Taking action: Implementing your written investment plan. BITING THE BULLET part 2

6 Jan
2012

The Europe Australia Far East (EAFE) index is the most widely used benchmark for evaluating the performance of for­eign equity money managers. It is interesting to note that inter­national managers have performed much better than their Canadian counterparts compared with passive forms of money management (Figure 2). Some argue that there are more oppor­tunities to capitalize on market inefficiencies in some of these less developed markets and that it is, therefore, easier to exploit over-reactions to market activities.

The advantages of indexing are as follows.

  • An index mutual fund buys securities across all the sectors of the market represented by that index. This provides built-in diversification and avoids money manager risk because managers’ areas of specialization tend to be more sector specific.
  • For smaller investors, indexing may cost less to implement because purchases can be executed with mutual or pooled funds, and transaction and administrative costs are shared among all investors in the fund.
  • Indexing allows for a great degree of certainty when matching the risk/reward profile of the investor to the performance measurement standards established in their written IPS.

The disadvantages of indexing are as follows.

  • If a given market drops, the respective index fund will drop proportionately, whereas an actively managed portfolio with a basket of securities of superior quality may drop less than the market during that same correction.
  • Active management can more readily take advantage of mispriced securities as investment opportunities.
  • Indexing can lead to underdiversification when only well known indexes containing large capitalization stocks (TSE 300 or S&P 500) are chosen. This can expose a portfolio to the ‘large cap’ bias inherent in choosing such indexes.
  • When an active manager believes that securities have become overpriced, that manager has the option of increasing the size of the cash component in their portfolio. Then, if a correction occurs, the cash portion can cushion the portfolio from losses that would have been incurred had the portfolio been fully invested.
  • Improved technology has made the development of indexing possible. The same technology has also made it possible to discover inefficiencies in the market that make indexing an imperfect practice. In other words, it is now possible for active managers to exploit the price inefficiencies in the markets caused by the buying or selling activity of large institutional investors when their trading of large blocks of securities moves stock prices dramatically up or down.
  • The returns of an index fund always vary from the performance of the index it replicates, due primarily to three factors: the commission costs of executing purchases and sells within the fund; the fact that some portion of the

fund will always be in cash, either awaiting investment or raised to meet redemptions; and the cost of management fees. This difference in performance and its causative factors are collectively referred to as the tracking error of the fund.

Pooled versus separate account portfolios: ‘Pooled portfolios’ are commonly referred to as mutual funds. As you probably know, they represent the combined assets of a group of investors with the same investment objectives, managed by an invest­ment expert with a formally stated set of objectives. On the other hand, the ‘separate account portfolios’ referred to here are managed on a ‘discretionary’ basis by qualified professional money managers. ‘Discretionary’ refers to the managers’ re­sponsibility to make the day to day decisions and execute trans­actions on behalf of their clients as long as these decisions fall within the guidelines established in a contract between the cli­ent and the manager.

Figure 2) A ten-year perspective

Figure 2) A ten-year perspective of active versus passive strategies internationally. Note that all returns are gross of fees. Avg Average; EAFE Europe Australia Far East; Int’l International; MSCI Morgan Stanley Capital International. Reproduced with permission from Northern Trust Global Advisors, Inc

‘Separate account portfolios’ differ from most common in­vestment accounts with a stockbroker in that it is rare for bro­kers to be qualified or licensed to manage accounts on a discretionary basis. According to securities regulations, brokers must ask for and receive consent on every transaction in a cli­ent’s account before executing that transaction. Failure to do so is the practice of ‘discretionary trading’ by stockbrokers and can lead to not only serious penalties, but also, in extreme cases, the removal of their license to practice.
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