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Fund Categories Explained: Is Your ‘Active’ Fund Secretly Passive? | Canadian Investing · How Canadian Markets Work

0:00
So imagine you're logging into your brokerage
0:02
account today, right? And you decide to buy a
0:04
mutual fund. OK, sure. And the label at the top
0:07
of the screen probably says, I don't know, Canadian
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equity growth. Right. And you feel pretty good
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about it. I mean, it sounds sturdy, forward -looking,
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safe. But what if I told you that that label
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is essentially just a lie? Yeah, that's a harsh
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reality. What if instead of buying this broad
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stable market you imagine, you've actually just
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bought a portfolio of like 12 highly volatile
0:31
micro cap companies that aren't even in the main
0:34
index. It's I mean, it is a terrifying realization
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for a lot of investors when they actually look
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under the hood because the marketing department
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at a fund company, you know, they get to choose
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the name on the brochure. And unfortunately,
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they are heavily incentivized to name those funds
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based on what is currently selling, not based
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on what is actually inside the portfolio. Which
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brings us right to the core of our deep dive
0:57
today. Because in our previous discussion...
0:59
You know, we spent a ton of time looking at the
1:02
structural plumbing of these funds. Yeah, right.
1:04
The whole custodian versus manager dynamic. Exactly.
1:07
We explored that crucial separation of powers,
1:10
like how the fund manager makes the investment
1:12
decisions. But this completely separate entity,
1:15
the custodian, actually holds your money. Yeah.
1:18
To protect you from the manager basically going
1:21
bankrupt. Right. It's a brilliant defense mechanism
1:23
for your money. But today, We're kind of pivoting
1:27
away from the plumbing. We're looking squarely
1:29
at the actual decisions that managers making
1:31
with your cash. Because, I mean, protecting your
1:33
assets from a manager's insolvency, it doesn't
1:36
protect you from their strategy. Right. Or their
1:39
fees or their marketing spin. No, it doesn't
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at all. Yeah. And so that is our mission today.
1:44
We are going to dismantle how funds are actually
1:47
categorized behind those slick marketing labels.
1:50
Yes. We're going to expose the hidden legal rules
1:53
that constrain your managers every move. And
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finally, we're going to unpack this insidious
1:57
industry practice called closet indexing. which
2:00
is just brutal for investors. Oh, it really is
2:04
because it's where you're charged these premium
2:06
active management fees for essentially an almost
2:10
mathematical guarantee that you're going to underperform
2:12
the market. It is arguably one of the most expensive
2:15
illusions in modern finance. I mean, by the end
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of this conversation, we really want you to know
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exactly how to look past the marketing and really
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spot the structural realities of what you actually
2:27
own. So let's start with the the chaos of the
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labels. Because if we accept that a fund heir's
2:36
name is largely just marketing fiction, how does
2:40
the industry actually categorize these products?
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Well, they have to use something objective, right?
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Yeah, because if I decide I'm not going to outsource
2:45
my asset allocation to an advisor and I want
2:47
to build my own portfolio, I'm suddenly fared
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with thousands of funds. Oh, it's overwhelming.
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So how do I navigate those categories mechanically?
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So the compass you really need here is the official
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industry classification system. OK. Which, you
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know, in Canada is maintained by a specific industry
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committee. And what's vital to understand here
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is that this committee assigns funds to categories
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based entirely on what they actually hold. In
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the portfolio itself. Exactly. Not what the brochure
3:13
promises. It is a strictly objective look at
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the underlying assets. OK, so show me the receipts.
3:19
Don't just tell me the name. I like that. Let's
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walk through the core categories then, because
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we really need to understand the mechanics of
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how these different buckets function. Sure. So
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right off the bat, we have money market funds.
3:31
My instinct here is that this is the, you know,
3:34
the I need to buy a house next year and cannot
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afford to lose a single dime bucket. Yeah, that's
3:39
exactly what it is. But mechanically, how does
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a fund actually guarantee that kind of stability?
