Morneau Shepell maintains a proprietary database with detailed data on hundreds of DB plans. Every so often, it yields up some interesting tidbits of information. For example, consider the prevalence of active versus passive investment management. You might be surprised at the percentage of plans that are actively managed, but let’s set the stage before revealing the answer.
Active versus passive management is an ongoing debate that we are not going to resolve any time soon. Some of the evidence in favour of passive management is intriguing, though, and certainly seems worthy of further study if nothing else. As is described in a 2009 paper by Sprott School of Business professor Vijay Jog, the existing studies—which are predominantly American—reveal that (a) mutual funds net of fees underperform the benchmark indexes, (b) managers don’t do well trying to time the market and (c) superior performance reverts to the mean.
I’ll pick up on the third point. You would think that superior skill in investment management would persist over the longer term, the same as it does in other endeavours that clearly involve skill. For instance, Miguel Cabrera is likely going to keep batting .300 or more on a regular basis. Barring injury, Alex Ovechkin will find himself among the top goal scorers year after year.
We don’t find Cabreras or Ovechkins in the investment world. If we did, the same managers would remain in the top quartile year after year. This isn’t what happens though. As Vijay Jog points out, there is a remarkable lack of persistency among Canadian fund managers. Over a certain 19-year period in one study, no one manager did well consistently. It’s sort of like seeing a .300 hitter dropping down to .150 for a few seasons for no good reason.
While the Canadian Institute of Actuaries is careful not to make a definitive statement on whether active management adds value, the instructions given to actuaries suggest they are ambivalent at best, if not downright skeptical. The guidelines they provide to actuaries stipulate that “the actuary would assume that there will be no additional returns achieved, net of investment expenses, from an active investment management strategy…” unless the actuary has supporting data that show such additional returns will be consistently and reliably earned over the long term. This turns out to be a severe test, and, to my knowledge, no actuary attempts to show it.
I have no wish to prove that active management isn’t worthwhile. I am merely trying to show that if all plan sponsors delved more deeply into the data, one would expect to see a healthy percentage of plans that are invested passively.
That’s why the actual statistics are so shocking. Our database shows that 96% of DB pension funds are actively managed. A mere 4% are managed using passive investments such as index funds or exchange-traded funds.
What’s more, active management is more popular among the small pension funds in our database than it is among larger plans. This is counterintuitive for a couple of reasons. Smaller funds stand to gain more from passive management because they will reap a bigger drop in management fees in percentage terms than is the case for larger plans. Moreover, smaller plans cannot afford to devote as much time and effort to meeting and monitoring active managers, whereas passive management would reduce their governance burden. In spite of this reasoning, 98% of plans with less than $25 million in assets use active management versus 89% of plans over $150 million.
So why is active management so dominant in the Canadian pension market? My guess is that it is primarily because many plan sponsors haven’t seriously considered the question. To be fair, if they did, they might conclude that the Canadian data is not robust enough to make a move nor is all the data in favour of passive management.
Active management does add some value in certain situations, such as down markets. Another reason that active management remains in vogue is that it keeps pension committees engaged. Bringing the investment manager in to share his or her insights is usually the most stimulating portion of pension committee meetings. Finally, there is the comfort that comes from doing what virtually everyone else is doing.
While I probably come across as a die-hard fan of passive management, I should disclose that my own personal assets are held in actively managed pooled funds, with an institutional manager. This isn’t as much of a contradiction as it sounds. The fee difference in my case is about 30 basis points annually (maybe less if my manager adds at least some value) but I do receive nicely bound reports, regular rebalancing of asset mix without having to lift a finger, and when the market plummets (as it did in 2008–2009), I can minimize the angst by shutting my eyes and leaving the mess with my fund manager. My point is, I, at least, considered passive management before dismissing it. Shouldn’t Canadian pension funds be doing the same?