Why actively managed funds will fall further behind indexing

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It never pays to gloat over a bad period for index investing.

Led by two sectors left for dead not too long ago, the S&P/TSX composite index is once again outperforming the average actively managed mutual fund. The index made 6.1 per cent for the five months to May 31, while the average Canadian equity fund made 3.7 per cent. Powering the index over this period were the materials and energy sector, up 57 per cent and 19 per cent, respectively, on a year-to-date basis.

Energy and materials have been absolutely dreadful over the past five years, losing more than 35 per cent each on a cumulative basis. With their combined weighting of 34 per cent as of mid-year, these two sectors have been big contributors to the weak overall index returns of recent years. Even the average fund outperformed the index over the five years to May 31, though only by a margin of 3.6 per cent to 3.4 per cent on an annualized basis.

Active managers had a good run during the lean times for energy and materials by underweighting these sectors and loading up on defensive plays like consumer staples Now, that approach can be a liability. Unless energy and materials tank again – it's possible with global economic growth once again looking fragile – then expect active funds to fall further behind the index.

Let's not glorify the index. The S&P/TSX composite is overly skewed to financials and resource stocks and pathetically lacking in technology and health care. You should definitely have plenty of U.S. and international content to provide some sector balance. But don't give up on indexing the Canadian market. As much as those slippery oil and mining stocks can hurt you, they can also power the market to major gains.

The final word on indexing can be seen in the long-term numbers – an average annual 20-year return of 7.5 per cent, compared to 5.8 per cent for the average Canadian equity mutual fund. Subtract maybe 0.1 of a percentage point from the index to cover the cost of owning the lowest-cost Canadian equity ETFs, and you're still way ahead.