 7 of 10 Largest global equity mutual funds match or outperform index, Including the #1 performing Cundill Value Fund and #2 performing Ivy Foreign Equity Fund – with lower volatility

Source: Paltrak