There must be some misunderstanding

There must be some kind of mistake

—Genesis

Losing an illusion makes you wiser than finding a truth

There is barely a month that goes by where I don’t learn something new about some widely held views on investing. While some of these views are rooted in reason, logic, and evidence, others are not.

Active versus passive management: A no-brainer

There is a growing sentiment among investors that passive funds, or index-tracking

exchange-traded funds (ETFs)

, are generally superior to actively managed portfolios. To be blunt, there is no reasonable counterargument to this assertion.

According to the most recent S&P Indices Versus Active (SPIVA) Canada scorecard the vast majority of managers have underperformed their benchmarks in almost every single investment category.

For example, based on absolute returns, 88.06 per cent to 98.19 per cent of actively managed funds underperformed their benchmarks — which range from Canadian Equity to Canadian dividend focused and income equity, U.S. equity and global equity — at the 10-year mark.

What about risk?

Many investors are not focused solely on return but are also concerned with volatility and risk-adjusted returns. As such, condemning a manager for lower returns may be unjust in instances where their clients are compensated in the form of reduced volatility.

However, the percentage of funds that underperform their benchmarks on a risk-adjusted basis is similarly high to those based on simple returns.

Based on risk-adjusted returns, 51.92 per cent to 100 per cent of actively managed funds underperformed their benchmark at the 10-year mark.

It’s not about the wrapper, it’s what’s inside that counts

A growing number of investors have been ditching fund investments in favour of index-tracking ETFs.

All else being equal, the only difference between a

mutual fund

and an ETF is the wrapper (in other words, the legal structure). If a mutual fund and an ETF have the same portfolios and charge the same fees then investors should be indifferent between the two. However most mutual fund assets are actively managed whereas most ETF assets are in passive, index-tracking mandates. As such, the problem isn’t that mutual funds are inferior to ETFs per se, but rather that most actively managed portfolios underperform their index-tracking counterparts.

Active mandates charge higher fees than passive ones. However, given that there are a small proportion of active funds that outperform their benchmark by a sufficient margin to more than offset their higher fees, investors would be well-served to expend the effort to identify them. Relatedly, it is important to understand the main reasons why most active managers have underperformed.

It’s hard to win if you’re not even trying

Many active managers limit the degree to which their portfolio holdings deviate from those of their benchmark indexes. This practice, which is pejoratively referred to as closet indexing, tends to produce gross returns that lie within a few basis points of indexes and net returns that lag them, which is simple math. If an actively managed portfolio is essentially the same as its benchmark, then its returns will also be the same, less fees (in other words, a quasi-guarantee of underperformance).

A 2013 paper titled

“The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance,”

analyzed the prevalence of closet indexing in different countries. Out of the 20 countries which the study analyzed, Canada ranked highest in terms of its percentage of actively managed funds that were not truly active, with more than 40 per cent identified as closet indexes.

Imitation, flattery, and underperformance

There seems to be no shortage of managers who subscribe to John Maynard Keynes’s conclusion that “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Although imitation may be the greatest source of flattery, it is value destructive when it comes to investing. When managers strive to outperform using the same approach, their respective efforts will cancel each other out, thereby leading to average results that generally range from mediocre to subpar.

Bigger isn’t better

There has been research showing that small and emerging fund managers often outperform their large, household name peers by a significant margin with less risk. And yet, larger managers tend to dominate asset growth.

As

investing icon Warren Buffett

’s longtime partner Charlie Munger said, “Show me the incentive and I’ll show you the outcome” (no pun intended). Smaller firms need to grow to survive and thrive. Conversely, for larger firms, growth is a “nice to have” rather than a necessity. Moreover, smaller managers lack the sales and marketing budgets of their larger peers and thus are more dependent on performance to grow.

The visibility and familiarity of large fund companies give investors comfort. This reassurance can dull people’s critical thinking and come at the cost of mediocrity and frequent underperformance. Even when these household names underperform, people give them the benefit of the doubt and overlook better-performing yet lesser-known managers. There have been countless instances where I have been asked by clients and prospective clients to analyze brand name manager funds in which they have been longtime investors. In the vast majority of cases, these funds underperform, and often meaningfully so.

Small, different and focused

For investors who are interested in average performance, passive investing constitutes a practical and attractive option.

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However, if you are interested in something more, then my advice is to expend the effort finding managers that have demonstrated a track record of outperformance, are relatively small and have a clearly defined process that differs from the crowd.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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