Faceoff: core or explore

Rick Ferri, father of low-cost index indexing, calls the core and explore strategy the core and pay more strategy—he argues it’s a marketing ploy to justify the high costs of active management.

Simple math

The guiding principle behind the core-only philosophy is based on William Sharpe’s premise laid out in “The Arithmetic of Active Management.” Sharpe calculates that before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar. After costs, the actively managed dollar will fare lower. Sharpe adds, “Any empirical analyses that appear to refute this principle are guilty of improper measurement.”

Some assets will always outperform others. With an explore strategy, investors are tempted to jump to the next fad, continuously buying high and selling low.

In an overall portfolio, you have different core index products covering various asset classes (such as Canadian bonds, REITs, Canadian equities, U.S. equities, international equities and emerging markets equities). If one asset class is outperforming, you’d sell it and buy the underperforming asset class.

Risk averse

A core-only philosophy is not necessarily risk averse. If risk is volatility, both core and explore portfolios can increase or decrease the amount of volatility by increasing or decreasing their exposure to stocks.

If risk is deviation from the market, again, stick with a core-only philosophy. If you’re less risk-averse in terms of tracking error to the benchmark, consider tilting the stock component of the portfolio to small-cap and value companies for higher expected returns and risk. You should broadly diversify across these companies and keep costs at a minimum. But that’s still a core strategy.

Historical evidence

If we compare the S&P indices and Active Funds (SPIVA) scorecards for the so-called inefficient asset classes, such as emerging markets stocks, U.S. and Canadian small-cap stocks and high-yield bonds, a similar trend emerges:

1. As of year-end 2012, 80% of actively managed U.S. small-cap core funds lagged the benchmark S&P Small-Cap 600 Index over five years.
2. As of year-end 2012, 76% of actively managed emerging markets funds lagged the benchmark S&P/IFCI Composite Index over five years.
3. As of year-end 2012, 95% of actively managed high yield funds lagged the benchmark Barclay’s High Yield Index over five years.

Most of this lag was due to higher management fees. The only discrepancy appears in the international small-cap arena. As of year-end 2012, only 21.05% of actively managed funds lagged the benchmark S&P Developed ex-U.S. Small-Cap Index over five years. But if we change the benchmark index to the MSCI World ex USA Small Cap Index, we see a 3.5% improvement in benchmark returns, which may change the results.

Core holdings

I use broad-market ETFs that buy all the companies in the index. For the Canadian market, I use the BMO S&P/TSX Capped Composite Index ETF, which holds roughly 250 stocks. I use the Vanguard Total Stock Market ETF for the U.S. market. It comprises roughly 3,300 companies. For international emerging markets, I use the Vanguard Total International Stock ETF, which encompasses roughly 6,000 companies. It is broadly diversified across markets and company size.

Alfred Lee, Portfolio Manager & Investment Strategist, BMO Asset Management Inc.

Stance: Core and explore

Investors should reap the rewards of combining passive and active investment styles.

ETFs have evolved beyond traditional index-tracking products into alternative-weighted strategies such as low-volatility and dividend-weighted indexes. You could complement strategic holdings with tactical positions in various asset classes through ETFs or mutual funds that take advantage of market pricing anomalies or strong market sectors. Another way is to combine ETFs with non-traditional asset classes such as U.S. high-yield bonds, preferred shares or emerging-market debt.

Seasonal strategies

The TSX is weighted 75% in financials, energy and materials. While that concentration may have worked in the last 10 years due to a commodity super cycle, it may not fly going forward. Emerging markets are looking to internalize growth and move away from infrastructure-related stimulus programs, and commodity consumption rates of some developing countries are waning. As a result, a market cap Canadian index product could underperform markets such as the U.S.

Despite those headwinds, areas in the Canadian market have outperformed. Over the last year, the consumer staples and consumer discretionary sectors have delivered total returns of 28.5% and 28.3%, respectively, easily outpacing the TSX’s 8.1% total return.

Low-volatility ETFs based on Canadian equities have also fared well in the last several years, whereas the S&P/TSX Composite has faltered. Instead of weighting stocks in a portfolio by their market cap, low-volatility ETFs emphasize stocks with lower price variances, providing more defensive exposure.

Alternative beta strategies include equal- or dividend-weighted index funds. As the name suggests, every stock in an equal-weighted index—Apple Inc. or Expedia—has the same weight.

The S&P 500, for example, has an equal-weighted version. Although both indexes comprise the same stocks, their different weighting conventions result in different outcomes. The S&P 500 market-cap-weighted index is over-weighted in large-cap companies. A market-cap-weighted index may expose investors to company-specific or idiosyncratic risk, given its concentration of larger stocks. An equal-weighted index, on the other hand, aims to minimize stock-specific risk by placing an equal emphasis on each stock, but may introduce a smaller-cap bias.

A combination of such different concentrations—both size and sector—can dramatically improve the efficiency of an overall portfolio.

Further, over the last several years we have recommended overweighting U.S. relative to Canadian equities to generate alpha and/or lower the risk profile of portfolios. Since the beginning of 2010, the 35.0% total return of the S&P 500 Composite has outpaced the -3.0% of the TSX Composite.

Institutional inspiration

The institutional world has been using explore strategies for several decades. And while it isn’t a new concept for many retail investors, it has been made more readily available given the abundance of products now available. Most investors today construct portfolios based on a core of index funds for cheap access to beta, sprinkled with actively managed products designed to capture alpha. The recession has taught us it’s a more constructive and systematic way of generating alpha. Instead of making active bets overall, take a portion of your portfolio in a certain asset class (e.g., Canadian equities), and invest it passively. That guarantees part of your portfolio will get market-like returns. The remaining percentage is where you take active risk—go with an active manager or an alternative-weight ETF.

Cost concerns

A growing number of active managers can now be accessed through ETFs, which can bring down costs considerably.

Investors should look beyond returns, and consider the investments from a risk-adjusted perspective. Consider that 37% of managers in the Canadian equity market have a higher Sharpe ratio—a measure of the excess return per unit of deviation—than the TSX. Even though they’re not necessarily beating the index, these managers are getting better returns for the amount of risk they’re taking, which means they’re being more efficient with the risk.

For emerging markets, a third of the managers outperformed the market on a risk-adjusted basis; for U.S. small caps, 46% of the managers did so over a three-year span (from 2009 to 2012). While that may not seem like a high number, it is a large enough selection to construct high quality core-satellite portfolios.

Asset mix

For many investors, the simple core of a portfolio tends be an ETF that tracks the DEX universe for overall bond exposure. However, if interest rates continue to rise, investors might want to tactically position themselves in the short end of the curve, and increasing their exposure to corporate bonds.

Among equities, traditional asset allocation models tend to utilize the TSX for Canadian exposure, S&P 500 for U.S. representation, and an MSCI EAFE and MSCI Emerging Markets for international and emerging markets.

Among explore components, U.S. investment grade and U.S. high-yield bonds could provide diversification to Canadian bonds. In addition to low-volatility and dividend-weighted ETFs, preferred shares could also provide yield and more stability to the equity component of a portfolio.

Given the recent concerns about rising interest rates, we’ve been advocating industrials and U.S. health care as tactical exposure. For the last nine months, we’ve also been leaning toward U.S. banks as we believe they’re well exposed to the U.S. housing recovery.

The decision of active or passive should not be mutually exclusive. Further, you shouldn’t just set and forget asset mixes. Instead, to improve the risk-adjusted characteristics of a portfolio, make tactical adjustments made during key inflection points of the market, not only within and across multiple asset classes, but also between active and passive mandates.

Kanupriya Vashisht is a Toronto-based financial writer.