How to Pick Last Year’s Winners

For several years now, I’ve been encouraged that Canadians are coming around to the idea that trying to pick winning funds or this year’s hot asset class is a loser’s game. And then I read something like Gordon Pape’s recent Fund Library article, ETF Winners, and I realize we have a long way to go.

The article looks at the “outstanding performances” of three ETFs this year: the Claymore Gold Bullion (CGL), the Horizons COMEX Gold (HUG) and the iShares S&P/TSX Capped REIT (XRE). What makes these funds winners? They had the highest returns, of course.

For a distressingly large number of media commentators and investors, recent performance is still the only criterion that matters. “If you invested in gold and real estate this year, you were a winner. If you owned a globally diversified portfolio of stocks, you were a loser. Better luck next time.”

Let’s start by pointing out that the three ETFs Pape names are passively managed. So the fact that gold had another great year and real estate outperformed other sectors does not make these particular funds “outstanding” in any way. The measure of any passive ETF is how well it tracks its index, regardless of whether that asset class has a good year or a lousy one. If these ETFs had large tracking errors (for the record, they did not), their absolute returns would still have been very high, but they would have been losers for not delivering on their mandate.

I realize this kind of thinking doesn’t come naturally to most investors who focus only on outcomes. But if you’re going to be a Couch Potato investor, you need to understand the best investing strategy is the one that gives you the highest probability of long-term success. It’s not the one that would have delivered the highest return over the last 12 months, because that is always unknowable in advance and has no bearing on the future. Identifying winners and losers after the fact is a favourite pastime of the financial media, but it has absolutely zero value to investors.

A smooth sailing metaphor

Think of investing as a journey across the ocean. As a passive investor, you’ve decided to travel in a well-built sailing vessel designed to capture as much of the prevailing winds as possible, with a hull that glides through the water with a minimum of drag. You know a ship like that is likely to arrive at your destination more swiftly and efficiently than a small motorboat. But you need to be prepared for the inevitable days where there is no wind, and for the gales that will temporarily blow you backwards. During these periods, it makes no sense to kick yourself for not buying an outboard.

Clearly many people disagree: they think it makes more sense to try to predict the direction of the wind, and to jump from boat to boat. “I have always believed that ETFs are much better trading vehicles than buy-and-hold funds,” Pape writes in his article, “and the mediocre performance of the Couch Potato Portfolio that we have been tracking on the Fund Library bears this out.”

This logic is flawed from the start. It’s mathematically impossible for a diversified portfolio to outperform the year’s hottest asset classes. By design, a Couch Potato portfolio will always fall somewhere in the middle of the pack over short periods, but over the long term it is likely to beat the vast majority of active strategies. That’s not good enough for some investors. Instead, they feel they must move in and out of asset classes in search of the “winners.”

How hard can that be? Have a look at this periodic table of investment returns, which shows the best and worst performing asset classes over the last decade. Do you see a pattern? Think you can use this information to predict the top asset class of 2012? I know I can’t, and neither can anyone else. But I have no doubt we’ll be able to read about next year’s winners after the race is over.

34 Responses to How to Pick Last Year’s Winners

  1. Canadian Capitalist November 24, 2011 at 1:18 pm #

    If anything it should be the other way. Buy asset classes that have terrible recent returns. When prices fall, expected returns increase. When prices go up, expected returns decrease. It is very simple really.

  2. Mike Holman November 24, 2011 at 1:59 pm #

    I’m pretty sure he makes some good coin from his investment newsletter.

    It would be a boring newsletter if it didn’t have some sort of “new” recommendation each month.

  3. Paul T November 24, 2011 at 2:01 pm #

    Actually, I do see a pattern in the periodic table of investment returns. Real or not, it’s likely because humans tend to try and find patterns in everything.

    An no, I won’t be investing based on picking the next “hot” sector.

  4. Andrew Hallam November 24, 2011 at 2:54 pm #

    Dan,

    I’m utterly amazed by this quote of Mr. Pape’s:

    “I have always believed that ETFs are much better trading vehicles than buy-and-hold funds, and the mediocre performance of the Couch Potato Portfolio that we have been tracking on the Fund Library bears this out.”

