Next, we turn to results achieved by bond and equity managers over the past 15 to see whether active management has added value We reviewed information ratios of the median manager across a number of asset categories used by Canadian plan sponsors—Canadian bonds and equities, US, EAFE, Global and Emerging Market equities. Information ratio (IR) is the ratio of outperformance or alpha divided by risk or tracking error. There were many years when, on a risk adjusted basis, and before fees, the median manager has failed to exceed the benchmark and in some cases even meet it. Once adjusted for fees, most asset classes would have failed to generate a positive IR on an annual basis.
When we do the same analysis for 1st quartile managers, the situation changes. The 1st quartile manager in each of these asset categories has added value year to year. Even adjusted for fees, these asset classes have benefited from active management.
One conclusion that can be drawn from this analysis is that manager selection and monitoring are extremely important activities and critical to the success of active management. The implication is that a plan has to have the governance in place to manage an active slate of managers.
As already noted, the U.S. equity market is often considered one of the most efficient, and at times has been difficult for the average manager to “beat”. However, there are periods when the average manager has fared well, and 1st quartile managers have certainly performed better than the index. The chart below shows the percentile ranking of the Russell 1000 Growth Index over rolling 5 year periods.
As you can see, there are times when the Index has been in the top quartile (the five year period ending December 1998), when an investor would have been better off with an index fund. There have been more times, however, when the Index was in the 3rd or 4th quartile, and active management was the better strategy. We also charted the VIX which is a measure of implied market volatility. Not surprisingly, the higher the volatility of the market, the more likely it was for active managers to perform better than the Index.
In the chart below, you can see the same analysis for the Russell 1000 Value Index. You will note a similar result to the Growth Index—the Index was in the 1st quartile for the 5 year period ending December 1998. However, unlike the Growth Index, where active management has been the better approach, the results for the Value Index are much more mixed.
Another conclusion that can be drawn from the above analysis is that style does matter, and should be considered when making the active/passive decision.
There are other considerations in determining whether an index should be actively or passively managed. For example, the DEX Universe Bond Index has been difficult to beat by active managers over the past 10 years. However, there are some risks inherent in the Index and its construction which need to be considered before being borne passively by an investor. Unlike equity indexes, there is no “listing” requirement in the bond indexes. Bonds that have been issued are included in the construction of the index regardless of credit quality or availability. The DEX Universe Bond Index currently comprises over 1000 bonds, many of which are not traded (and have not been for years). Almost 29% of bonds included in the Index have been issued by corporations (i.e. they have credit risk), and approximately 5% of Index securities are rated BBB. A passive investment in the DEX Universe Bond Index accepts all these factors.
There are also concerns with the equity indices. Presently, the S&P/TSX Composite Index comprises approximately 209 securities. As at March 31, 2009, energy and materials accounted for almost 48% of the Index while financials represented 28%. Thus, three sectors total over 75% of the Index. While the energy and material weightings seem high, Canada has a large proportion of these companies globally. Of greater concern is the financials weighting. Canada represents about 4% of the total financial services market capitalization globally while financials represent 29% of the Index. Therefore, passive investment in Canadian equities exposes the investor to the fate of three sectors.
So back to the original question—to index or not? It is clear from the analysis that there are many asset classes that have benefited from active management and where skillful managers can outperform the relevant index. Passive management is a good tool to control risk and cost, and certainly provides governance constrained plan fiduciaries some relief from their monitoring obligations.
These plan sponsors should consider whether they want to spend their time on monitoring active managers, and if so, how many. For those plan fiduciaries who are willing to invest the time, the good news is that active management can be a successful strategy.
Janet Rabovsky is the Practice Leader, Investment Consulting, Central Canada for Watson Wyatt Worldwide.
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