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The mechanism is maturity. So money market funds
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invest in very short term debt instruments. Like
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what? We're talking about treasury bills issued
3:53
by the government or a highly rated commercial
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paper issued by massive corporations. And these
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have lifespans often measured in days or weeks,
4:02
not years. Oh, wow. That's short. Yeah. And because
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the loan is being paid back so quickly, there's
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virtually zero risk of the borrower defaulting.
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And there's very little sensitivity to changing
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interest rates. OK, so the mechanical trade -off
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there is that you're strictly preserving capital.
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Like, you do not use this bucket to generate
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real inflation beating returns. Precisely. It's
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capital preservation, plain and simple. Got it.
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So it's essentially a parking lot for your cash.
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Next up on the risk ladder, we have fixed income.
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Right, these are your bond funds. So when you
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buy a fixed income fund, you are basically lending
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your money out in exchange for regular interest
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payments. OK. But this category gets subdivided
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based on the actual mechanical risks the manager
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is taking. So they subdivide by geography, like
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are you lending to the Canadian government or
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an emerging market government? Right. And they
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also subdivide by credit quality. Meaning? Are
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you lending to a rock solid tech giant or are
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you lending to a struggling retailer that might
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go bankrupt before they pay you back? Exactly.
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And the math backs that up perfectly. Like if
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a manager buys high yield bonds, which is what
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they used to call junk bonds, right? Yeah, exactly.
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Junk bonds. If they buy those, they are taking
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on significant credit risk. So the fund will
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pay you a higher yield, sure, but if the economy
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takes a hit, those underlying companies might
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default. And the value of your fund just drops.
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Right. So even within the fixed income label,
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the risk profile can vary wildly. OK, so moving
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up from bonds, we hit a category that I know
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is incredibly popular, especially for folks who
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just want to like... Set it and forget it. The
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balanced fund. The balanced fund, yes. This is
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a stated mix of equity and fixed income, just
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all wrapped up into one single product. Yep,
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very popular. You know, buying a balanced fund,
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it always reminds me of going to a high -end
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restaurant and ordering the fixed tasting menu.
5:57
Oh, that's a good way to look at it. Because
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it is incredibly convenient. You don't have to
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look at the menu, you don't have to think about
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wine pairings, but you are completely outsourcing
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the most critical decision of the night to the
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chef. Like... If you happen to hate seafood and
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the chef decides it's a scallop -heavy menu tonight,
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you are just stuck with it. That analogy hits
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the absolute core of the problem. Because a balanced
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fund is convenient, sure, but asset allocation,
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meaning the decision of exactly how much money
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to put in stocks versus bonds, that drives over
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90 % of your long -term returns. Wow. Over 90%.
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Yeah. So when you buy a balanced fund, you are
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handing that singular wealth -defining decision
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over to a fund company. Right. You're just trusting
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that their generic ratio of stocks to bonds somehow
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perfectly matches your specific retirement timeline,
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your tax situation, and your emotional tolerance
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for risk. Which is a massive leap of faith when
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you really think about it. It really is. Oh,
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and speaking of timelines, before we move on
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to equities, we should mention target date funds,
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right? Because they kind of play in this space,
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too. Oh, absolutely. Target date funds are here.
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especially in retirement accounts. So how do
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they differ from a standard balanced fund? Well,
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a target date fund actually automatically shifts
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your asset allocation as a specific date approaches,
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so it mechanically moves your money from equity
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over to fixed income over time. So if I plan
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to retire in 2050, I buy a 2050 fund, and the
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manager just dials down the risk as I get older.
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Exactly. Again, super convenient, but you're
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still completely outsourcing that glide path.
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to the chef, so to speak. OK, so if I reject
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the tasting menu and I decide to pick my own
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dishes, I am likely looking at equity funds.
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But this is where the menu gets massive. It does.
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Equity funds, which simply buy ownership shares
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in companies, they're subdivided primarily in
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three ways. OK. First is geography, meaning Canadian,
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US, global, or emerging markets. Right. Second
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is size, or market capitalization, meaning they
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focus on massive companies or small, nimble ones.