    It’s my belief that he’s aware of how to invest, but with his articles/newsletter, he has caught onto something Warren Buffett insisted on, a few years ago:

    “People will always pay more to be entertained than to be educated.”

    I don’t believe that Mr. Pape believes he can beat a couch potato portfolio over many years. He has been writing about funds for many years, and privately, he probably knows the truth. But can he sell that truth?

  5. Superior John November 24, 2011 at 3:11 pm #

    From the “reverse mortgage guru”, and we know how dismal this couse of action can be, is he onto something that John Bogle has refuted many times before?

  6. Mike Holman November 24, 2011 at 3:24 pm #

    Andrew – Here’s another applicable quote:

    “It is difficult to get a man to understand something when his salary depends on his not understanding it – Upton Sinclair”

  7. Canadian Couch Potato November 24, 2011 at 3:58 pm #

    @Andrew and Mike: I’m not sure that fund pickers are all cynical. I don’t know for sure, but I think they truly believe that they are providing a useful service to investors. Because they are so focused on outcomes rather than strategies, they can’t shake the idea that “indexing only works when markets go up, not if markets go down” and “it’s OK to pay higher fees if you end up getting a higher return.” They can’t seem to get past their hindsight bias.

  8. Chris November 25, 2011 at 4:42 am #

    Although I do agree that his reviews of active mutual funds are generally dubious, to be fair to Gordon Pape, he has always seen investing as “building wealth” (he even wrote a book with this title in the early 80s), which he defines as positive returns after inflation. We’re now looking at a decade in which the S&P 500 has a -5.4% total real return (dividends included; measured in US dollars for simplicity; Nov. 25, 2001 to today) and the MSCI EAFE index has done even worse.

    Contrary to what you’re saying, it has not been hard to spot trends in asset classes over the last decade. Bonds have been on an ongoing bull run for 30 years; Japanese stocks have been doing nothing for 15 years; gold has been on a bull run for 10 years; dividend stocks have been on a bull run for a decade. At some point there has to be reversion to the mean, but failing to capitalize at least partly on these trends has meant near zero real returns for investors for a decade.

  9. Canadian Couch Potato November 25, 2011 at 10:17 am #

    @Chris: I should stress that it was not my intention to criticize Mr. Pape personally. I have read and enjoyed several of his books, and I think he’s done a lot for Canadian investors. I just feel that this particular article is an example of two common problems in the investing advice we often read in the media. Namely:

    – It suggests that a passive ETF is a good fund because it tracks an asset class with strong recent performance. In fact, it was just a fund that was in the right place at the right time. Anyone thinking about becoming a passive investor needs to understand this.

    – It suggests that investors would be better off trading in and out of ETFs rather than building a diversified portfolio for the long term. This sounds eminently sensible in theory, but the track record of active investors who do this is terrible.

    That’s it. Nothing personal.

    To your second point, I’m not arguing that there have been no trends in the last decade or so, only that trends can only be recognized in hindsight. There’s a reason why few people were buying gold and dividend stocks a decade ago: because their recent performance had been poor. I made this argument in a recent post:
    http://canadiancouchpotato.com/2011/08/05/lessons-from-the-last-decade/

  10. My Own Advisor November 25, 2011 at 9:21 pm #

    All I can say is, geez.

    I too, have enjoyed Pape’s books but with those comments, there definitely seems to be some conflict here.

    Trading is where recent performance matters. Investing is where long-term performance matters. Personally, my trading days are long over. Investing should be boring but many people don’t like reading about that.

    Instead, everyone wants and loves to be a winner ;)

  11. Jon Evan November 25, 2011 at 11:03 pm #

    Your post Dan is unkind to Mr. Pape. It leads readers to conclude that he is a “loser” because he might want to watch asset class trends and by you generalizing Mr. Pape’s position as one who believes “recent performance is still the only criterion that matters.” This post has fuelled some disparaging comments which are even more unkind to Mr. Pape. I think you owe Mr. Pape an apology.

    Dan, you hold tenaciously to Modern Portfolio theory and that is commendable. But MPT is just that a theory which has flaws the major one being that the market always follows a normal distribution and that it will always revert to the mean and that therefore risk is always in every time period to come mitigated by asset diversification. This may not be true in the decades ahead. Following asset class trends as Chris and perhaps Mr. Pape believe is another way to mitigate risk and is not as far fetched as you make it sound. There are different positions and I think we need to accept them without being unduly unkind to people who hold them.

