Can’t We All Just Get Along?

I’ve never been shy about criticizing actively managed mutual funds, but I’m starting to think this debate is getting old. More than that, I feel like it’s driving a wedge between people who should be allies. So let me be the first to extend an olive branch and say that the active v. passive debate is too often a distraction from what’s really important in personal finance.

I’ve been thinking about this issue since reading Tom Bradley’s It’s Not Rocket Science, which the author has made available for free. Bradley is president and co-founder of Steadyhand, a small firm that offers a family of low-cost mutual funds sold directly to investors.

A fundamental part of Steadyhand’s investment philosophy is that an active manager’s best chance to beat the market is to ignore index benchmarks and build concentrated portfolios. They even call their strategy “undexing.” So you might expect that a committed passive investor would be filling the margins with indignant notes when reading a book by someone with such confidence in active management. But here’s the thing: I agree with about 95% of what Bradley writes.

One of the first pieces in the book—which is a collection of Bradley’s past blog posts and Globe and Mail columns—is called “Three Keys to Investment Success.” He identifies these as the discipline to set financial goals and decide on a strategy to reach them, the patience to recognize that investing is a marathon and not a sprint, and the courage to stick with your strategy amid the noise of the markets and the media.

Notice that the ability to pick winning stocks or forecast the economy doesn’t even show up on the list (maybe it was the fourth key). In fact, security selection barely comes up in the book at all. Rather, Bradley focuses on the importance of temperament, smart risk-taking, keeping your costs and turnover low, ignoring short-term results, and being suspicious of the charlatans in his industry. When he does get specific about his investing strategy, he writes about the crucial role of asset allocation, and urges Canadians to shake off their home bias and invest globally. Even the most starchy Couch Potato would agree with virtually every word.

Bradley believes that active managers can add value by making tactical shifts in asset allocation—though not too often, and always within a fairly narrow range. And even then, he writes, “For investors who don’t have the wherewithal or inclination to outguess their long-term targets, it’s best to set the portfolio mix and keep it there.” You’d have to be a pretty ideological index investor to argue strongly with that.

The 5% we disagree on

So where do we disagree? The Steadyhand equity funds are concentrated in a small number of stocks—as few as 17 in their Small-Cap Equity Fund. Bradley argues—correctly—that an active manager trying to beat a benchmark index has little hope of doing so if he simply buys most of the stocks in that index. Funds that do this wind up acting like an index fund, but with a higher fee, which is a lethal combination. A low-cost concentrated portfolio has a greater likelihood of outperforming the market than a high-fee index hugger. Fair enough.

I would counter that the evidence suggests the odds of even a low-cost concentrated portfolio delivering long-term, risk-adjusted outperformance are still not very good. But that’s the extent of our philosophical differences, and at the end of the day, this point doesn’t matter as much as we might think.

The fact is, if Canadian investors are suffering from chronic underperformance, it isn’t because their portfolios are actively managed per se. The problem is that most investors pay too much for active management, largely because the fund industry is driven by commissioned salespeople. Disciplined, patient and courageous investors can do just fine if they stick to low-cost, prudently run active funds, whether they are from Steadyhand, or Mawer, or Phillips, Hager & North. I have little confidence that these investors will beat the market consistently, but you could make the same argument about many of the overpriced ETFs and index funds available in Canada.

More important, as Bradley argues with both wisdom and wit, investors are usually their own worst enemy. They sabotage themselves with overconfidence, myopia and an inability to keep their emotions in check. The Couch Potato strategy is designed specifically to minimize these behavioural problems, but I accept  that it can never eliminate them.

The active v. debate still matters, but it isn’t the most important issue in an investor’s success or failure. I think it’s time we all stopped acting as though it were.

28 Responses to Can’t We All Just Get Along?

  1. Dave June 27, 2011 at 11:02 am #

    Excellent post,
    As Carl Richards says, successful investing is about behaviour and costs, not product.

  2. Echo June 27, 2011 at 11:14 am #

    Very nice post, Dan. Tough to argue with “the importance of temperament, smart risk-taking, keeping your costs and turnover low, ignoring short-term results, and being suspicious of the charlatans in his industry.”

    Thanks for pointing out the free book too, I’m going to check it out.