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Got it. And third is style, which really dictates
8:02
the fundamental philosophy of the manager. OK,
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let's hold on to style for just a second, because
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before we dive into that, I want to tackle the
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fifth category our sources highlight, which is
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sector and specialty funds. Right. Because these
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are funds concentrated in one specific industry,
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like technology or financials. Yep. So let me
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pose a scenario to you. Let's say I own a broad
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Canadian index fund, okay? It holds a little
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bit of everything in the country. And I decide
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I want to add some flavor, so I buy a Canadian
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financial sector fund to put right next to it.
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In my head, I am diversifying my portfolio. I
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am adding a new bucket. Does the math actually
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support that logic? If we look closely at the
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structural makeup of the Canadian market, the
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answer is a resounding no. Really? Why not? Because
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the broad Canadian equity market is notoriously
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top -heavy. It is heavily dominated by a handful
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of massive banks and energy companies. Oh, right.
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So if I buy a broad Canadian index fund, I already
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own a massive concentrated chunk of those specific
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banks. You absolutely do. So if you then go out
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and buy a Canadian financial sector fund, you
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aren't diversifying at all. I'm just doubling
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up. You are actively concentrating your risk.
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You are deliberately doubling down on the exact
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same companies. So if the banking sector takes
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a hit, both of your funds crash simultaneously.
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Wow. You've essentially taken the exact same
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risk twice, just wrapped in two different marketing
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brochures. That is such a fascinating psychological
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trap. Like, you feel safer because you own more
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funds, you see more lines on your screen, but
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mechanically, you've just put all your chips
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on one number on the roulette wheel. Exactly.
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It's the illusion of diversification. All right.
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Let's circle back to that equity subdivision
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you mentioned earlier. Style. Because from everything
9:48
in our source material, style seems to be the
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most distinct, fiercely debated dividing line
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in the investment world. Oh, it really is. It
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seems like it completely dictates how a fund
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behaves over a long period of time. It is a fundamental
10:01
philosophical divide. When we talk about equity
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styles, we are generally talking about a war
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between two competing mechanics, value versus
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growth. OK, unpack the mechanics for us. How
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does a value manager actually operate? A value
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manager is essentially a strict bargain hunter.
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They rely on the mechanic of mean reversion.
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So they are scanning the market for companies
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that are currently trading below what the manager's
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financial models say the company is intrinsically
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worth. So they're looking for low price to earnings
10:30
multiples. Exactly. So they are buying the unloved
10:33
companies, the boring manufacturer, the bank
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going through a minor scandal, the company where
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the stock price has been beaten down, but the
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underlying business still generates reliable
10:45
cash. Yes, exactly. They buy it cheap. wait for
10:48
the market to realize its actual worth, and profit
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when the price normalizes. I'll test. Now, a
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growth manager, on the other hand, operates on
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a completely different mechanical premise. Right.
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They are looking for companies whose earnings
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are expanding at a rapid pace. Think of major
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tech innovators or disruptive software platforms.
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So they don't care about the bargain. The growth
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manager doesn't care about getting a bargain
11:11
today at all. They are entirely willing to pay
11:14
a massive premium a huge price to earnings multiple
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because their models project that the company's
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future cash flows will be so massive that today's
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high price will actually look cheap in hindsight.
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I have to push back on this binary system though.
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Okay. Because if I'm an active fund manager and
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I can clearly see that growth stocks like say
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the big tech companies over the last 10 years,
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are just crushing value stocks year after year.
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Right. Why on earth wouldn't I just switch sides?
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Like, why stubbornly stick to bargain hunting
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when the market is clearly rewarding high -growth
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innovation? Well, it seems like common sense
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to pivot, I know, but understanding the cyclicality
11:53
of the market explains why they don't. Oh, so.
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Value and growth take turns outperforming each
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other, and they do it for incredibly long stretches.
