There's little denying that folks regularly consuming leafy green vegetables are healthier than those stuffing themselves daily with burgers and fries. Sure, you might find someone who shuns vegetables, dines exclusively on Big Macs and lives to 100. But that doesn't mean you should give it a try.
Arguments against actively managed mutual funds carry the same weight. Most financial advisers are much like McDonald's Corp. shareholders. Their wallet sizes depend on massive consumptions of fat – fees, in this case. Academic studies draw the same conclusions: Most actively managed portfolios perform sluggishly.
But what about risk? It's the thread many advisers cling to when trying to keep themselves on the actively managed payroll. Financial academics measure risk with beta or standard deviation. Beta is a measurement of how much an investment fluctuates relative to the market's movements. Standard deviation measures volatility. If a fund or portfolio earned 1 per cent every single month, its standard deviation would be zero. In comparison, Morningstar rates the S&P 500's 15-year standard deviation at 15.45. The higher the number, the greater the risk.
Portfolios of actively managed funds, so the sales pitch goes, exhibit less volatility than their indexed counterparts. Or is that Ronald-McDonald thinking?
In reality, risk has little to do with whether a portfolio is actively managed. Instead, asset allocation is key. Portfolios heavily weighted in stocks are riskier than those that emphasize bonds. Portfolios diversified across multiple asset classes are also less risky than those focused on equities.
Determining whether active or passive portfolios are riskier can only be done when standard deviations are compared between two such portfolios with relatively equal asset class proportions. In many cases, when given the freedom to speculate, many individual investors, advisers and fund managers increase risks without increasing returns. Here are two such examples.
TD's Balanced Index fund comprises roughly 46 per cent bonds, 54 per cent stocks. Its allocation is similar to TD's active Balanced Income Fund. As such, when comparing the two, the asset allocation variable is removed. This allows us to compare whether active management reduces risk. Unfortunately, it doesn't.
According to Morningstar, TD's Balanced Index has lower standard deviations over the past three- and five-year periods compared with its actively managed counterpart. The index's three and five-year figures are 4.22 and 4.54. Standard deviations for its actively managed equivalent over the same time periods measure 4.53 and 4.65. So, the active managers added risk.
CIBC is the second Canadian firm offering balanced funds that are both indexed and actively managed. Its Balanced Index comprises 43 per cent bonds and cash, with the remainder in stocks. It has three- and five-year standard deviations of 4.68 and 5.03. Its actively managed balanced fund comprises 46 per cent bonds and cash, 54 per cent stocks. The fund's three- and five-year standard deviations recorded 5.89 and 5.97.
Once again, active managers didn't reduce risk. They increased it. And they did so while reducing returns. In both cases, TD and CIBC's balanced indexes provided stronger 10-year profits.
TD's actively managed Balanced Income Fund earned 46.3 per cent for the decade. The firm's Balanced Index earned 72.4 per cent – outperforming its active counterpart while recording lower risk over the past three- and five-year periods.
A good financial adviser serves many purposes. He or she assists with goal-setting and prevents investors from foolishly chasing rainbows. But advisers building portfolios with actively managed funds are like nutritionists selecting client meals from McDonald's. If you must have an adviser, insist on one who will build your portfolio from a much healthier menu of index funds.