  3. Canadian Couch Potato June 27, 2011 at 11:46 am #

    @Echo: Thanks for the comment. I will continue my campaign for the Nobel Peace Prize later this week when I talk about stock pickers. :)

  4. Steve in Oakville June 27, 2011 at 12:04 pm #

    Dan – I couldn’t agree more with this post. You’ve said on numerous occasions that our ability to stick with a disciplined saving strategy should be the key focus for most individuals. Getting your money in regularly with an appropriate asset allocation, and then ‘turning off BNN’, would do us all wonders…go fishing instead.

  5. Echo June 27, 2011 at 12:17 pm #

    @Dan: Haha – good luck with that! I keep getting trounced in these debates but somehow keep coming back for more ;)

    At the University where I work they built a Wall Street style trading floor and have brought in a few Ph.D’s in Economics and Finance. I’ll have to try and enlist their help for this next round. Looking forward to it.

  6. Canadian Couch Potato June 27, 2011 at 12:26 pm #

    @Echo: Don’t worry, it will all be very conciliatory. In no time we’ll all be sitting around the campfire singing Kumbaya. But your Wall Street trading floor guys aren’t invited. :)

  7. Tom Bradley June 27, 2011 at 1:41 pm #

    Dan, glad you enjoyed the book. Your points are right on the money. More focus on the fundamentals of good investing practices and less on the ‘debate’ would serve us all well. Cheers, TB

  8. Canadian Couch Potato June 27, 2011 at 1:55 pm #

    @Tom: Thanks for stopping by, and keep up the great work.

  9. Jon Evan June 27, 2011 at 6:58 pm #

    I think Tom diagnoses me correctly in his book when he says: “They are savers at heart, not investors”! That leap is difficult particularly for those like me who have had to start from nothing I mean not even a matress! Savers are very risk averse and become uncomfortable with BNN quite quickly.

  10. Canadian Couch Potato June 27, 2011 at 7:46 pm #

    @Jon: There’s nothing wrong with being a saver. The key is to determine a risk level you’re comfortable with over the long term, rather than taking more or less risk based on market forecasts. Maybe you’re only comfortable with 20% in stocks, and that’s fine, but if you stick with that allocation you remove a lot of the guesswork. Oh, and turn off BNN and watch the Golf Channel instead. :)

  11. Value Indexer June 28, 2011 at 2:27 pm #

    I’ve heard about the many studies that show individual investors doings worse than the funds they invest in. A fund that underperforms by 1-3% per year does make a difference but if it’s tied to the right advice it might lead to higher overall returns. We can always dream of an industry where responsible advisers are paid appropriate fees and then recommend only good products :)

  12. Canadian Capitalist June 28, 2011 at 2:32 pm #

    Great post Dan! One more point that we passives can agree with Tom is the importance of not under performing our investments. This appears to be a huge issue for active funds (the investors under perform the funds) but it is also an issue for passive investors. Many studies show that performance chasing extracts a much higher cost than mutual fund costs, so this is one more area we can agree on.

  13. Canadian Couch Potato June 28, 2011 at 2:44 pm #

    @Value Indexer and CC: You both make a great point. In fact, Steadyhand offers a discount on the MER for investors who stay in their funds for five years, and a further reduction at 10 years. It’s a good incentive to stay put.

    Investing is one of life’s few activities where sloth and neglect are often good qualities. Assuming, of course, that you set up the portfolio properly in the first place.

  14. Dan Hallett June 28, 2011 at 3:55 pm #

    Dan B – In this post, you’ve so nicely captured many of my feelings on this perpetual debate. Well done!

  15. Canadian Couch Potato June 28, 2011 at 4:09 pm #

    @Dan H: Thanks for the note. Our recent conversation reinforced some of these ideas and I thought it was time to make the point publicly. :)

  16. My Own Advisor June 28, 2011 at 8:16 pm #

    Great post Dan! Does that mean we won’t have any more debates, it is all about behaviour investing from here on in? That could be boring ;)

    Your post reminds me about what Jason Zweig wrote in his book “Your Money & Your Brain”:

    “Like frogs, people are inherently excited by motion.”

    Most of us, investors included, really don’t understand our own behaviour. I will agree with that, because that requires high EI. I think the more we learn about ourselves and our emotions, the better investors we will be, regardless of the active or passive approach we take.