  12. Andrew Hallam November 26, 2011 at 2:28 am #

    Hi Jon,

    A belief or idea can be challenged, of course, but the idea we challenge should be exactly that: an idea that’s challenged–not an individual. Thanks for the reminder. I’m guilty as charged.

    Cheers,

    Andrew

  13. Canadian Couch Potato November 26, 2011 at 3:06 am #

    @Jon Evan: Thanks for your comment. As I said in an earlier comment, it wasn’t my intention to be unkind to Mr. Pape or anyone personally. If it came across that way, I apologize. I certainly did not call anyone a “loser,” nor did I mean to imply it.

    Re: my comment that “recent performance is still the only criterion that matters,” I urge you to reread Mr. Pape’s article. The funds get their top ratings because of their recent performance only. There is no discussion of their strategy, cost, or tracking error compared with other funds in the same asset class. CGL, for example, tracks the price of gold in US dollars, while its competitor IGT does not use currency hedging and is half the cost. BMO’s REIT fund uses an equal-weighting strategy that differs from XRE’s. It resulted in lower returns this year, but the strategy may be superior going forward. Some discussion of these differences would have been more useful than simply reporting their short-term performance.

    Jon, from your comments I gather that you’ve disagreed with the majority of posts I’ve written. You are more than welcome to do so, and to post your thoughts here. I welcome the debate and I don’t take it personally. I would hope that Mr. Pape sees my comments in the same light.

  14. Ms. Investor November 26, 2011 at 10:26 am #

    Why is the “periodic table of investment returns” based only on the Dow Jones? It is interesting to note the best and worst performing US asset classes, but where is the table based on Canadian asset classes? I bet the table would look much different.

  15. Gordon Pape November 26, 2011 at 11:44 am #

    I think some of you are missing the point. The column in question did not recommend any of those ETFs. The purpose was to point out that even in a bad year, some ETFs have done well, especially those that focus on precious metals and long bonds. There was no suggestion that they will do as well next year (I don’t believe they will) or that they should be purchased now.

    As for an ETF buy-and-hold strategy, you need to be very patient. We created a balanced ETF portfolio for my Mutual Funds/ETFs Update newsletter in January 2008 and have been tracking it since. It consists of 40% XBB, 30% XIC, 15% XSP, and 15% XIN. Despite the large bond position, it is still underwater almost four years later.

    I used to be a strong believer in buy-and-hold. But given the volatility and uncertainty this century has produced, I am no longer convinced that is the best strategy for most people. Human nature being what it is, the natural reaction when markets plunge is to get out – which, of course, defeats the whole purpose of a buy-and-hold approach.

  16. Canadian Couch Potato November 26, 2011 at 12:12 pm #

    @Gordon: Thanks for adding your comments. I won’t belabour my points, but I will say that I completely agree that you need to be patient for an indexing strategy to work, and that this can be behaviorally difficult. That’s why one of my goals with this blog is to give people the confidence to stick to the strategy over the long term. The strategy doesn’t work unless you have the fortitude to stick it out during periods like the last four years.

  17. Canadian Couch Potato November 26, 2011 at 12:18 pm #

    @Ms Investor: There are several versions of the periodic table floating around. They are all different in the details, but their main message is the same: asset class returns follow no pattern and cannot be predicted in advance. The best strategy for investors, therefore, is to diversify across many asset classes and rebalance periodically.

    http://wheredoesallmymoneygo.com/40-years-of-asset-class-rankings-infographic/
    http://callan.com/research/periodic/
    http://www.ndir.com/cgi-bin/PeriodicTableofAnnualReturns.cgi
    http://corporate.morningstar.com/ca/asp/area.aspx?xmlfile=6822.xml

  18. Jon Evan November 26, 2011 at 1:08 pm #

    I’ve asked Mr. Pape to respond to your criticisms. I believe his articles are more meaningful for seasoned investors who can sort through his various analyses and pick out what might be pertinent to their own investment philosophies. His articles (as you know) are often all over the place commenting on different investment strategies unlike your own which are brilliantly focused with such clarity that they are excellent for the beginner investor :).