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Really? Like, how long? We are talking about
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entire decades where one style will completely
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dominate the other, and then the macroeconomic
12:08
environment shifts, maybe interest rates rise
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or inflation spikes, and the cycle violently
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flips. So if you're a listener holding a value
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fund right now, and you've spent the last few
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years watching your tech investing friends make
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like 40 % returns while your portfolio barely
12:24
moves, your instinct is probably to panic and
12:27
assume your manager is incompetent. Oh, that
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emotional reaction is incredibly common. But
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mathematically, judging a strict value manager
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against a broad index during a decade that happens
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to be dominated by growth stocks is just a flawed
12:41
comparison. Right. The manager isn't necessarily
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bad at their job. They're just playing a game
12:45
that is currently out of season. But even still,
12:48
let's say my job is on the line. I'm a value
12:50
manager. My investors are fleeing because my
12:53
returns look terrible compared to the S &P 500.
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Yeah. Why not just cheat a little bit? Why not
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sneak a little bit of Nvidia or Apple into my
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value fund just to boost my quarterly numbers
13:04
and stop the bleeding? Because legally, they
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cannot. And that brings us to the invisible rule
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book that governs every single mutual fund. The
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mandate. The mandate. The fine print. The document
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nobody actually reads when they click, except
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precisely. But that fine print is a legal framework.
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A mandate binds the manager to a specific stated
13:25
strategy. If a manager's legal mandate says they
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run a Canadian equity value fund, they are legally
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forbidden from taking half the money and buying
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high -flying U .S. tech stocks, regardless of
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how profitable those stocks might be in the moment.
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See, when you describe it like that, it sounds
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like a straight jacket. It kind of is. But it
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sounds like it actively penalizes the investor.
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If my manager is a brilliant stock picker and
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they see a fat pitch right down the middle of
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the plate, the mandate forces them to keep their
13:54
bat on their shoulder like they aren't allowed
13:56
to swing. Right. Why would I want a fund that
13:59
restricts brilliance? I completely understand
14:01
why it feels restrictive. But if we connect this
14:04
back to what we discussed earlier about asset
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allocation, that straight jacket is actually
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the most vital feature of the fund. It is not
14:11
a bug. How does restricting a manager protect
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me? Because without that strict boundary, your
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entire financial plan falls apart. Let's say
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you built a careful, risk -adjusted portfolio.
14:23
You decided you want 20 % in Canadian value,
14:26
20 % in US growth, and 60 % in government bonds.
14:30
OK, pretty standard. Right. Now, if that Canadian
14:33
value manager wasn't wearing a straight jacket,
14:35
if they could just go anywhere to chase returns,
14:38
they might secretly decide to buy US growth stocks
14:40
tomorrow. And suddenly, without me doing anything,
14:44
my carefully constructed portfolio now holds
14:46
40 % U .S. growth and zero Canadian value. Exactly.
14:50
Your risk profile has completely changed and
14:52
you are flying entirely blind. Wow. The math
14:56
of your financial plan would be destroyed. The
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mandate is the only mechanism that allows you
15:00
to trust that the puzzle piece you bought remains
15:02
the exact shape you need it to be. That makes
15:05
total sense. But managers are human, right? They
15:07
hate losing. Do they ever try to slowly slip
15:09
out of the straight jacket without anyone noticing?
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Yes. And our sources mention a phenomenon called
15:14
style drift. Style drift is the quiet danger
15:18
every investor needs to watch for. It happens
15:21
when a manager slowly, incrementally, lets their
15:25
holdings shift away from their mandate. So cheating,
15:28
basically. Basically. A value manager might start
15:31
stretching their definition of a quote -unquote
15:34
bargain to justify buying companies that look
15:37
suspiciously like growth stocks, simply to keep
15:40
up with the benchmark. Oh, wow. And over a few
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years, they change the fundamental mechanics
15:45
of what you own without ever making an official
15:48
announcement. profile without my consent. That
15:52
is frustrating. It's very frustrating. But let's
15:54
transition to the climax of this deep dive because
15:57
style drift is when a manager does something
15:59
different than what they promised. Right. But
16:01
the absolute worst trap in the industry, the
16:03
one that really bleeds retail investors dry,
16:06
is when a manager essentially does nothing different
16:08
from the market. Yes. But they still charge you
16:10
a massive premium as if they did. This brings
16:13
us to closet indexing. Right. And to me, closet
16:16
indexing is basically like walking into a high
16:19
end luxury designer boutique. You pay a massive
16:22
2000 % markup for a shirt because you think you
16:26
are getting bespoke elite craftsmanship. Sure.