    BTW – I watch much more Golf Channel than BNN. Both of these channels drive my wife crazy. At least we have another TV in the house for True Blood and Vampire Diaries :)

    Keep up the great work!
    Mark

  17. Michel June 29, 2011 at 7:00 am #

    Yes, but….I like the debates. Makes me think, especially when debating active vs passive in my own portfolio. Please don’t stop provoking our minds.

  18. Canadian Couch Potato June 29, 2011 at 8:01 am #

    @MAO and Michel: Don’t worry, I have no plans to abandon the debate. I just want it to stay constructive, and I’d like to stress that using passive products is not enough.

    Index investing doesn’t work because there’s something inherently special about indexes, or about ETFs. It works because it is the best way we know to reduce costs and turnover to an absolute minimum while maintaining broad exposure to the risk premiums in the markets.

    Asset allocation doesn’t work because 12% of this and 7% of that is some magic formula. It works because combining assets with low correlation reduces volatility and increases risk-adjusted returns.

    Both of these principals require the investor to implement them properly, and that’s the most difficult part.

  19. Kevin Cork June 30, 2011 at 12:21 pm #

    As a financial planner who earns most of his income off investment commissions, specifically the DSC and trailer fees I imagine you all are fully aware and dismissive of, let me poke at this lovefest a bit.

    As mentioned indirectly -or at least implied- by the Canadian Capitalist and the Value Indexer, the problem with most active fund fees is not the fees per se but the lack of value provided for the cost of the fee. Further, the destruction of capital by the improper use of index funds (bailing at the bottom, loading up at the top, etc) ETFs or really ANY investment product has a far higher cost than a 2.5% fee vs a 0.5% fee.

    Now, I am fully aware that by using an advisor of some sort there is no guarantee that your personal investment results will be more successful than if you do it alone. (And, btw, I define ‘personal investment success’ as reaching your short, medium and long term financial goals, not beating a market or an average over a three month or five year period.)

    I am also fully aware that most of the people on this forum use the index funds, ETFs correctly and buy more into the market when it craters, even if it continues to crater for the next six month or two years. That’s sweet and reassuring and inspiring.

    However, MOST people who use index products do not use them correctly. They read the articles (or sometimes just the headlines of the articles telling them that index funds are best -based on the single qualifier of the cost of the management fee- plop some money in, add more when it is 40% more expensive and yank it all after it drops 50% and take very little comfort from the fact that in an active fund their loss would have been 52%.

    Now, admittedly both my self and my sample are biased. First because we get plenty of index-refugees in the door after each correction, Also, like Bradley, I am a total manager groupie. However, 20 yrs of doing this and getting all these roadshow backstage passes has made me pretty cynical so my list of suggested management teams has dropped to about 21 names for all the various asset classes based on four factors. We evaluate and re-evaluate them every quarter and change some around based on same factors though its really only 2-3 changes a year for the last 7 yrs. And a couple of the teams I have used since 1989.

    We do have access to cheap, cheap index products and I have a tiny number of client who are DIY investors and simply pay me a fee for planning the rest of their finances (and doing ‘second opinion’ work on their choices) but I have lots of joys and satisfaction in my work because I have had proven to me based on my experience with hundreds of clients that an active manager is THE best way to invest and I have seen the results of that ‘best’ in terms of the success people have.

    Anyway, I almost fully embrace the couch potato philosophy as you have laid out and I recognize that the possibility of adding extra value to the portfolio -in the form of increased returns or reduce volatility- with the use of active management requires quite a bit more work and no guarantee.

    To be obvious and somewhat redundant, I simply think that the active management strategy should not be dismissed based solely on fee costs and some vague generalizations about underperformance.

  20. Canadian Couch Potato July 1, 2011 at 6:12 pm #

    @Kevin: Thanks for sharing your thoughts. There is no question that index funds and ETFs are just tools, and if they’re used improperly, they can be more “expensive” than any actively managed fund. I’ve also argued for a long time that many (probably most) investors would be better off with an advisor — not just to manage their investments, but also their goal setting, tax planning, etc. — and to keep them on course. As you say, most people who use index products do not use them correctly.

    However, where we differ is in identifying the value of an advisor. There is simply no evidence that any advisor has the ability to identify superior active managers in advance. The track record of active funds is not about “vague generalizations about underperformance.” The data are real and well documented.

