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Passive Investing in a COVID-19 World

The active versus passive investing debate rages on. Active proponents argue that you should trust your hard-earned savings to be managed by highly skilled, highly trained professionals. Passive investing proponents scream “bunk” and argue that any potential benefit from hiring trained professionals is more than offset by the higher fees being charged. Wealth grows by the after-cost rate of return.

The SPIVA Canada Mid 2020 Scorecard is available and it should be required reading and understanding for all market participants, especially professional active managers.

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The data is as of June 30, 2020 and captures the major market effects of the COVID-19 pandemic. Proponents of active investment management must believe that the active managers navigated the treacherous investment climate of early 2020 better than “dumb” market capitalization weighted indexes. After all, active managers have underperformed the dumb indexes for years. Wait for extreme market events to uncover the brilliance of active management was the message from active proponents.

We had a COVID-19 induced extreme market event. In a roughly one-month period, markets around the world shed close to 1/3 of value. “Dumb” passive investing followed the markets and shed the same value. We would expect the highly trained, professional active managers to finally prove their value.

We have the data and guess what. Dumb (and inexpensive) wins again! 88% of Canadian equity funds, 84% of US equity funds offered to Canadian investors (return and benchmark are after currency conversion) and 63% of International funds offered to Canadian investors (International = non-North American) underperformed their appropriate benchmarks for the year ending June 30, 2020.

The active manager underperformance isn’t much different than 10 years numbers. 90%, 95%, and 86% are the respective underperformance of active managers in the same categories for the 10-year period ending June 30, 2020.

Will the underperformance continue? It is certain. Why? Outperformance by some active managers will be exactly offset with underperformance by other active managers. The investment performance of the group of all active managers must equal the market return pre-cost. All active managers can’t outperform the index just like all students can’t outperform the class average. As long as the cost of active management remains higher than the cost of passive management, the group of active managers will always underperform the group of passive managers post-cost. This is certain and is based on simple arithmetic and is valid in any time-period measured.

Where is the value of active management? It is time for all active managers to convert their funds into low-cost passively managed investment vehicles. Don’t bank on the conversion though. The margins are horrible and active investment managers can’t eat (well) on fees collected through passive management.

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