16:29
And then you get home, you look closely at the
16:31
stitching and you realize they just took a generic
16:34
$5 t -shirt from a discount big box store and
16:38
sewed their fancy label onto the collar. That
16:40
is a devastatingly accurate analogy. Let's break
16:43
down the actual math of how this works because
16:45
the mechanics guarantee that the investor loses.
16:48
Okay, let's hear it. So let's start with a true
16:51
passive index fund. It mechanically buys all
16:55
the companies in the market to track the average
16:57
return. And because a computer runs it, the fee
17:00
is tiny. Maybe 0 .1 % a year. Right. It's the
17:04
cheap, reliable, generic t -shirt. Now, you look
17:07
at an actively managed fund. The manager promises
17:10
to use their elite research and brilliance to
17:13
beat the average market return. The bespoke craftsmanship.
17:16
Exactly. And for that specialized service, they
17:18
charge an active management fee. Let's call it
17:20
2 % a year. It's a heavy fee, but I mean, if
17:23
they actually protect my downside or beat the
17:25
market, I'm willing to pay for it. But here is
17:28
the mechanism of a closet indexer. Behind the
17:31
scenes, the manager is terrified of being wrong
17:34
and losing their job. Right. So they build a
17:36
portfolio that is 95 % identical to the passive
17:40
benchmark index. They buy the exact same companies
17:44
in roughly the exact same proportions. Wait.
17:47
If they hold the exact same stocks as the index,
17:50
their gross return is going to be identical to
17:52
the index. The math dictates it. The fund's performance
17:55
will mechanically track the market average, but
17:58
remember they are still charging you that 2 %
18:01
active fee. So you get the exact same return
18:04
as the cheap index fund minus 2%. Which means
18:07
it is an arithmetic certainty that they will
18:09
underperform the market by roughly 2 % every
18:11
single year. Yes. It's a compounding loss. You
18:14
aren't losing because they made bad bets. You
18:16
are losing because you are paying boutique prices
18:19
for a generic product. Exactly. So how do we
18:22
measure this? Like if the stock market is constantly
18:24
moving and rebalancing, how does the industry
18:26
actually calculate if a manager is just hugging
18:29
the index? Institutional investors use a mathematical
18:32
metric called active share. OK. How does that
18:34
calculation work? Is it like a daily snapshot?
18:37
It is regularly calculated by comparing the fund's
18:40
holdings weightings directly against the benchmark
18:43
index weightings. OK. Active share measures the
18:46
total percentage of a fund's portfolio that differs
18:48
from the index. So if a fund holds the exact
18:52
same stocks at the exact same weights, its active
18:56
share is zero. If it holds completely different
18:59
stocks, its active share is 100. So if I'm looking
19:03
at a mutual fund with an active share of, say,
19:06
15 % and they are charging me 2 % a year. then
19:09
you are paying a 2 % fee for 15 % of a decision.
19:12
Wow. You are paying for active management that
19:15
simply does not exist in the portfolio. That's
19:17
rough. Now, we must be intellectually honest
19:19
here. Having a very high active share does not
19:22
guarantee the manager will generate outsized
19:24
returns. No, of course not. They could use their
19:26
freedom to make wildly different choices that
19:29
turn out to be terrible, and they could lose
19:30
your money faster than the index. Right. Being
19:33
different doesn't automatically mean being right.