    I also believe that the commission model (whether through DSCs or trailer fees on no-load funds) creates an inherent conflict of interest that does not serve the investor. Other countries (the UK and Australia) have woken up to this and banned the model altogether, but it remains a chronic problem in Canada. Clients should pay a planner for a plan, or pay an advisor for ongoing, unbiased advice. They should pay the fund company directly for the products. That said, I am well aware that investors are part of the problem here: most prefer to have their fees buried in products and pretend that they’re getting advice for free.

  21. Kevin Cork July 3, 2011 at 1:38 am #

    Now CCP that was hardly the energetic condemnation I was hoping for but you did plop in some things I can work with:

    I know there are lots of vague references along the lines of “75% of mutual funds don’t keep up with the index” I assume you mean. But I am not sure what that means exactly. I know what it means literally of course.

    But doesn’t that also include 100% of all index products? (Since they have both -some- management fees and cash flow issues to dilute the returns) And if that is the case then would it not be better to use an active manager and at least have a CHANCE of ‘beating the index’?

    And what does ‘beating the index’ mean? Over a year, two? Ten? And are we talking raw returns, a risk-adjusted return, or….?

    And given the world we live in now, why is a relatively simplistic index a goal? A static collection of the ‘biggest representative stocks’ means what for the average investor going forward? That approach is reasonable but only if you have only the most pessimistic view of the manager’s ability to add value. (The manager is only a negative so let’s find the one that that is the least negative.)

    As for skill in choosing management teams, it is relatively simple in concept and very hard in execution, absolutely. And it never remains constant.

    Now lets talk commission. Even when we did solely commission-based work, the only real conflict of interest potential was that some of the no-load fund companies were not offered. Otherwise the DSC loaded companies offer essentially the same commission across the spectrum. And, of course, the no-load companies had alot of crap, dud funds as well of course.

    So baring dealer incentives -which existed but I dont think exist now- there was little conflict of interest. And the UK and Australia ‘solutions’ are going to implode for them over time simply because the system created now cheats lower end investors of alot of advice, biased or not.

    All advice is biased, otherwise it is useless. I recognize you mean ‘biased by commission, revenue, personal gain.’ On that end, the ‘problem’ as you define it IS chronic. But that is not an advisor issue, it is 90% a client investor issue. The structure already is firmly in place here in Canada.

    F-class shares already exist for the huge mass of funds out there, I can set up an account for a client and use almost any fund from almost any company and the management fee cost is much closer or better than many no load and even some index funds. I don’t use any and all companies of course. I am biased and use the management teams I think are best and will help the clients succeed in their specific financial goals. But they are the same ones I use for my conventional DSC-based accounts (aside from a few that have too high a minimum to be well diversified.)

    But people just hate them, every single quarter, they HATE the fee and forget the lower cost advantage. A truism in our industry is that 90% of investors focus on relative performance on the way up and absolute returns on the way down. And that ongoing struggle is a key reason so many no-load firms either shift or are sold to a load firm, to get the handy ‘advisor buffer’ the extra-cost commission fee buys.

    Good managers and good investment products are good regardless of the fee structure and crap is crap even when its cheap. The same with advisors and planners, whether I collect commission and trailers or set-up and ongoing fees, we offer the same work and planning and ongoing review and monitoring and re-balancing. And if our annual cost to the investor is the same as the conventional discount brokerage who does nothing but execute and report trades, then who is getting the better value?

  22. Canadian Couch Potato July 3, 2011 at 10:45 am #

    @Kevin: I’ve lost interest in “energetic condemnations,” which was one of the main points of the original blog post. However, I’ll respond to a few things in your last comment.

    Regarding the data on the underperformance of active funds, the methodology used depends on the study, of course. Standard & Poor’s Index Versus Active scorecards look at one-, three- and five-year periods. The latest report, just released last week, reports that “Over three- and five-year periods, only 11% and 2.5%, respectively, of actively managed Canadian equity funds have outperformed the S&P/TSX Composite Index.”

    For a laundry list of academic studies on this topic, see Rick Ferri’s The Power of Passive Investing and Larry Swedroe’s The Quest for Alpha. The data are not vague: they are robust and overwhelming. If you have spent 20 years promoting active management without being aware of this literature, that’s alarming.

