Recent policies writing off active management may be based on flawed premises
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At the heart of investors’ shift to index-based ETFs and the clamour for lower fees lies one argument: active management doesn’t achieve better returns than the passive approach. As the pro-passive camp gains support, more policies are being crafted to discourage the alternative.
But one expert has warned that it’s wrong to count out active management. “[P]assive investment works when market prices convey all the information about a security,” Jack Mintz, who is the President’s Fellow at the University of Calgary’s School of Public Policy, said in a piece to the Financial Post. “[But] while prices provide an important signal about the future, they are subject to ‘noise,’ resulting in informational inefficiency that creates value for active traders.”
While Mintz acknowledged the existence of smart-beta ETFs, which incorporate screens for features such as volatility, size, and value, he asserted that ETFs are based on market capitalization. More weight is given to bigger companies, which aren’t necessarily better. “[F]unds based on an index will often end up holding many unprofitable firms,” he said.
However, he continued, more and more policy seems to be geared toward discouraging active investing. “During the debate over Canada Pension Plan [CPP] reforms, for instance, advocates argued that investors in actively managed mutual funds earned inferior returns due to high fees and insufficient pre-tax returns,” Mintz said. It helped make the case for enlarging the CPP as a supposedly better alternative to private investing, “forcing Canadians to pay higher payroll taxes to hold supposedly ‘cost-efficient’ government retirement portfolios.”
He also noted current proposals to eliminate trailing commissions in active funds, based on the premise that they raise conflicts that hurt investors, who’d therefore be better off with advice-free passive investments.
“While there is a case to be made for fee transparency, when the UK ended embedded commissions, the result was that lower-wealth investors would not or could not pay for advice, leaving them less well-prepared for retirement,” Mintz said.
Rather than favouring passive over active investing, he asserted, policy should remove cost barriers to financial planning services. “Ottawa charges GST on financial-management fees, for instance, which is not consistent with an overall approach of exempting financial services from the sales tax,” he said. He noted that while investors are able to deduct certain advisory fees related to specific transactions from their income taxes, fees for general advice aren’t deductible.
As for the argument that no active manager can consistently beat the market, Mintz said it’s not necessarily true because determining a benchmark to compart the two approaches is not straightforward. Some studies suggest active management can perform better, depending on the time frame; certain active strategies can also outperform on an after-tax basis because of specific opportunities to avoid or minimize tax. Recent studies of emerging markets show that active management strategies get better returns because of information inefficiency.
“The healthiest portfolio, and market, is surely one with a balance of both active and passive investments,” Mintz said. “But for that to happen, policy-makers will need to take a more balanced view themselves towards active management.”
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But one expert has warned that it’s wrong to count out active management. “[P]assive investment works when market prices convey all the information about a security,” Jack Mintz, who is the President’s Fellow at the University of Calgary’s School of Public Policy, said in a piece to the Financial Post. “[But] while prices provide an important signal about the future, they are subject to ‘noise,’ resulting in informational inefficiency that creates value for active traders.”
While Mintz acknowledged the existence of smart-beta ETFs, which incorporate screens for features such as volatility, size, and value, he asserted that ETFs are based on market capitalization. More weight is given to bigger companies, which aren’t necessarily better. “[F]unds based on an index will often end up holding many unprofitable firms,” he said.
However, he continued, more and more policy seems to be geared toward discouraging active investing. “During the debate over Canada Pension Plan [CPP] reforms, for instance, advocates argued that investors in actively managed mutual funds earned inferior returns due to high fees and insufficient pre-tax returns,” Mintz said. It helped make the case for enlarging the CPP as a supposedly better alternative to private investing, “forcing Canadians to pay higher payroll taxes to hold supposedly ‘cost-efficient’ government retirement portfolios.”
He also noted current proposals to eliminate trailing commissions in active funds, based on the premise that they raise conflicts that hurt investors, who’d therefore be better off with advice-free passive investments.
“While there is a case to be made for fee transparency, when the UK ended embedded commissions, the result was that lower-wealth investors would not or could not pay for advice, leaving them less well-prepared for retirement,” Mintz said.
Rather than favouring passive over active investing, he asserted, policy should remove cost barriers to financial planning services. “Ottawa charges GST on financial-management fees, for instance, which is not consistent with an overall approach of exempting financial services from the sales tax,” he said. He noted that while investors are able to deduct certain advisory fees related to specific transactions from their income taxes, fees for general advice aren’t deductible.
As for the argument that no active manager can consistently beat the market, Mintz said it’s not necessarily true because determining a benchmark to compart the two approaches is not straightforward. Some studies suggest active management can perform better, depending on the time frame; certain active strategies can also outperform on an after-tax basis because of specific opportunities to avoid or minimize tax. Recent studies of emerging markets show that active management strategies get better returns because of information inefficiency.
“The healthiest portfolio, and market, is surely one with a balance of both active and passive investments,” Mintz said. “But for that to happen, policy-makers will need to take a more balanced view themselves towards active management.”
For more of Wealth Professional's latest industry news, click here.
Related stories:
IIROC’s Rule 42 viewed as good first step
Investor Advisory Panel voices support for embedded-commissions ban
