Republished courtesy of the National Post
by Tom Bradley

Bifurcate (v): to divide into two branches or forks

I don’t usually use such big words, but this one fits nicely with what’s ahead in the investment world. Let me explain.

The wealth management industry is large and highly competitive, so there are always assets in motion. One of the biggest transitions will be the redistribution of what I call the “mushy middle.” That is, funds that purport to be actively managed, but instead closely follow an index. In the industry, they’re affectionately referred to as closet indexers or index huggers.

Indexing, of course, is a perfectly good strategy. Its main advantage is low cost. Unfortunately, closet indexers are not low cost. They charge a fee that suggests an active attempt to beat the index.

Why so mushy?

In Canada, there are hundreds of billions of dollars in this category, which begs the question. How did we get here?

First of all, most closet indexers didn’t start out that way. They were truly active funds, but with success, they grew to a point where the manager had little choice. The larger the fund, the harder it is to look different than the index. This is particularly true in the small Canadian market where managers are forced for liquidity reasons to own the largest stocks in the index.

Some of the hugging has emanated from the institutional side of the business. Pension funds often have consultants who monitor their investment managers. This constant scrutiny pushes managers towards the middle because committees want index-beating returns with little deviation from the index (referred to as tracking error). The words “overweight” and “underweight” are used repeatedly to describe strategies linked to the index. “We’re overweight oils and underweight banks.”

The next factor relates to tracking error. Like anyone, portfolio managers must manage their career risk. They can’t afford to lag too far behind the index or they’ll lose their job. The not-so-subtle message from management is, “don’t have a really bad year and cripple our sales momentum.”

And finally, the emergence of the bank branch as a force in wealth management has fed the mushy middle. The Big Five’s distribution network is so powerful, they don’t need to get adventurous with their products. Down the middle is just fine. And of course, their managers also have the size issue to deal with. Most core bank funds have billions of dollars in assets.

Game changer — cheap indexing

With the evolution of low-cost indexing via ETFs and the likely elimination of trailer commissions, the mushy middle is about to undergo a bifurcation. I suspect a majority of the assets will go the ETF route, as indexing has momentum behind it and is most similar to the mushy funds.

Some assets, however, will go the other way. Maybe it’s wishful thinking (our firm is on the active side), but I believe many investors still want a chance of beating the index over time. They’ll look for non-index strategies to fit the bill.

Giving active a better shot

Beating low-cost index funds is hard. For fund managers to do it, some changes are in order.

First, they need to be truly active, which means looking and behaving differently than the index.

Second, they need to keep their fees under control. There are plenty of managers who add value on a “pre-fee” basis, but not by enough to offset the big price tags on their funds. The fees charged by active funds must reflect the probability and magnitude of excess return.

Third, managers need to tout the benefits of their approach. For instance, active funds generally hold up better in down markets. For many individual investors, this smoother pattern of returns is a good fit with their goals and personality.

And finally, active managers need to point advisers and the media toward fairer performance comparisons. I say this because the often-quoted SPIVA survey (Standard & Poor’s Indexing versus Active) is seriously flawed. It compares mutual funds after all fees (including trailers) to index returns with no costs or tracking error. An apples-to-apples comparison would be ‘F’ series mutual funds (no trailer) and actual ETFs.

The time of reckoning is coming. If active managers aren’t willing to address these issues, they won’t survive the Great Bifurcation.