    You ask, “Would it not be better to use an active manager and at least have a CHANCE of ‘beating the index’?” Given the high cost of trying and the low probability of succeeding, the answer must be a resounding no. A blackjack player has a chance of beating the house, but that does not make blackjack a viable investment strategy.

    As for index funds and ETFs also trailing the indexes, this is absolutely true, and it is a point I have readily acknowledged:
    http://canadiancouchpotato.com/2010/05/10/indexing%E2%80%99s-dirty-little-secret/

    I prefer to compare actively managed funds to index funds or ETFs rather than indexes themselves. For the record, most of the TD e-Series Index funds were first quartile over the last decade, and 11 of the 16 iShares ETFs that have five-year track records were also first quartile. Active funds don’t just trail abstract benchmarks: the vast majority trail the index funds in the real world, too.

    RE: the commission-based structure of the industry, I fully agree that investors must share the blame for this situation. There are plenty of fee-only advisors who use F-Class funds, and lots of low-cost direct-sold mutual fund options, but investors would rather pay 2.5% in hidden fees than 1.5% in transparent fees. I made a similar argument in response to the arrival of Vanguard in Canada:
    http://canadiancouchpotato.com/2011/06/13/will-vanguard-really-change-anything/

    However, to say that this “is not an advisor issue, it is 90% a client investor issue” is awfully contemptuous of your clients. Many people are ignorant, but they need to be educated by professionals for a reasonable fee, not exploited by salespeople for exorbitant fees. Fee-only advisors do need to spend some time educating their clients about what is worth paying for (advice) and what is not (active management). It’s a struggle, because it goes against most people’s intuition. But it must become the model of the future.

    Re: “All advice is biased, otherwise it is useless.” A bias is not the same as a conflict of interest. Advisors who act as fiduciaries may be “biased” in favour of passive management—if you call a belief in math and academic research a “bias.” But this is fundamentally different from an advisor who has a financial incentive to sell inferior products because of his compensation model.

  23. cynical investor July 3, 2011 at 4:18 pm #

    “More important, as Bradley argues with both wisdom and wit, investors are usually their own worst enemy.”

    So true !

    With the funds I had I didn’t lose more money than the market and made it back when the market rebounded. With individual investments I have lost more than the market. “

  24. Kevin Cork July 3, 2011 at 8:52 pm #

    Hello CCP, now THAT’s more like it…

    Let’s rock:

    The ongoing S&P study is often quoted but since it doesn’t rank/rate the ETF/Index funds the same way, it’s only of marginal interest to me trying to form investment strategies.

    RE: “Given the high cost of trying and the low probability of succeeding, the answer must be a resounding no. A blackjack player has a chance of beating the house, but that does not make blackjack a viable investment strategy.”

    I am not sure where this argument is based. If you are telling me that you can use past track record to determine the chance of an active fund manager doing well or poorly, then why can you not use the same past track record to choose above average active fund managers??

    No one has said gambling was a viable investment strategy.

    RE: “I prefer to compare actively managed funds to index funds or ETFs rather than indexes themselves. For the record, most of the TD e-Series Index funds were first quartile over the last decade, and 11 of the 16 iShares ETFs that have five-year track records were also first quartile. Active funds don’t just trail abstract benchmarks: the vast majority trail the index funds in the real world, too.”

    The same argument for past track record applies here but, setting that aside, lets dig into your remarks about TD and ishares. You know that those broad, generalized comments do not tell the whole story. None of the funds you mentioned were first quartile for every single reporting period or even for every one of those last ten years.

    For example, the TD European Index-e shares –one of the funds you allude to- were 3rd quartile (returned less or lost more than the average European fund costing almost 2% more) in 2010, 2007, 2006 and 2005. So 40% of the time in the last decade it did not beat the ‘vast majority’ of funds. Technically, the majority of expensive funds beat it. On top of that, its higher than average volatility would make it a pretty rough ride for many investors though few of the 25% of funds (all actively managed btw) that beat it over ten years had lower volatility.

    I think what you mean is that at this current time, when a line is drawn in the sand, these certain funds have a 10 yr reporting number that is higher than the average one. Fair enough. Though $10,000 invested in this fund ten years ago would have just $175 more in than the average fund so we’re talking pretty thin lines.

    That also assumes that you didnt pay any trading fee to buy this fund which is likely in this case since its a bank fund but how likely is that with the ishares?

