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

5 Jan

For most investors, implementation consists of simply ‘biting the bullet’ and putting real money into action. However, we can learn from people with successful pension plans who first complete a due diligence process, and then implement their IPS by proceeding with the investment options and strategies pro­posed by an investment management consultant.

This is an appropriate time to address, debate and resolve some remaining theoretical issues including passive versus ac­tive money management approaches; pooled versus separate ac­count portfolios; dollar-cost averaging versus lump sum investing; and market timing versus strategic asset allocation. Passive versus active investment strategies: Passive investing is also referred to as ‘indexing’. It involves buying an invest­ment product that contains the entire basket of securities that make up a particular index, such as the Standard and Poor’s (S&P) 500 or the Toronto Stock Exchange (TSE) 300. For ex­ample, if after a thorough assessment, the asset allocation calcu­lated as optimal for a particular investor consists of 40% in Canadian equities, and the TSE 300 is selected as the appropri­ate benchmark against which to compare the performance of that portion of the portfolio, then a purely passive strategy would be to invest 40% of the portfolio in a TSE 300 index mu­tual fund.

This is in contrast with active management, where a money manager sorts through the universe of stocks and bonds, and se­lects only those that are appropriate for the investor’s invest­ment objectives as well as consistent with their own particular management style or investment specialty.

Indexing, or passive management, has been around for a long time but gained significant popularity in the late 1980s. Reviews of performance results of equity money managers through the 1980s suggested that some 60% of those managers ‘underperformed the indexes’. This underperformance, coupled with higher fees and transaction costs for active manage­ment, convinced many institutional investors to switch from active to passive management strategies.

In light of such research, some well known and respected academicians and practitioners supported the argument that us­ing active management to try to beat the indexes was not worth the risk. However, the research on which many of them based their recommendations did not separate money managers into investment styles (such as value versus growth), nor did it cate­gorize managers according to their average portfolio capitaliza­tion weightings (as in small capitalization versus large capitalization). All equity managers were grouped together and compared with a single index as the benchmark, the S&P 500.

Had such variables been considered in determining which index to measure managers’ performances against, the conclu­sions would undoubtedly have been different. Today, active eq­uity managers typically build portfolios containing stocks that are not as large in capitalization weighting as those of the S&P 500. Therefore, when large capitalization American stocks per­form well, as was the case in the mid- to late 1980s, the S&P 500 index outperforms active managers. When mid-capitaliza­tion stocks perform well, thanks primarily to technology and Internet companies, as was the case in the late 1990s, active managers specializing in these stocks tend to outperform the S&P 500.

It can be argued that the average mid to large cap Canadian equity active manager has not added much value to portfolios over the past 10 years (Figure 1). In fact, when management fees are included, active managers may have underperformed the index approach (using the TSE 300) over this 10-year time frame.
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Either indexing or active management should be chosen for a portfolio by comparing managers’ performance with indexes that provide a benchmark appropriate for those managers’ par­ticular styles. The S&P 500 is a proper index to use as a bench­mark in the case of ‘large cap’ equity managers, but obviously not for every equity manager. As the need for matching indexes to manager style becomes more widely recognized, less known indexes (such as the value and growth indexes of BARRA and Wilshire, respectively) are becoming more accepted and used in the marketplace and, therefore, more accessible in financial publications.