Winning in bad times

Kelly Rodgers, MoneySense December/January 2001

If we've learned one lesson from the volatility of the stock markets this fall, it's that actively managed mutual funds may not just be for fools after all. Maybe it's time to rethink our devotion to index investing.

Many financial observers have touted the benefits of index investing through the purchase of index mutual funds or exchange-traded funds. An index mutual fund tracks a targeted index-such as the TSE 300-without trying to beat it. Exchange-traded funds do the same thing, but they're bought and sold like stocks. Fees are much lower than actively managed mutual funds, and therefore the performance of index products over the long term is nearly always better than actively managed funds.

For many years, the popularity of index investing has been increasing, with a resulting backlash against active investing. Indeed, I've seen internet chat room participants accuse active investors of being stupid. Their reasoning: if managers can't outperform the market, why bother paying higher fees for active management?

The actions of the markets this fall have demonstrated the fallacies of this argument. Neither indexing nor active management is the right approach all the time. Sure, if you buy and hold for the long term, index investing is the hands-down winner. However, in the short term-particularly during volatile markets when huge swaths of cash can evaporate overnight-some active managers (and I emphasize "some") can moderate your risk. Keep in mind that a bet on the TSE 300 this fall was a bet on Nortel, which, at its peak in value, made up more than 30% of the index.

Look at the month ending Sept. 30. The TSE 300 composite index fell 7.6%. The Green Line Canadian Index Fund, which mirrors the TSE 300, fell 7.2%. But the average Canadian equity fund, which is actively managed, lost only 2.6%--beating the index by a fairly substantial margin.

Why? One reason is that good active managers can tilt their investments in more conservative directions and away from high-priced fads. The table below demonstrates that active managers have shown their value during rough patches.

A tough time to be an index   Most actively managed funds beat the market during these troubled years.         1998* 1990* 1988*     Average Canadian Equity Fund** -18.1% -13.6% -10.4%     TSE 300 -19.0% -16.9% -12.9%     Green Line Canadian Equity Index Fund -19.5% -17.9% -14.2%

For those of us who have been around longer than the last five years, and actually remember times when markets did something other than go straight up, this is not a surprise. We have always known that the purpose of active management is to moderate risk and volatility rather than to outperform passive investments.

Sure, index investing does better over the long term-but these returns come with more volatility than a conservatively managed active fund. So, before you decide whether indexing is for you, you should first decide how much you detest financial roller-coaster rides.

This means thinking about the two kinds of risks that are inherent to investing: capital risk, which is the possibility of your investments dropping in value; and opportunity risk, which is the possibility of your investments failing to keep up with rising markets.

If you are concerned about opportunity risk, look to index mutual funds or exchange-traded funds to match the market. Decide which index matches your risk tolerance (for example, the Nasdaq 100 is relatively risky; the S&P 500 less so). Then choose the appropriate fund.

If you are more concerned about capital risk, look for good, actively managed funds with conservative leanings. I recommend the funds from Phillips Hager & North Investment Management Ltd., Leith Wheeler Investment Counsel Ltd. and Mawer Investment Management. These funds will probably outperform indexes when the market is tumbling, giving you better returns in the short term and a more restful sleep at night.