    Contrary to what you write, I do not disagree with the majority of your posts. My ire only goes up when you seem to imply that passive investing is the ONLY way to invest when it is only one of many investment strategies that are out there. Even your analogy of the sailing ship is as you say ‘a bad sailing metaphor’ because most sailing boats today have auxiliary motors for days when there is no wind and that’s why some investors have hybrid portfolios where they mix passive with active investments for those decades when there is no wind.

    In my work world I meet many savvy investors with large portfolios who use many investment styles with success. But there are those colleagues who have amassed large portfolios but have little or no interest in investing and are being abused by investment firms with high fees and poor returns. I recommend your site to them wholeheartedly because they can learn much about your simple low cost investment strategy which is a safe place to begin.

  19. Canadian Couch Potato November 26, 2011 at 3:25 pm #

    @Jon: I’m glad that you asked Mr. Pape to respond, and I appreciate that he took the time to do so.

    I am not ideological about passive investing. And I agree with both you and Mr. Pape that many people are simply not temperamentally suited to it. The best investment strategy for anyone is the one they will adhere to during difficult times. Over the last couple of years, for example, I have come to appreciate that many dividend investors take great comfort in holding specific companies that pay a good yield, and this allows them to hang on even when the stocks fall in price dramatically. If those same people would be inclined to bail on an index fund when the markets fall, then they should not be passive investors. Another example is real estate investing: many people who are terrified of the stock market are quite comfortable buying rental properties for income. Whether stocks might deliver higher or lower returns than real estate over the long run isn’t really important, because these investors will almost certainly not be able to hold a stock portfolio. So I get that, and I have no issue with those decisions: they’re none of my business.

    The only time I dig in my heels is when people disparage passive investing as unsophisticated and naive, and suggest that their active strategies (whether that’s active stock trading, market forecasting and tactical asset allocation) offer retail investors a greater likelihood of long-term success. I will continue to demand that they produce evidence for their claims. Far too many investors have been led astray by these promises.

  20. Chad Tennant November 26, 2011 at 4:59 pm #

    Dan,
    You couldn’t be more spot on with your assessment of Gordon’s article. Quite frankly I found his article to lack investor education and supportive evidence on a couple points:

    1. “Active fund managers can raise cash and/or move to more defensive stocks during bear markets. With ETFs, there is nowhere to hide.” Try reading a Random Walk Down Wall Street or reviewing the latest SPIVA (S&P Index vs. Active) report to understand how poorly active fund managers are doing against the benchmarks. In fact, if active managers were fired for their performance over a five year period, Bay Street would be a ghost town. Active managers seem to be able to “raise cash” and “move to more defensive stocks”, but they the majority of them can’t seem to beat the index over the long haul (in part due to charging unaware investors high fees).

    2. “I have always believed that ETFs are much better trading vehicles than buy-and-hold funds”. This again advocates active management so unless Gordon is willing to publish his active management results (if he has please let me know) versus the indexes, I would take his statement with a grain of salt. It’s easy to write about trading and market timing, but harder to show results year in year out.

    That said, I personally believe it doesn’t have to be an “or” situation, but rather the Core & Explore approach satisfies a couch potatoe style of investing seeking beta “and” allowance for alpha seeking above market returns. For example, 80% market/custom index ETFs and 20% individual stock selection.

    Lastly more often than not there nothing wrong with taking “whatever the market gives you”.

  21. Peter November 27, 2011 at 11:33 pm #

    Hi Dan, just bought your book today and started reading it.
    Wow, I love it, and it is already offering more than I expected. I thought your web site was great, but the book offers even more.
    Best part? I love the illustration on page 21 — all the mutual fund managers and savvy investors are diligently researching stocks, while the couch potato can relax and do what’s important in life.
    Thank you

  22. Canadian Couch Potato November 27, 2011 at 11:51 pm #

    @Chad: Thanks for the comment. I like Rick Ferri’s line about the passive and active approach: he calls it “Core and Pay More.” :) That said, I do agree that many (perhaps most) investors find it impossible to resist being active with part of their portfolio, and 10% to 20% is probably a good mix.

