Now's the time to get active, brokerage says
Jonathan Chevreau The National Post Thursday October 17, 2002

Passive investments might miss crest of next wave: CIBC Wood Gundy

With the latest bear market rally stalling yesterday after a four-day run, investors have a chance to consider the best way to dip their toes deeper into the equity waters.

But whether we're still deep in bear territory or early in the next bull market, active management may be a safer route than passively managed index funds, according to CIBC Wood Gundy.

"Although inexpensive, we believe passive investing is dangerous for investors at this point in the equity cycle," says financial advisor Craig Basinger in a report entitled "Passive investing. Is it cheap for a reason?"

While you might dismiss this as the biased view of one commission-oriented brokerage firm, Basinger says he is personally "not a dedicated fan of either active or passive management, but believes there to be a cyclical relationship with extended periods of active outperformance followed by passive outperformance."

Basinger works on the Private Client Investing side of Wood Gundy. Over the long run, "there is no clear winner" between active and passive, Basinger concedes.

These things run in cycles. Passive did better than active from early 1986 to late 1990 and then again between April, 1994, and October, 1999, Basinger and colleagues suggest. Active management did better from January, 1982, to January, 1986, and from January, 1991, to March, 1994.

Active has been doing better since November, 1999, to the present. Furthermore, Basinger expects active management will continue to outperform in the early stages of the next bull market.

This conclusion would confound American authors William Bernstein (The Four Pillars of Investing) and Larry Swedroe (What Wall Street Doesn't Want you to Know), both of whom have combed academic research and concluded active management does not do better in a bear market.

Canadian authors like Brian Noble (The Index Investing Revolution), and indexing executives Ted Cadsby and Howard Atkinson have come to similar conclusions in their own books: costs matter.

Don't count on the average financial advisor being aware of such books or the arguments underpinning them. I was appalled the other day when I interviewed a young fund salesperson who had authored his own book. He blithely sells Deferred Sales Charge mutual funds but was unfamiliar with any of the aforementioned books.

Readers can judge for themselves by accessing 15 years of data at the "other stuff" section at The site concludes indexed portfolios provide a 1% annual advantage over active management.

Basinger says the problem with broad market indices is the lack of risk management. If we are indeed in the worst bear market since the 1930s, the risk management accompanying actively managed mutual funds is arguably worth paying for, at least until we're clearly out of the woods.

CIBC Wood Gundy seizes as evidence the standard whipping boy of how investors in Canadian index funds were bludgeoned by the 99% drop in the price of Nortel Networks Corp., which once made up a third of the TSE 300. With Nortel selling for a buck, however, this is no longer an issue.

I buy the risk management argument, but only to a certain extent. Ultimately, true risk management is attained through proper asset allocation. Using the active-passive cycle to choose your equity allocation strikes me as a variant of market timing. I prefer to mix both strategies, using active funds where I perceive greater risk, and passive funds where risks seem minimal.

Thus, personally, I own the Barclays i60s and some sector ETFs for Canadian equity exposure. My perception is active large-cap Canadian equity funds own various subsets of the same stocks anyway, such as BCE, the banks, Alcan, etc., so why pay them high management expense ratios? I do, however, own an actively managed small-cap Canadian equity fund because the picks are less obvious and I lack the expertise or time to identify and value small caps for myself.

Admittedly, the index and the i60s have been hammered in recent months. As Morningstar Canada indicated Tuesday, the median actively managed Canadian equity fund has slightly outperformed the S&P/TSX composite index the last six months.

The median Canadian Equity fund lost 6.2% in September, 12.4% during the quarter and 19.1% over the past six months. The TSX lost 6.3%, 13.1% and 20.6% over the same periods. Morningstar attributed the added value to stock-picking, not sector selection.

It's not unusual for active management to outperform in small markets like Canada. The indexing argument is stronger in highly liquid markets like the United States.

However, valuations there still seem lofty enough I can't find it in me to invest in an S&P 500 or Nasdaq-based fund. Also, the problem with foreign indexing junkies is they end up slicing and dicing the world into a half dozen index funds or ETFs. It takes a sophisticated investor to properly construct such portfolios.

For ordinary investors with modest portfolios, one or two actively managed global funds are a valid alternative: let the fund managers decide how to divvy up small- or large-cap stocks, economic sectors and geographical exposure. An active global fund or two will be considerably more concentrated than half a dozen index funds, providing at least a shot at outperformance.

CIBC Wood Gundy's three global picks are Ivy Foreign Equity, AIC American Advantage and Clarington Global Equity. In my own account, I use Cundill Value (half in Japan and almost zero U.S. exposure), balanced by Trimark Fund (70% U.S.).


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