(Illusration by Serge Bloch)
After the Great Recession erased their portfolio gains in 2008, many investors started to wonder whether active management was really worth it. If stock-picking managers couldn’t keep their funds afloat in tough times, then what was the point? At the same time, study after study was showing that most actively managed mutual funds could not beat their benchmarks, mainly because of the management fees (averaging over 2%) embedded in their returns.
That opened a door for low-fee, technology-enabled alternatives, such as exchange-traded funds (ETFs) and online “robo-advisers,” that build portfolios with a minimum of human interference and at a cost typically less than 1% of the value of assets under management per year. They were all about passive investing at first—using index funds to match the returns of stock and bond benchmarks like the S&P 500. Their adherents slept well knowing that they’d still do better than most of their neighbours, who shelled out big fees to chase elusive “alpha,” or above-market returns.
Today, though, the pursuit of alpha may be coming back in style—brought to you by the same people who once shunned active management. In the United States, about a fifth of ETF assets are invested in everything from algorithm-driven “smart beta” funds to ones using complicated hedge strategies—only with management expense ratios (MERs) under 1%, instead of the hedge-fund standard two-and-20 (annual fees of 2% of assets under management plus 20% of gains above a set threshold).
Cheap managed products are popping up in Canada too. This fall, for example, discount brokerage Questrade is rolling out a line of ETFs sub-advised by venerable Montreal investment house Jarislowsky Fraser, none with MERs greater than 85 basis points. Beginning in 2013, Purpose Investments introduced ETFs that employ hedge strategies, with MERs of 80 basis points. In another twist, robo-adviser Wealthbar is offering clients access to private pooled funds managed by affiliate Nicola Wealth Management and invested in private equity and real estate limited partnerships—asset classes hitherto reserved for high net-worth investors.
But can they really deliver what they say they can? Or is low-fee alpha a contradiction in terms? Wealthbar co-founder Tea Nicola notes with satisfaction that the Nicola Composite Portfolio, available to her firm’s clients at a cost of 1% to 1.14% (on top of Wealthbar’s 0.35% to 0.6% portfolio management fee), has returned 5.1% year to date, in contrast to the losses recorded by Canadian and American index ETFs. However, like all low-fee managed products, its track record falls far short of a complete market cycle.
Undeniably, the chance of outperforming a benchmark is greater if fees are lower, says Jim Rowley, a senior investment analyst with Vanguard Investments, which sells both active and passive funds. And active management can add value; before fees were subtracted, 57% of large-capitalization funds outperformed the S&P/TSX composite over the past 10 years, according to Russell Investments.
Personal finance speaker and author Bruce Sellery, long an advocate of passive investing, sees a place for actively managed products—especially low-cost ones—once you’ve built a base of index-hugging securities. “Start by getting the performance of the benchmark, and then go with actively managed ETFs,” he says.“But you need to have a strategy and you need to have a view of the variables that will drive your investment.” Have realistic expectations too; over time, even a very good fund might beat its benchmark by 2%.
Whether to give low-fee alpha a whirl ultimately comes down to what kind of investor you are and what you want out of your portfolio, says Elena Pikulina, a finance professor at UBC. She doesn’t think personal investment objectives should be linked to market benchmarks to begin with. Most peoples’ goal should be to reach retirement with a healthy nest egg. The 2008 crash notwithstanding, numerous studies have shown that active managers tend to perform better in falling markets and periods of high volatility. That should be a factor in your decision on whether to use an active or passive product. “We should be more concerned with the final objective and concerned with how much risk I’m going to accept,” she says.
The key is to pick a style of investing that suits you and stick with it, says Purpose Investments president and CEO Som Seif. As with any investment, if you’re bouncing in and out of funds, you’ll lose money. But if you stick it out—in the outperforming and underperforming times—you could, thanks to lower fees, be farther ahead. In the past, he notes, “if you wanted to own value stocks, you had to pay some active money manager and get charged 1.5%. Today, you can get a great value strategy for 50 basis points. You’ll get the same gross return but, over time, with the alpha tip, you should outperform the market.”
As more lower cost alpha-seeking products enter the market, the long-raging battle between ETFs and mutual funds will need to be reframed, Rowley predicts. The real question will become whether you want to own an actively managed security or a passive one. Over the last few years, that query was easy to answer—passive was better.
That’s less clear now. Active managers can, and do, outperform the market and more will do so if fees are lower. If certain products consistently outperform, the money will come to them, they will grow and be copied. “The industry is going to reinvent itself over the next five to 10 years,” says Wealthbar’s Nicola. “We’ll see more online options and there will be more downward pressure on fees.”
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