19:35
Exactly. But if a fund has a high active share,
19:38
at least you are actually receiving the specialized
19:41
service you're paying for. Right. With a closet
19:43
indexer, the combination of index -like holdings
19:46
and high fees guarantees you will lose to the
19:49
market over the long term. Okay, so let's make
19:51
this actionable for the listener who wants to
19:53
go audit their own portfolio the minute this
19:57
deep dive ends. Sure. Because our sources highlight
19:59
a frustrating reality. Not all funds in Canada
20:03
actually publish their active share number. No,
20:05
they don't. They aren't required to print it
20:07
on the glossy brochure. Yeah. So if a fund manager
20:09
is intentionally hiding this metric, how can
20:12
an everyday investor spot a closet indexer? Well,
20:15
you don't need a Bloomberg terminal or a complex
20:18
math degree for this. You can run what we call
20:20
the two -minute test. Oh, I love a practical
20:22
tool. Walk us through the mechanics of the two
20:24
-minute test. It's simple. Every fund is legally
20:27
required to publish its top 10 holdings, which
20:30
are readily available on their website or in
20:32
their fact sheet. You pull up that document.
20:34
Then you open a second tab and pull up the top
20:37
10 holdings of the benchmark index that the fund
20:40
claims to be competing against. Okay, so you
20:43
put them side by side. You literally just look
20:45
at the two lists. If the actively managed funds
20:48
top 10 holdings are the exact same three banks,
20:51
the exact same two pipelines, and the exact same
20:54
telecom giants in roughly the exact same percentages
20:57
as the passive index, you have your answer. If
21:00
the top of the portfolio looks exactly like the
21:03
index, but the fee is 2%, you are looking at
21:05
a closet indexer. That is incredibly empowering.
21:09
Like, you don't need to model cash flows, you
21:10
just need to compare two lists of ten names.
21:12
It completely demystifies the illusion they are
21:15
trying to sell you. Man, we have covered a massive
21:18
amount of mechanical ground today. Let's wrap
21:20
up the core mission for the listener. What are
21:23
the undeniable takeaways when it comes to navigating...
21:26
fund categories. First, completely ignore the
21:29
marketing name on the brochure and read the mandate.
21:32
The mandate is the legal constraint that tells
21:34
you what risks you actually own. Second, check
21:38
your blind spots with balanced and sector funds.
21:41
Make sure your convenient tasting menu isn't
21:43
forcing you into a bad asset allocation, and
21:46
make sure your sector funds aren't accidentally
21:48
doubling your concentration in risks you already
21:51
own through your broad index. And third, Always
21:54
run the two minute test. Like, never pay boutique
21:57
active management fees for a generic index portfolio.
22:01
If you want to mirror the market, just buy a
22:03
passive index fund for a fraction of the cost.
22:06
The mechanics of fees will eat your retirement
22:08
if you aren't paying attention to what's under
22:10
the hood. Absolutely. Now, before we leave you
22:12
today, we want you to think about one last psychological
22:15
trick that the fund marketing machine has up
22:17
its sleeve. Oh, this is a big one. If you are
22:19
flipping through a financial magazine, You will
22:22
inevitably see a glossy ad for a mutual fund,
22:24
right? And in giant bold letters, it will brag
22:27
that it ranks in the top quartile of its peer
22:30
category. It sounds incredible. You think, wow,
22:32
this manager is in the top 25 % of all their
22:35
competitors. I've found a winner. But if you
22:39
remember everything we've talked about today
22:41
regarding how categories and styles behave over
22:44
long cycles, you need to ask yourself a critical
22:48
question. What if the entire category crashed
22:50
that year? Exactly. If a manager ranks in the
22:53
top quartile of a category where every single
22:56
fund lost money, congratulations to them, but
22:59
they still lost your money. Yeah, being the tallest
23:01
person on a sinking ship doesn't keep you from
23:03
drowning. Category rankings can completely mask
23:06
the fact that the underlying asset class is destroying
23:09
your wealth, yet the manager is still taking
23:11
a victory lap. and charging you for it. Exactly.
23:15
So go check your portfolio's performance against
23:17
an absolute benchmark, not just against its peers.
23:20
Are you paying a manager a premium fee just to
23:22
lose slightly less of your money than the guy
23:24
next door? It's a question you have to ask. That's
23:26
your deep dive for today. Tess, dress the label
23:29
on the t -shirt. Look at the sketching.