October 16, 2020 – The past year’s historic volatility presented investors with an opportunity to stand out from the unwieldy and substandard performance of the Canadian benchmark index. The first quarter’s historic market drop, in which the S&P / TSX Composite fell more than 37% in just 22 days, should have allowed Canadian equity fund managers to stand out from the benchmark.

Unfortunately for most Canadian investors, the majority of long-only Canadian equity mutual funds woefully underperformed the major stock market index. In fact, according to S&P Dow Jones Indices, a stunning 88.4% of Canadian equity mutual fundsunderperformed the S&P/TSX Composite Index in the 12-month period ending June 30, 2020.

The underperformance of Canadian equity mutual funds appears to be a long-term trend.

When aiming to closely match the index without differentiating too much, known as “benchmark hugging”, in aggregate, mutual funds would earn the returns of the index minus their high fees.

Benchmark hugging, which is prevalent in Canadian mutual fund management, effectively guarantees the industry’s underperformance on average.

Clearly, a different approach is needed.

What is an Enhanced Index?

Index investing is extremely popular these days. Investors can pay low fees for matching the index return through low-cost index ETFs (with no risk of underperforming, however no opportunity for outperformance either).

Allocating to a low-cost index ETF seems like a sensible strategy to get broad-based equity exposure (within a diversified portfolio), given that long-only mutual funds charge high fees for seemingly consistent underperformance.

An enhanced index is fairly straightforward, such that it represents exposure to the broad equity index that is, obviously, enhanced in some way. There are many ways to enhance index exposure, including tax strategies, derivative strategies and overlay strategies.

One methodology of an enhanced index is an overlay strategy, in which a long-short portfolio is overlaid upon the index exposure to accomplish two objectives:

  1. Outperform the index over the long-term while tracking it relatively closely, and
  2. Exhibit lower downside participation compared to the index;

This enhanced index with a long-short overlay is referred to as Alpha + Beta.

What is Alpha + Beta Investing?

Alpha + Beta refers to a strategy that combines the index returns (“Beta”) with a long-short multi-factor overlay portfolio (“Alpha”).

In “Alpha + Beta: One Year In,” I stated that “Alpha + Beta represents one of the latest innovations in investment management because it offers a considerable improvement over the traditional index.”

What makes the Alpha + Beta strategy great, conceptually, is it combines two major psychological forces to the benefit of investors:

  • The Beta component of the strategy tracks the index, therefore, the strategy’s return exhibits a reasonable correlation to the broad market index. This index tracking allows investors to stick with the strategy long-term by eliminating the psychological challenges that accompany strategies that deviate too much from the index.
  • The Alpha component, as represented by a long-short multi-factor overlay portfolio, not only adds long-term upside given the overweighting of securities with the highest expected return but mitigates downside risk by short-selling securities with the lowest expected return. This long-short alpha overlay component provides investors with additional performance along with risk-mitigation characteristics.

Generally, Accelerate implements Alpha + Beta as follows:

  • 100% index exposure,
  • 50% exposure to the long multi-factor overlay and,
  • 50% exposure to the short multi-factor overlay;

Investors can access an Alpha + Beta strategy through the Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX), a publicly-listed ETF.

How Does Alpha + Beta Stack Up?

The 12-month period ending June 30, 2020, represented an interesting point in time. We had a year-end market rally, followed by the swiftest bear market in history in the first quarter, and then a substantial bounce back.

Unfortunately for Canadian equity mutual fund managers, they underperformed the index markedly, with the average Canadian dividend and income equity fund dropping -8.4% compared to the -1.4% decline of the S&P / TSX 60.

Alpha + Beta, represented by the Accelerate Enhanced Canadian Benchmark Alternative Fund, finished up 3.7% over the same period, ahead of the S&P / TSX 60 Index by 5.1%. More importantly, it provided investors with positive returns while the average Canadian dividend and income equity fund lost nearly -10%.

Source: Accelerate, Bloomberg, Globe & Mail
Not only did Alpha + Beta outperform the equity index by a material amount, while nearly all equity mutual funds underperformed, but Alpha + Beta accomplished this with lower volatility and less of a drawdown. One key aspect of Alpha + Beta is its ability to mitigate risk for investors, lowering downside volatility and leading to potential long-term outperformance.

Tired of Underperforming the Index? Here’s What to Do

If you own a Canadian equity mutual fund, it may be time to leave it for good and invest in the index (where you are guaranteed the average return, not more underperformance). An investor may consider enhanced indexing through an Alpha + Beta strategy, for those interested in a different approach, exhibited by a track record of success

-Julian

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