    Further, some have not been properly categorized or compared. For example, the ishares S&P 500 index product. It is one of those ranked very well over the last five years and actually its done well vs its ‘peers’ over the last ten years as well. Except that it has the ability to hedge the currency. Given what we have seen with the strength of the Canadian dollar over the last decade, how is it fair to rank this fund highly compared with funds (index-based or actively managed) that do not hedge currencies?

    More concretely for those seeking to build a well-allocated couch potato portfolio, I would also have a concern if people simply plucked up some of those currently top quartile funds/ETFs since many of the names you allude to are very specialized, sectoral ETFs that I assume would not be appropriate for the couch potato portfolio.

    I know many of the mainstream products you refer to are fine. And I can tell you use them properly. As a side question, when you are looking for investments, do you choose the ones that are as closely correlated to the index as possible or do you choose the cheapest or do you pick the best performer within a specific asset class over a certain time frame?

    RE: “However, to say that this “is not an advisor issue, it is 90% a client investor issue” is awfully contemptuous of your clients. Many people are ignorant, but they need to be educated by professionals for a reasonable fee, not exploited by salespeople for exorbitant fees.”

    Hm, I would say that YOUR words are contemptuous, not mine. Most of my clients are pretty well educated with above average financial awareness and understand the costs and fees pretty well. In the end of course, if you do not feel that paying anything for active management (even the F-class level of fees?) is worth it, which I understand given your words above, then nothing I say is going to make any difference is it.

    I do agree that Canadians –of all income levels- overall need more financial education.

    RE: “Advisors who act as fiduciaries may be “biased” in favour of passive management—if you call a belief in math and academic research a “bias.” But this is fundamentally different from an advisor who has a financial incentive to sell inferior products because of his compensation model.”

    Advisors who act as fiduciaries may be biased in favour of or against passive management. The ‘math’ argument –that a 2.5% fee is worse than 0.5% fee- only applies in a a tiny number of situations where all other factors (managers, investments, cash flow, distributions, transactions, etc) are exactly the same, such as in a choice between F-class shares vs regular shares of an actively managed fund. Or maybe one index fund vs another.

    Many seem tempted to apply it on a broader basis to say that all lower-fee funds are better than all higher-fee funds automatically, it seems to be the only factor in their decisions. If the `math argument` actually worked that way, then it would work that way all the time, not just some of the time. Math is math, it doesn’t matter whether you believe in it or not.

    Further, no good, serious advisor and certainly no focused salesman of any type would be interested in deliberately selling inferior products, especially in this business where so much of the focus (and revenue) comes from lifelong repeat business. Of course there are some advisors who are lazy and a few who are crooked. The crooked ones will make money regardless of regulations or how they are paid, since they cheat system. The lazy ones will do less harm but simply follow the path of least resistance and go with whatever is doing well or is popular. That`s one of the reasons some advisors have gone to using only index products-since they are blame free and require little to no work.

    Now, despite all the poking I have done at you and the obvious permanent disagreement we will have on the validity of active management (at whatever price) I DO have clients in index funds and can see how they could work for some people.

    Whatever the stats on current performance and the future projections you want to make based on those current stats, in the end- for me- its more about making sure the clients stick to their plans to reach their goals. I understand you think that`s best done using passive products. That has simply not been my experience.

  25. Dave July 3, 2011 at 9:19 pm #

    It is difficult to get a man to understand something when his salary depends on his not understanding it. – Upton Sinclair US novelist & socialist politician (1878 – 1968)

  26. Value Indexer July 4, 2011 at 10:09 am #

    Kevin: You’re right that the index returns don’t represent what investors truly want – what would you be looking at as a benchmark? I would primarily look at 5 to 10 year returns since there’s too much luck in anything shorter. It would be interesting to see what active managers have met different fixed benchmarks (say 7%, 10%, 12% per year) over those time periods.

  27. Kevin July 4, 2011 at 12:20 pm #

    VI
    It varies some based on whether its an income vs not-yet-income portfolio, assets, needs and level of chicken but on average we use a net real return of approx 3-4% for our projection module

    BTW, are you a follower of the Value Averaging concept -since I assume the ‘Value’ doesn’t mean to you the same management style the word value means to me.

  28. dj January 9, 2013 at 12:39 pm #

    I hope Noel read this blog post…

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