Do Passively Managed ETFs Perform Well?

Recent research established that passively managed funds are gaining acceptance steadily worldwide. While the market share of passive funds in Canada is a solid 15%, this type of fund has become a dominant force in the US market, with 45% of the market. This paper reviews the relative performance of passive ETFs compared to the Canadian retail fund market.

What does “passive” mean?

 “Passive investment” was coined to contrast with “active management”. “Active management” aims to outperform the market with security selection and other strategies. Active portfolio managers attempt to buy “good” stocks and avoid “bad” ones, raise cash when they are pessimistic about the market outlook, and invest more heavily in the sectors that are expected to outperform. Research has demonstrated that the vast majority of actively managed retail funds fail to outperform market indices over ten years. By contrast, passive management buys and holds most securities on the market and accepts from the outset that it will own “good” and “bad” stocks on the premise that the market has correctly priced all stocks, and none of them are “bad” on expectation. A common criticism of passive funds is that they “guarantee average performance.” Our analysis will put this to the test.

One key characteristic that differentiates passive from active is diversification. Active managers need to differentiate their portfolio from the market to outperform. The more stocks you own, the more likely you will perform like the market. Thus, active portfolios tend to be more concentrated, while passive portfolios are typically more diversified. Active funds tend to experience more portfolio turnover: more buy and sell transactions will occur as perceived opportunities appear. By contrast, the composition of the total market only changes slowly over time with IPOs, new issues, stock buybacks, mergers, and acquisitions. Finally, passive funds charge much lower fees than active funds, thus generating substantial savings for investors.

A broad spectrum of funds shares characteristics of both passive and active funds. At one extreme, a “pure” passive fund has broad market exposure (including large, mid, and small capitalization stocks from all sectors) and low portfolio turnover. On the other hand, a “pure” active fund holds a handful of “high-conviction” stocks based on human judgment and will have a high portfolio turnover.

Not All ETFs are Passive

Investors often equate passive funds with ETFs. In Canada, most passive funds are ETFs, but not all ETFs are passive. According to Morningstar data, there currently are 670 passive ETFs and 1,040 active ETFs in Canada, but 70% of the money invested in ETFs is with passive funds. Investors must not expect any ETF to be passive, therefore, to identify passive ETFs, one must look under the hood. The key is whether the ETF portfolio tracks a broad market index. Even ETFs that passively track an index may more closely resemble actively managed funds due to the composition of the underlying index.

How do Passive Canadian ETFs rank among their Peers?

We study Canadian passive ETFs performance by identifying all the “ideal” passive ETFs in the relevant asset classes: Canadian fixed-income, Canadian equity, US equity, international developed market equity and emerging market equity.

Our ideal passive ETFs bear the following characteristics:

• They track a well-recognized broad market index
• Securities are weighted according to their market value
• They have a minimum track record of five years
• For fixed income, they cover the total market
• For equity markets, we include both total market ETFs and large & mid-cap stock ETFs. While total market funds are “ideal” passive funds, large & mid-cap stocks typically make up 85% to 90% of the market, which is close enough.
• We exclude swap-based ETFs because their objective is to optimize returns on an after-tax basis. These products are understandably less competitive on a pre-tax basis due to their higher fees.

For each asset class, we document the percentile rank among peers. For example, a mutual fund or ETF ranking at the 25^th percentile means that this ETF would be among the 25% best-performing funds in its category. In other words, this ETF had excellent returns. Conversely, a fund ranking at the 75^th percentile was among the poor performers for the period under review. We find our data from Morningstar.ca as of May 31, 2023.

The percentile rankings provided by Morningstar have two caveats. First, they are not adjusted for survivorship. Thus, the passive ETF rankings provided here are calculated among surviving funds. On the other hand, the fund universe to which the passive ETFs are compared includes a substantial share of commission-based ETFs and mutual funds, which include a trailer fee to compensate the advisor. The survivorship bias theoretically reduces the reported performance of passive ETFs.  The “commission-based” effect will tend to increase their reported performance. We implicitly assume these two effects offset one another.

Canadian Fixed Income

We identified four Canadian fixed-income passive ETFs with at least five years of data. Our results are displayed in Table 1. Over five years, all the funds rank between the 32^nd and the 41^st percentile. The results are even more compelling over ten and fifteen years, with passive ETFs ranking between the 23^rd and 26^th percentile.

Table 1: Percentile Rankings of Passive Canadian Fixed-Income ETFs

Canadian Equity

Table 2 highlights five Canadian equity passive ETFs with at least five years of history. Over five years, passive ETFs ranked between the 18^th and 27^th percentile. Over ten years, they ranked at the 29^th and 30^th percentile, and the iShares Core S&P/TSX Capped Composite ETF ranked at the 28th percentile over fifteen years.

Table 2: Percentile Rankings of Canadian Equity Passive ETFs

US Equity

Two US equity passive ETFs with at least five years of history are ranked at the 22^nd percentile.

Table 3: Percentile Ranking of Passive US Equity ETFs

International Developed Market Equity

We found five passive international developed market equity ETFs. ZEA and TPE, which only target large and mid-cap stocks, performed well over five years, ranking at the 36^th and 38^th percentile. QDX, XEF and VIU were closer to the median at the 43r^d, 45^th and 54^th percentile. The relative underperformance of XEF and VIU is likely due to the inclusion of small-cap stocks, which did not perform well over the period. However, XEF performed extremely well over 10 years, ranking at the 17^th percentile.

Table 4: Percentile Rankings of Passive International Developed Market ETFs

Emerging Market Equity

Table 5 documents the three passive emerging market ETFs with sufficient history. Over five years, passive ETFs ranked between the 30^th and 53^rd percentiles. Over ten years, their results are far better: they ranked at the 24^th and 31^st percentiles.

Table 5: Percentile Rankings of Emerging Market Passive ETFs

Conclusion

With few exceptions, passive ETFs performed way better than the median Canadian fund in most categories over five, ten and fifteen years. Canadian fixed-income and Canadian, US and emerging market equity passive ETFs excelled, often producing returns within or close to the first quartile. International Developed Market Equity passive ETFs had more of a mixed performance but were still mostly above the median.

Nevertheless, a couple of nuances are essential here.

First, the value of passive ETFs comes from their performance but also from their diversification and the consistent results that come with it. When you hold the total market at a low cost, you have a cost advantage, but you also have a portfolio that will be hard to beat year in and year out because outguessing the market is extremely difficult. Passive ETFs’ excellent past performance is likely to repeat.

Another important point is, as was mentioned earlier, that many mutual fund costs embed a trailer fee to compensate advisors, while passive ETFs do not include such compensation. Therefore, the good rankings of passive ETFs are partly explained by their lighter cost structure, with less service. Investors who value their advisor’s services should consider paying directly for advice (switch to a fee-based account) and invest with passive ETFs. This said, passive ETFs are among the best investment products for do-it-yourself investors by a landslide. In our sample, they deliver above-average performance across all time periods and increasingly strong performance at longer horizons a result that is confirmed by academic research.