Tips from Donna (February 2014)
by Donna Gordon on February 11th, 2014


ETFs Versus Actively Managed Funds

Do we have a winner? Ever since passively-managed funds like exchange-traded funds (ETFs) came into being, there has been much debate about active management versus passive management. Research published by industry professionals presents different arguments. Some studies show that only a fraction of active funds beat their respective benchmarks. Other studies show that, while active funds have failed to beat their benchmarks, they do provide added-value when a disciplined approach is adopted over longer periods.

An exchange-traded fund strives to achieve a return similar to a particular market index. The ETF will invest in either all or a representative sample of the securities included in the index that it is seeking to imitate. ETFs provide passive diversification, are tax-efficient investment vehicles and have cost advantages. However, the return on an ETF is capped by the return of the index it tracks. Active managers, on the other hand, attempt to pick the best investments in the market and, if well executed, their performance is not limited by the return on an index. However, active funds are prone to style drift—the tendency of a fund to deviate from a particular investment style over time to improve performance. These modifications in investment style may be attributed to changing trends in the market environment.

Let’s take a look at how the “average” ETF and “average” active fund performed over the last decade. The image compares the performance of the “average” ETF with the “average” actively managed mutual fund during the past 10 years. As evident from the image, in periods of poor market performance (2008 and 2011) when the market experienced negative or very low returns, the “average” actively managed mutual fund performed better than its passive counterpart. When the market experienced strong positive performance, ETFs fared better in some years (2004 to 2007, for example). In other years, actively-managed funds performed better (2012 and 2013).

Why is this, you may ask? One reason for this behavior is the underlying structure of active and passive funds. Passive funds like ETFs are designed to track a particular index or benchmark. This means that when the benchmark experiences poor performance, the ETF also fares badly. On the other hand, active managers may be able to quickly adjust their portfolios depending on the underlying market conditions. This may be one reason for better performance in down markets.

Making a choice between active and passive investing isn’t an easy one. When deciding which style of management is better for you, it is important to take into account several factors, such as costs, style, risk, transparency of investments, manager performance, and tax implications. Consult your financial advisor to learn more about investing in ETFs and actively managed funds.



Fund Flows and Asset Class Performance

Over the last 20 years, markets have experienced many shocks and recessions, including the Asian currency crisis, the Russian debt default, the dot-com crash of the early 2000s, and the recent global financial crisis. When these events occur, investors frequently attempt to reduce (or increase) investments to certain asset classes in order to lower exposure to (or take advantage of) the situation.

In 2008, the global financial crisis caused U.S. large stocks and international stocks to perform poorly, with losses of 37.0% and 43.1%, respectively, while bonds rose by 25.9%. In the wake of the recession, bonds performed very well in 2011, returning 28.2% as concerns about a possible double-dip recession grew. In the same year, international stocks fell 11.7%, most likely the result of events such as the sovereign debt crisis that rippled throughout the global landscape.

For all asset classes, demand and supply determine the market price of an investment. Understanding this trend may help investors ascertain how an asset class fits into their portfolio. Starting in 2007, annual net asset fund flows into U.S. stock funds became negative and stayed that way through 2012. Flows into bond funds, on the contrary, reached a peak in 2009 and remained high in 2010, 2011, and 2012 as investors flocked to relatively safer assets. As bond returns grew unusually high over the last few years, flows into bond funds may have increased as investors chased bond performance. Interestingly, outflows from U.S. stock funds continued despite U.S. large stocks showing positive returns since 2009. Was chasing bond performance the right thing for investors to do, or did investors just miss out on the returns of U.S. large stocks over the last couple of years?

About the data

U.S. Large Stocks—S&P 500® Index, which is an unmanaged group of securities and considered to be representative of the U.S. stock market in general. International Stocks—Morgan Stanley Capital International (MSCI) World ex-U.S. Index. Bonds—20-year U.S. government bond. Annual Net Asset Fund Flows: U.S.-domiciled open-end fund flows from Morningstar. Start date of 1994 constrained by data availability. U.S. stock: funds that primarily invest in U.S. stocks; International stock: funds that invest in specific regions or a diversified mix of international stocks with 40% or more in foreign stocks; Bond: taxable bond funds (government, corporate, international, emerging markets, high yield, multisector) that invest primarily in fixed-income securities of varying maturities.


Chasing Performance

Investors often endure poor timing and planning as many chase past performance. They buy into funds that are performing well and initiate a selling spree following a decline. This becomes evident when evaluating a fund’s total return compared with the investor return. Overall, the investor return translates to the average investor’s experience as measured by the timing decisions of all investors in the fund.

The image illustrates the investor return relative to the total return for a given fund. Over the short term, both the total and investor returns were positive and relatively similar. Over a 10-year period, however, total return greatly exceeded investor return. Investors who attempted to time the market ran the risk of missing periods of exceptional returns.

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