I received a question from a reader via email in which he asked me to address passive investing in a secular bear market. The reason for this is that he had been to numerous presentations recently which all seemed to tout “now” as being time for active managers to shine - “the return of active management” was how he described the message.

The latest SPIVA Q4 Scorecard (which stands for Standard and Poor’s Index Versus Active scorecard) indicated that active fund managers just barely managed to beat the S&P/TSX Composite Index in the fourth quarter of 2008 as a whole. Is there something to this?

Further, I’ve spoken to a number of advisors who paradoxically had recently been leaning towards indexation strategies only to now perceive active managers as being akin to kids in a candy store, that there are so many value opportunities that it should be “easy-pickings” and active management will deliver great returns going forward.

Wishful Thinking

First, let’s not forget how much money goes into marketing of active management. Actively managed mutual funds pull about $10 billion out of Canadians’ pockets every year if you assume an average cost of 2% on total mutual fund assets of about $500 billion. The industry knows what butters its bread - and they’ll spare little expense to convince investors and advisors of the merits of active management (in ANY market).

Second, according to a report I read recently (but the name and location of which escapes me at the moment) about 20% of the market is indexed. That means that 80% of the market is being actively managed in some way, shape or form. Active managers haven’t gone away, so there is no great “return” in the first place. If the best they can claim is that they don’t go down as much in a bear market (good) and don’t go up as much in a bull market (bad), then given that the market tends to go up twice as much as it goes down it’s not a very compelling argument, is it?

Third, 80% of the market is actively managed (yes, this is the same as the point above). So being able to outperform the market has the same hurdles as it ever did. Let’s pretend for a minute that there are no management fees for passive or active investors. Passive investors will get the market return no matter what because they hold the market. The rest of the investors (the active investors) in aggregate will get the market return too, since for every one who is overweight RIM, there must be someone underweight RIM, and so on for all the stocks in our universe. Some will beat the average, and some will lose to the average - but put them all together and they will get the market return too. So now, we re-introduce fees. Passive investors pay very little to blindly track an index, but active investors pay a lot. It’s a mathematical truth that a passive investor will beat the average active investor - and that holds true in bull markets, bear markets and everything in-between.

Another way to sum this up is to examine the statement “everyone being better than average” (and average represents the index). This can’t happen. The average is the average. And for passive investors the “average” costs less.

Finally, I’m not going to argue that all active managers simply cannot beat the average going forward, it’s just that there is no way to reliably identify these out-performers in advance… just ask Peter Lynch, who was responsible for finding his replacement when stepping down from Magellan. Take a look at the post-Lynch track record. If arguably the world’s greatest fund manager couldn’t do it, why do so many others think they can?

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