Editor's note: This article is based on a Morningstar research paper published in April. Co-authors Christopher Davis, director, manager research, Canada, and Michael Keaveney, director, Morningstar Investment Management, Canada, examined how well Canadian investors have been served by active managers of domestic equity funds over the long haul.
A new Morningstar study on the past performance of active managers in the Canadian Equity and Canadian Small/Mid Cap Equity categories gives credence to the argument that investors should favour passive vehicles in more efficient markets and consider active management in less efficient ones.
Covering the 10-year period ended Feb. 28, the study measured differences in risk-adjusted performance between active and passive funds. To do so, it employed a metric known as the information ratio, which weighs funds' excess returns over their benchmarks against the volatility of those returns. Put another way, the information ratio measures whether the returns have been good enough to justify the risks managers took against their benchmarks.
The success ratio compiled by the authors was the percentage of funds in each category that survived the period and outperformed the benchmark. For each of the two categories, the study calculated success ratios for gross returns and for net returns.
In the Canadian Equity category, the study found a high success ratio before fees. Of the 59 Canadian Equity funds examined, 71.7% outperformed, gross of fees. But only 13.6% of active funds outperformed a broad-market alternative after fees.
Most Canadian equity funds charge too much to come out ahead of the passive alternative. Indeed, high costs weighed down many managers who performed strongly before fees. The information ratio of BMO Canadian Equity, for example, landed in the 31st percentile gross of fees, but with an MER averaging 2.33% over the decade, the information ratio fell to 61st on a net-of-fees basis.
On the other hand, low to moderate fees gave relatively weak performers a boost. The information ratio of PH&N Canadian Equity Series D went from the 79th to the 53rd percentile on a net-of-fees basis, thanks to its low MER. And though Leith Wheeler Canadian Equity was a decent performer gross of fees, it looked markedly better net of fees. With one of the category's lowest price tags (the fund is offered without an embedded trailer fee to do-it-yourself investors) its information ratio went from the 40th percentile before fees to the 21st percentile after fees.
The study found that consistency counts. There was a positive correlation between the proportion of monthly periods in which a fund outperformed and its 10-year information ratios in both categories. However, even funds with very positive information ratios did not consistently outperform the passive alternatives.
Mawer Canadian Equity, which had the highest information ratio in the Canadian equity category , lagged the index in 54 of the 120 monthly periods (45%). There were 15 of 82 periods (18%) when it trailed the index over a rolling three-year period and 12 of 61 periods (19%) when it trailed over a rolling five-year period. Even among funds that have outperformed over the long term, investors must be prepared to weather the inevitable performance droughts.
The success ratio was much higher for active Canadian small/Mid-cap Equity managers, whose investment universe is less efficient because stocks of smaller companies tend to be less actively traded and less widely followed by analysts. Of the 46 small-cap funds studied, 95.7% outperformed on a risk-adjusted basis before fees, and 93.5% prevailed even after having to clear their fee hurdles.
The fact that nearly all Canadian small/mid-cap equity funds outperformed net of fees does not mean expenses did not affect relative performance. Indeed, the relationship between MERs and information ratios was stronger among Canadian small/mid-cap equity funds than it was with Canadian equity funds.
Investors shouldn't necessarily interpret success versus the small-cap benchmark as proof of manager skill. In addition to weighting strong-performing mid-cap stocks more heavily than the index, active small-cap managers may have successfully exploited other systematic factors historically tied to outperformance, such as value, momentum and quality. Once these factors are taken into account, it is likely that fewer active small-cap managers will have demonstrated true skill in stock selection.
| |
Category | # of funds | Successful funds, gross of fees | Success ratio | Successful funds, net of fees | Success ratio | |
 |
|||||||
|
|||||||
| |
Canadian Equity | 59 | 43 | 71.7% | 8 | 13.6% | |
| |
Canadian Small Cap | 46 | 44 | 95.7% | 43 | 93.5% | |
|
|||||||
| |
Source: Morningstar | ||||||
|
|||||||
To compare active versus passive in the two categories, the study chose the S&P/TSX Capped Composite and S&P/TSX Small Cap indexes as benchmarks because they are widely used by fund managers. (Many Canadian equity funds use the S&P/TSX Composite Index instead of the S&P/TSX Capped Composite as their benchmark, but the two indexes performed identically over the study period.) Also, since at least one ETF tracks each of the indexes by investing in their underlying constituents, the benchmarks enable realistic depictions of investors' choices to be made.
The study compared net returns of the actively managed funds with the ETF returns. Specifically, it measured the excess return of funds in the two domestic equity categories to iShares Core S&P/TSX Capped Composite Index (XIC) and iShares S&P/TSX Small Cap (XCS), respectively.
The case for passive investing could be further strengthened in the future, since the fees charged on some Canadian ETFs have dropped sharply in recent years. To replicate what the small-cap ETF would have returned before its inception in June 2007, the study substituted the index return minus the ETF's management-expense ratio. While current MERs will have more bearing on future performance, the study used the then-prevailing MERs to calculate net returns for the benchmarks.
If comparable active managers are unable to match the ETF fee reductions, the hurdle for active management success becomes even harder to clear. This doesn't rule out active management in the category. Since most Canadian equity funds outperformed gross of fees, active management could be an attractive option at the right price.
The methodology used for calculating information ratios and success ratios has some limitations. Because of the lack of reliable historical data on embedded trailing commissions, it was not possible to separate the cost of management from the cost of advice.
For funds sold through commissioned brokers and dealers, the trailer commission typically adds another percentage point to a fund's MER. This gives low- or no-trailer funds, sold through discount brokers or directly to investors, an inherent advantage. The latter accounted for 14 of 59 Canadian Equity funds in our data set and nine of 46 Canadian Small/Mid-cap Equity funds. Excluded from the data sets were index funds, as well as high-net-worth, pooled and institutional funds.
The information ratio has potential weaknesses as a risk-adjusted return measure. It is highly dependent on choosing the right benchmark for comparison. High information ratios can signify an improper benchmark, rather than manager skill. Volatility is also an imperfect proxy for risk, since many investors instead view risk as the potential for permanent capital loss.
Of course, there's more to successful manager selection than choosing funds with the highest information ratios, no matter the category. Strong performance, even over a 10-year period, may simply be the result of happenstance or luck. Reviewing historical performance within the context of a fund's strategy, alongside continuity of management and investment approach, as well as fees, improves the odds that success has not been a fluke.