    @Peter: Many thanks for the kind words, and glad you’re enjoying it. I think they did a great job with the artwork and design, too. Cheers.

  23. Jon Evan November 28, 2011 at 1:59 am #

    Index funds have been helpful to cause active funds to lower their fees and to be in other ways more competitive (certainly Steadyhand is one amongst others). Despite the growing index field active funds are not going away. Even Vanguard continues to offer both and makes a good case to combine index and active funds in one’s portfolio (see their web site :) ). The following is an interesting review of this topic from an indexer :) : http://www.indexuniverse.com/publications/journalofindexes/joi-articles/2330-what-if-active-works.html

  24. Adrian P November 28, 2011 at 9:03 am #

    This open discussion between well known activists and passivists, and maybe the rest somewhere along the fence has been long over due — “best potential for long term success, is all that matters at the end of the day” do agree.

  25. Dale November 29, 2011 at 1:14 pm #

    I have my own models in a couple of accounts that are 60-70% cbo (corp bonds). I couldn’t help but sell some winners given the environment. I have trimmed gold a few times at the tops. Just sold my remaining Barrick and XGD. I’m happy to cash out some winners. I find it truly hard to ignore macro economic events (that are not positive). And Gold stocks do not hold up in market meltdowns. I have also recently nibbled at some equity exposure, and will add modest amounts of equities (etf’s) when we have carnage. I think some market timing is useful in the most basic sense. Sell doubles and triples. Buy equities when people are puking on their shoes.

  26. Canadian Couch Potato November 29, 2011 at 1:28 pm #

    @Dale: “Buy equities when people are puking on their shoes.” Now that is an investment thesis if I’ve ever heard one. :) If you have the stomach to do that, your long-term prognosis is probably very good.

  27. Dale November 29, 2011 at 1:49 pm #

    Thanks. Yes easier said than done. Have you ever considered adding bmo canadian banks covered calls to your income portfolio model. zwb. 9-10% income. A great way for retail investors to add covered calls. There’s the supercharged hex as well with some 18% income or more.

  28. Canadian Couch Potato November 29, 2011 at 1:55 pm #

    @Dale: The covered call ETFs are all actively managed and not consistent with the Couch Potato strategy.

  29. Canadian Couch Potato November 29, 2011 at 2:05 pm #

    @Jon Evan: Finally had the chance to the read the IndexUniverse article you linked to. I don’t think it’s all that surprising. It deals only with Vanguard’s active funds which, according to the article, have an average expense ratio of 48 basis points. That’s less than many passive ETFs, and about half what most Canadian index funds charge (not to mention four times what active funds charge).

    I have no doubt that a significant portion of equity managers can beat their benchmarks with fees that low. Unfortunately, active funds with MERs in this range do not exist in Canada, period. And outside of Vanguard, they don’t exist anywhere else either.

    Many active mangers can and do beat their benchmarks before costs. Look at how many equity funds with 2.5% MERs lag their benchmark by only 1% to 1.5%. These guys are adding value, but then they’re taking it right back, and then taking some more.

    This is why I say I’m not ideological about passive investing. I think it’s entirely reasonable to choose an actively managed portfolio with a fee of 50 basis points rather an index portfolio with a fee of 1%. (Provided it is broadly diversified and has very low turnover.) Many people have come to me and said they have used low-cost funds from PH&N and Mawer for many years, and I always reply the same way: keep doing what you’re doing. I would say the same thing to anyone who said they use Vanguard’s actively managed funds.

    But as you know, the vast majority of investors are paying 2% or more to performance chasers and fortune tellers, and their portfolio changes are usually based on emotion. These are recipes for disaster for long-term investors. I would rather stick to a consistent plan that offers diversified exposure to the world’s capital markets for less than 30 basis points.

  30. Alice Knowl January 17, 2013 at 12:50 pm #

    I noticed that the “periodic table of investment returns” link is broken because iShares took the document down.

    However, it can be found on the Internet Archive’s Wayback Machine, and also here: http://www.ohioscpa.com/OAS/COL/27C_Historical_Sector_Returns.pdf

    It really is a fun, colourful table with no recognizable pattern.

  31. Canadian Couch Potato January 17, 2013 at 1:08 pm #

    @Alice: Thanks, I’ve updated the link.

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