In the debate over the merits of investing actively or passively, it’s easy to lose track of a third option. Combining both approaches may be the better way to go.
Some investors prefer to invest exclusively in actively-managed mutual funds, while others are ardent supporters of index investing. But in the debate over which is the best way to invest, we don’t think there is an either/or answer. Rather, by combining both styles, you can build a more intelligent investment portfolio that may provide better results.
Here are three ways you can combine active and passive investing to achieve better results:
■ Buy index funds or exchange-traded funds that track diversified, efficient markets. Buy active funds in narrower, less-efficient markets.
The Canadian stock market is heavily concentrated with financial stocks and resource stocks. This lack of diversification makes a Canadian index offering, such as iShares S&P/TSX 60 Index ETF (TSX—XIU), vulnerable to a setback in just one or two economic sectors.
To solve this problem, pair this ETF with at least one active Canadian equity fund in your portfolio that under-weights these sectors. An example from our Canadian Equity Funds Recommended list is Mawer Canadian Equity Fund.
Mawer has 23 per cent of its assets invested in financial stocks, while iShares S&P/TSX 60 Index is 35-per-cent invested in the sector. And again, Mawer Canadian Equity has about 13 per cent of its assets in resource stocks, whereas the S&P/TSX 60 Index has about 24 per cent of its weight in these stocks.
When you buy index offerings that track the broad US market, you’ll be given a fairly high exposure to technology stocks. TD US Index Fund currently has about 27 per cent invested in tech stocks. Pair this fund with Beutel Goodman American Equity, which has a weighting of just 16 per cent in tech.
Less-efficient markets, meanwhile, are areas where skilled managers can often outperform their benchmarks. These markets are less actively traded and react to information more slowly. Small-cap indices are a good example of this type of market. And in Canada, small-cap indices are not only less efficient, they’re even more heavily concentrated in resource stocks than the larger-cap indices.
■ Use active and passive investing to reduce overall portfolio volatility. By pairing specific index funds or ETFs with similar managed funds that have lower historical volatility, you can reduce the overall volatility of your equity portfolio. For example, iShares S&P/TSX 60 Index ETF has a standard deviation, which is a measure of volatility, of 16. Mawer Canadian Equity’s standard deviation is 15, making it a little less volatile than the index offering.
■ Use active funds to beat the market. A big advantage of index mutual funds and ETFs, of course, is their low cost. Plus, they are more tax-efficient. But you can only expect to earn a return that roughly mirrors the performance of the fund’s benchmark index, minus fees, with these products.
If you want the opportunity to earn market-beating returns, however, then your only solution is active management. Problem is, though, many active managers don’t beat their benchmark indices. But there are managers out there who have done so, and may do so again.
One of our recommended Canadian equity funds, Mawer Canadian Equity, has handily outperformed both the S&P/TSX 60 and S&P/TSX Composite Indexes these past 10 years. The fund’s compound annual growth rate over this time is 8.9 per cent, versus 6.4 per cent for the S&P/TSX 60 and 6.1 per cent for the Composite. We think Mawer Canadian is still a fine selection if you don’t mind the risk of possibly under-performing the main indices.
This is an edited version of an article that was originally published for subscribers in the April 16, 2021 issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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