Indexing’s Dirty Little Secret

“Most actively managed mutual funds underperform the market.” Couch Potato investors sing this refrain all the time in defense of ETFs and index funds. I’ve done it many times myself — a bit smugly, I confess. My FAQ page points out triumphantly that 92.6% of actively managed Canadian equity funds have trailed the S&P/TSX Composite over the last five years, according to Standard & Poor’s, which issues a quarterly report on active funds versus the indexes.

But here’s the part that S&P and most indexing advocates usually leave out: the vast majority of ETFs and index fund underperform their benchmarks, too. So it’s not fair for index investors to imply that they earn market returns, because they almost never do. Call it indexing’s dirty little secret.

This inconvenient truth is discussed in an excellent article by Scott Ronalds, published in this month’s Canadian Money Saver. Ronalds is manager of research and communications with Steadyhand Investment Funds. His article doesn’t disparage indexing, nor does he pull out the red herrings that Mackenzie Financial and others use to criticize ETFs. He simply points out that a true apples-to-apples comparison would pit actively managed funds against ETFs and index funds in the real world, not against hypothetical benchmark returns. “The all-in costs of ETF investing are not immaterial. Yet, they are often downplayed, if not completely ignored, in most comparisons of passive vs. active investing… The S&P scorecard exaggerates the outperformance of passive investing by ignoring the issue of fees.”

Ronalds is right. After all, the MERs on index funds are much lower than the average mutual fund, but they’re not zero. The trading expenses aren’t zero either. There are a host of other factors that can be a drag on returns, too, as I’ve discussed in several recent posts. And, of course, buying and selling ETFs incurs commissions. All of this means that it’s typical for a Couch Potato portfolio to underperform the broad-market indexes by 0.5% to 1% every year, and sometimes by much more.

I don’t agree with all of Ronalds’ arguments. While he’s right that the S&P scorecards ignore the cost of index investing, they also ignore some of its benefits. The greater tax-efficiency of ETFs, for example, isn’t measured by S&P’s survey, but it can have a big effect on net returns. Neither do the scorecards account for the corrosive front-end loads and deferred sales charges levied by many active funds. Indeed, the real problem with actively managed mutual funds is not their investment strategy: it’s that they’re hawked by commissioned salespeople who are in an inherent conflict of interest because of this fee structure.

I still believe that the Couch Potato strategy is the best hope that investors have for earning close-to-market returns over the long term. But all index investors should acknowledge and learn from Ronalds’ arguments. I took away three important points:

Tracking error is the enemy. Couch Potato investors should never assume that index funds and ETFs deliver market returns minus only the MER. That’s just not true. Many passive funds that track the broad Canadian equity and bond markets do so extremely well. But Canadian ETFs that track the US and international indexes are dragged down by factors such as currency hedging, withholding taxes and poor sampling. Couch Potato investors should therefore choose their international funds carefully: US-listed ETFs from Vanguard and iShares have a much better record of tracking their indexes than their Canadian counterparts.

Advisors who use passive strategies may be just as expensive. Do-it-yourself Couch Potatoes can easily keep their annual fees well below 0.5%, including fund MERs and a few trades a year. But DIY investing requires knowledge and commitment that not everyone has: there is a role for advisors, and if you need one, she deserves to be paid. Many advisors embrace ETFs and passive strategies, but once they add their own fees to the MER of the portfolio, any cost advantage over active management may disappear. What is clear, of course, is that paying MERs in the range of 2.5% to receive cookie-cutter services from an “advisor” who is nothing more than a salesperson is always a bad deal. So is paying front-end loads or deferred sales charges: there are always no-load alternatives.

The key is sticking to the strategy. Successful investing is not just about choosing the right strategy: it’s about sticking to that strategy. Active investors can do just fine if they stick to no-load, low-MER funds (like those offered by Phillips Hager & North, Mawer and Steadyhand) and hold them for the long term, through all market conditions. By the same token, investors who build so-called passive portfolios but then try to time the market are probably doomed to fail. I get emails all the time from investors who call themselves Couch Potatoes because they use ETFs, but then they talk about using leverage, chasing hot sectors and altering the strategy based on predictions about where the markets are headed in the next six months. A passive strategy only works when it’s truly passive.

6 Responses to Indexing’s Dirty Little Secret

  1. Canadian Capitalist May 10, 2010 at 12:57 pm #

    I don’t know if I’d go so far as to call this a “dirty little secret”. The S&P report is called Index versus Active Scorecard, not “index fund” versus active. I view the S&P report as simply tracking whether active funds deliver on their promise to beat the benchmarks. The consistent conclusion of SPIVA reports is that they do not.

  2. Canadian Couch Potato May 11, 2010 at 7:29 am #

    Yes, the SPIVA scorecards demonstrate that active management is usually folly, but they do not demonstrate that indexing is superior, even though that is clearly the implication. (As an index provider, S&P obviously has a vested interest here.) If SPIVA used the same criteria to track whether index funds deliver on their promise to match the benchmarks (or even trail them by an amount equivalent to the fund’s MER), most would also fail.

  3. Canadian Capitalist May 11, 2010 at 2:00 pm #

    I agree that you have a point in saying that SPIVA report by itself does not show indexing to be a superior strategy. But I don’t see why a criticism of SPIVA should turn into a criticism of indexing as a strategy. There is a mountain of evidence to show that index funds (by which, I mean broad market, low cost that aims to track a cap-weighted index) have delivered on their original premise: to beat the vast majority of active funds over the long term.

  4. Canadian Couch Potato May 11, 2010 at 3:22 pm #

    CC: Obviously I embrace the indexing strategy or I wouldn’t be writing this blog. All I’m arguing is that many index funds and ETFs have not tracked their indexes well. The problem isn’t the strategy, it’s the products.

  5. Brian May 15, 2010 at 11:27 am #

    Great points Dan. Choose the right product (low tracking error for the particular index), keep your fee’s low, and stick to it for the long term. That’s excellent investing advice. Keep up the great work!

  6. NeoCyber May 25, 2010 at 3:49 pm #

    I like to parallel this with golf:

    The typical average golfer tries to smash the course record and beat par every hole. In the end, he/she ends up struggling to break 90, perhaps on average (100 in my case).

    Indexing is a way to simply say, “You know what, shooting par every round is good enough for me. I don’t need to beat Tiger Woods’ record.” One can get vastly superior results simply by *not* trying to outperform.

    But it is true: virtually 100% of ETFs fail to beat their benchmark indices, since (a) they aren’t designed to, and (b) they charge a fee. So perhaps you could say the above becomes “You know what, shooting par +2 every round is good enough for me.”

    Honestly I don’t think the “dirty little secret” is all that big a deal. I’d still be a much better golfer if I shot 74 or 75 every round instead of my current method… JMHO.

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