Episode #74: Update on market volatility and review of active vs passive management

• INTRODUCTION

François Doyon La Rochelle:

You’re listening to Capital Topics, episode #74!

This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.

Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.

In our podcast today we will discuss the current volatility in the stock markets, and then revisit the state of ETFs Landscape in Canada, as well as the debate between active and passive funds.

Enjoy!

• UPDATE ON MARKET VOLATILITY AND REVIEW OF ACTIVE VS PASSIVE MANAGEMENT

François Doyon La Rochelle:

Hello, James! How are you today?

James Parkyn:

I’m very good, Francois. And how are you?

François Doyon La Rochelle:

I’m fine, thank you! Before we tackle our main topic today, we believe that it’s essential to address the current market volatility triggered by American tariffs, imposed on the Global economy. James, what do you want to share with our listeners?

James Parkyn:

François, it is at times like this, that most investors get to know their true tolerance to risk and downside financial market volatility. But one fact remains, when you have a long-term investor mindset, short-term macroeconomic events should not change your long-term investment plan. What investors need to keep in mind is that you have no control over markets.

François Doyon La Rochelle:

We’ve said it many times, you can’t predict human behavior, but you can control your own emotions. We have also said many times on our podcast, this is simple but not easy to do. What you need to do is to tune out the noise.

James Parkyn:

It’s at times like these that it is useful for François to review some of Warren Buffet’s famous quotes about investing.

François Doyon La Rochelle:

Well, James, the one I like most in this context is “stocks are safe for the long run and they’re very unsafe for tomorrow.”

James Parkyn:

François, I would like to share with our listeners something I read recently in my LinkedIn network. This was published by an American investment thought leader. He highlighted that there are 3 different types of investors in volatile markets:

• The 1st one is Headline Reactors, who follow the noise of the financial press and generally buy high and sell low. Their greatest advantage isn’t information but what information to ignore.
• The 2nd is Paralysis Victims, who are frozen by uncertainty. They miss out on taking advantage of cheaper prices in the markets. They don’t invest or they don’t rebalance their portfolio to their long-term investment plan. They are waiting for the quote “The right time to buy” which is when it will feel safer.
• The 3rd much smaller group is Strategic Operators. Like Warren Buffet, they understand this is when fortunes are made. They tune out the noise and manage their emotions sticking to their long-term investment plan.

François Doyon La Rochelle:

Yes James, if you have a well-thought-out long-term investment plan, what’s best for investors in times of uncertainty, like what we are living through now, is to stick with it.

Now for the main topic today we will give our audience an update on the ETF landscape here in Canada and the worldwide usage of passively managed retail funds.  In addition, we will also review, as we have done in the past, the Morningstar Active vs Passive Barometer for the U.S. and SPIVA Canada Scorecard from S&P Dow Jones Indices. Both of these reports measure the rate of success of active management compared to passive alternatives.

James Parkyn:

There is a lot to cover François, so where would you like to start?

François Doyon La Rochelle:

Well, James, I will start with an update on the ETF landscape in Canada and make our way to the other topics.

James Parkyn:

Ok, great let’s jump right into it.

François Doyon La Rochelle:

So, as I believe most of our listeners know, the popularity and growth of ETFs have been extraordinary in the last few years. According to National Bank Financial Markets, assets in Canadian listed ETFs at year-end 2024, have now surpassed the half-trillion mark to reach $519 billion of assets under management. This represents an annualized growth rate of 21% over the last 10 years.

James Parkyn:

Wow, that’s impressive François. The industry has grown tremendously from when we first started using ETFs at PWL back in the early days of 2001-2002. Back then, I think there were only two ETF providers in Canada with only a handful listed ETFs. So where is the ETF industry now?

François Doyon La Rochelle:

Well, James, believe it or not, there are now 1,497 ETFs listed in Canada and 45 ETF providers. In 2024 only, 224 ETFs were launched and Canadian ETFs gathered $76 billion in assets. A record year in terms of inflows.

James Parkyn:

François, the last time we reviewed this topic for our listeners I believe you had mentioned that a high percentage of the newly launched ETFs were active ETFs. Is that still the case?

François Doyon La Rochelle:

Indeed, James, the total number of passive ETFs hasn’t changed much since 2021 but in the last five years, an average of 119 active ETFs were launched every year in Canada. They now represent more than half (53%) of all Canadian ETFs and in terms of assets under management, they have gathered 161 billion dollars which represents 31% of the total assets in Canadian ETFs, up from 25% in 2021.

James Parkyn:

That statistic is an eye-opener for me. I don’t think that the growth of active ETFs is good news for Canadian investors. I recently came across an article from Morningstar entitled “15 Funds That Have Lost the Most Value for Shareholders Over the Past Decade” and this article makes it clear that some types of ETFs are real wealth destroyers for investors.

François Doyon La Rochelle:

Yes, James, I read this article, and out of the 15 funds that have destroyed the most wealth for shareholders over the last 10 years,13 of them were ETFs. These are not your plain vanilla total market ETFs, but the more specialized ones, the ones that invite investors to trade, to speculate. In that list, there are leverage and inverse ETFs but also active ETFs. In the active category, the once high-flying ARK ETFs that made the headlines and attracted huge inflows in 2020 and 2021 are now listed as being the fund family that destroyed the most wealth in the past 10 years for investors at an estimated US $13.4 billion.

James Parkyn:

Well, I guess Francois, some investors will never learn. Investors are reacting to past performance which is often random but in the end, they get burned.  As Morningstar puts it and I quote “Volatile and speculative categories as well as fund companies and active managers that attract a lot of short-term hype, are best avoided”.

