Active funds for passive investors

These actively-managed medalists play well with broad market index funds.

Christopher Davis 4 November, 2016 | 5:00PM

Active management has gotten a bad rap, and much of it is well deserved. Critics deride active funds as too expensive, too index-like, and likely to underperform an inexpensive broad market index fund over the long haul.

Given the difficulty most active managers in most markets, including Canada, have had in outperforming their benchmarks after fees, they surely have a point. Diversification, low costs and the high odds of long-term success make broad market index trackers appealing core holdings.

However, arguing that inexpensive, passive funds should form the core of a portfolio isn't the same as saying they should make up the entire portfolio. As philosophically inconsistent as it may seem to hold passive and active strategies in the same portfolio, there's a practical case for doing so.

Active and passive strategies often perform well at different times, leading some active funds to have diversification benefits. Passive alternative may poorly represent the asset class or be burdened by methodological flaws. Some actively-managed strategies aren't easily replicated by passive approaches. And let's not forget that manager skill, while scarce, does indeed exists -- a point all but the most ardent indexing enthusiasts concede.

These rationales don't support the case for active management in general. But they do argue active strategies can improve passive-dominated portfolios if they exhibit the following characteristics:

  • Relatively low correlation relative to broad market indexes or superior downside protection.
  • Distinctive, relatively concentrated portfolios. Index-like portfolios don't complement index funds well.
  • A sound process and long record venturing outside the index universe and exploiting flaws in market benchmarks.
  • Investments in illiquid, uncommon or other hard-to-index asset classes.

The following are some Morningstar Medalists that check some or all these criteria.

Fidelity Canadian Large Cap ´

Despite its name, this fund's portfolio isn't entirely Canadian or large cap. Manager Daniel Dupont can invest up to half of the portfolio in U.S. stocks and invest across the market-cap spectrum. Such flexibility has been a virtue, as Dupont's stringent value and quality standards would be restrictive had he limited himself to Canada. Unusually, he devotes a small piece of the portfolio to a merger-arbitrage strategy, a generally low-risk approach that historically mitigates volatility. His relatively concentrated portfolio means it looks little like U.S. or Canadian market benchmarks. As a result, returns have been just 53% and 69% correlated with the S&P/TSX Composite and S&P 500 Indexes, respectively. Since Dupont's April 2011 start, the fund has enjoyed 79% of a 50/50 TSX Composite/S&P 500 custom benchmark's gains and just 30% of the losses.

Sionna Canadian Small Cap Equity 

In an environment where it's difficult to find good, nimble small-cap funds still open to new investors, this tiny $60-million offering has somehow evaded detection. Its long-term record runs circles around the lone purely small-cap passive alternative in Canada, Negative-rated  iShares S&P/TSX Small Cap Index (XCS). Most of its rivals in the Canadian Small/Mid Cap Equity category have done so with mid-cap heavy portfolios, but the Sionna fund is focused on small-caps, enhancing its diversification appeal. The Sionna team, led by industry veteran Kim Shannon, has successfully adapted the value-driven approach it has employed at Bronze-rated Sionna Canadian Equity, though without the sector-neutral framework of its larger-cap sibling. Such freedom enables the managers to sidestep the low-quality basic materials names that have bedeviled Canadian small-cap benchmarks. More importantly, the team has been adept in preserving capital in down markets while outperforming its average peer in approximately 75% of rolling three-year periods since its December 2006 inception. One caveat: With a 2.51% MER for the commission-based A series and 1.51% for the fee-based F series, the fund is about average on price relative to the active competition, but it's a high absolute hurdle for management to overcome.

Lysander-Canso Corporate Value Bond Œ

There's a strong argument for indexing in the Canadian investment-grade bond arena given the decisive role costs play in fixed income returns. However, doing so results in a portfolio dominated by government bonds -- a bet this corporate bond fund can moderate. Canadian corporates comprise most the portfolio, but management's go-anywhere approach results in significant non-Canadian exposure (about 40% currently). The team has been adept at taking more credit risk when valuations are attractive and pulling in their horns when they're not. Their depth and experience gives them the chops to invest in securities that most Canadian competitors avoid. Their diligence has paid off: the fund's long-term record handily outperforms the benchmark, the FTSE TMX Canada All Corporate Index. The fund nicely complements broad Canadian bond market exposure, with 43% correlation with the FTSE TMX Canada Universe index for the five years to the end of September 2016.

CI Black Creek International Equity 

Manager Richard Jenkins looks for market leaders with growing market share and where he and comanager Bill Kanko believe their view differs significantly from the market consensus. Not many companies meet their standards: The portfolio holds just 30 stocks, few of which are household names. Its top holding is Portuguese energy firm Galp Energia (GLPEY), for example. All told, the benchmark-agnostic, concentrated portfolio differs from its benchmark, the MSCI EAFE Index, in its all-cap approach (its average market cap is $8 billion, versus $31 billion for the index) as well as regional and sector exposure (heavy on emerging Asia and consumer discretionary, light on Japan and financials). Not surprisingly, the fund is only 80% correlated with its benchmark and 45% with the S&P/TSX Composite. Jenkins, Morningstar's 2015 Foreign Equity Fund Manager of the Year, has delivered impressive results here and at Trimark, where he was a manager before cofounding Black Creek.

Chou Associates  

Manager Francis Chou is a true original. He employs a deep-value strategy that doesn't easily fit in any category. Chou invests globally, looking for stocks (and other investments) trading at a steep discount to what he thinks they're worth, and he's not afraid to hold cash when he can't find names meeting his criteria. His ultra-compact portfolio includes both  Berkshire Hathaway (BRK.B) and  Valeant Pharmaceuticals (VRX) as well a smattering of steeply discounted bonds -- an unusual combination that puts the fund out of step with most market benchmarks and its Global Equity peer group. This fund's recent woes are a reminder that it demands fundholders be as patient and risk tolerant as its manager, but over his sterling career as an investor, Chou has made the occasionally bumpy ride worthwhile. The fund also requires investors be comfortable with loads of key-person risk. Chou's firm is essentially a one-man show.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Bausch Health Companies Inc28.38 CAD-3.47
Berkshire Hathaway Inc B197.16 USD-1.92
Galp Energia SGPS SA ADR6.97 -0.64

About Author

Christopher Davis

Christopher Davis  Christopher Davis is Director of Manager Research at Morningstar Canada.