François Doyon La Rochelle:

I could not agree more. There is another quote in the article that summarizes our view and I quote “ETFs have many things going for them—including low costs, tax efficiency, and typically a passive investment approach that makes them suitable building blocks for diversified portfolios—but they can have a dark side. For instance, some ETFs focus on narrowly defined sectors or themes, which can make them harder for investors to use successfully and can attract speculators”. The good news however and I’m referring to the National Bank Financial Markets report that I highlighted earlier is that low-cost index-tracking market cap weighted ETFs still dominated inflows of funds in Canada with 29 billion dollars in 2024 out of the 76 billion dollars.

James Parkyn:

Exactly right François, that’s good news and it’s in line with the latest report from our good friend and colleague Raymond Kerzerho who highlighted in his report entitled “The Passive Versus Active Fund Monitor”, that passive funds dominated capital inflows and increased their market share not only in Canada but around the world last year.

François Doyon La Rochelle:

Correct James, according to his report passive funds attracted more new money than active funds in Canada, the US, and the rest of the world. Passive funds in Canada now have a market share of close to 20%. In the U.S., that market share has now surpassed the 50% mark and is currently at 53%, and in the rest of the world, the passive share has now reached 30%. Globally, passively managed funds have increased their market share steadily since 2015 and they now sit at 43%. Passive funds in the last 10 years have attracted US 8.7 trillion dollars while active funds saw outflows of US 839 billion dollars.

James Parkyn:

What is clear is that passive dominates active in terms of new funds invested. However, Raymond, in his latest report, cautions against drawing the simplistic conclusion that 43% of the market is passively managed. Here is a quote from his report “Even portfolios holding truly passive funds are often managed with an active approach based on “tactical” views. Plenty of individual investors and financial advisors can’t resist the temptation of market timing, no matter how flawed this activity may be. Holding passive funds does not make, in and of itself, a passive investor.”

François Doyon La Rochelle:

Well James, we mentioned this several times in the past, and podcast #68 was exactly on this topic when we reviewed Morningstar 2024 Mind the Gap report. A report we may review again this year.

James Parkyn:

Well, François, I think our listeners know that we are not fans of market timing and active management, and I think the latest Morningstar Active vs Passive Barometer for the U.S. and SPIVA Canada Scorecard from S&P Dow Jones Indices support our view that holding passively managed funds with a buy and hold investor mindset is the way to go.

François Doyon La Rochelle:

Exact and the results are quite compelling again this year. Looking at the SPIVA Canada report which measures the performance of actively managed funds against their respective benchmark or index, 2024 was yet another difficult year for active management in Canada.

James Parkyn:

Indeed Francois, across all fund categories covered by the report, an average of over 80% of active funds underperformed their benchmarks last year. International Equity funds had the lowest 1-year underperformance with close to 72% of them trailing their benchmark and the Dividend and Income Equity funds were the worst with almost 96% of them underperforming.

François Doyon La Rochelle:

I’m always shocked when I see these levels of underperformance, especially when we know that underperformance rates are generally higher as the time horizon increases.

James Parkyn:

Francois to that point, over the last 10 years, an average of 93% of active funds underperformed their benchmarks. The best-performing fund category was Canadian Small and Mid-Cap with 82% of managers underperforming their benchmark and the worst was Canadian Focused Equity funds with 100% of the active funds underperforming.

François Doyon La Rochelle:

To be fair to active managers James, when we review the performance of active funds against benchmarks, we must acknowledge that those benchmarks or indexes are not investible without incurring any fees.

James Parkyn:

I agree with you Francois, however, the underperformance in some fund categories can’t be explained by the differential in fees. For example, funds benchmarked against the S&P/TSX Composite Index underperformed by 4 percentage points the index last year and funds benchmarked to the S&P World Index underperformed by 9 percentage points the index. The active managers in the S&P World Index category left 1/3 of the performance on the table last year since the benchmark gained 30%.

François Doyon La Rochelle:

How are these poor returns explained, James?

James Parkyn:

Well, the SPIVA report highlights that since a minority of stocks drove most of the gains and that fewer than half of the constituents beat their benchmark in all the fund categories last year, poor stock selection by active managers is to blame.

François Doyon La Rochelle:

That’s the same reason as last year, if you don’t have the right stocks in your portfolio, you will underperform the indexes. Our listeners need to remember, over the long run only a small percentage of stocks generate most of the returns in the equity markets.

James Parkyn:

Now let’s look at the results in the US. For this, we use The Morningstar U.S. Active vs Passive Barometer. The Morningstar methodology is different from the S&P Spiva report. Morningstar measures active fund performance against their respective passive peers’ net of fees. I believe this is more of a fair comparison.

François Doyon La Rochelle:

The results from the Morningstar report demonstrate once again that active mutual funds and ETFs underperformed their passive peers last year. Like in 2023, the average success rate of active managers was only 47%. This means that throughout the 20 different fund categories on average only 47% of active managers were able to beat their passive peers. Over ten years less than 22% of active strategies survived and beat their passive counterparts. Also, as in the previous reports, if you increase the time horizon to 15 or 20 years, the success rates of active managers drop even further.  The only silver lining I see for investors who still want to believe that active management is better than passive is to select funds in the cheapest quintile since their rate of success is 11 percentage points higher than for the priciest funds. The success rate after ten years is nevertheless low at only 28%.

James Parkyn:

Francois, I think this covers what we wanted to talk about today. To conclude, I will quote from our colleague Raymond’s report: “Passive funds offer advantages that active funds can hardly compete with, including lower management fees, lower

transaction costs, consistently higher returns, transparency, tax efficiency, and peace of mind for investors.”

• CONCLUSION

François Doyon La Rochelle:

Thank you, James, for your contribution again today.

James Parkyn:

My pleasure, François.

François Doyon La Rochelle:

That’s it for episode #74 of Capital Topics!

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