Are Active Funds Adding Value?

Just how well are mutual fund investors faring in Canada? That question isn’t as straightforward as it may seem.

The Standard & Poor’s Indices Versus Active (SPIVA) reports are useful for determining the percentage of active funds that beat their benchmarks. The most recent one, for example,  found that just 2.5% of actively managed Canadian equity funds outperformed the S&P/TSX Composite Index during the five years ending in 2010.

But the SPIVA reports have some limitations: most importantly, they don’t tell you the degree of that underperformance. Indeed, as critics have pointed out, virtually all ETFs lag their benchmarks, too, so they would all appear on the SPIVA report’s list of losers. The key point, of course, is that the iShares S&P/TSX Capped Composite (XIC) lagged its benchmark by just 22 basis points last year, while the Investors Canadian Equity Fund—to pick on just one high-priced alternative—trailed it by 4.54%. Clearly that’s a crucial distinction.

Wishing upon a Morningstar

Justin Bender, portfolio manager at PWL Capital in Toronto, recently supplied me with some more useful data about fund performance. The Morningstar Fund Indices bill themselves as “the best available representation of the performance of aggregate dollars actually invested, currently and historically, in Canadian mutual funds and segregated funds.”

These Morningstar indexes asset-weighted, which means that larger funds have more influence than smaller funds. This, too, is a more meaningful comparison than a simple average of all funds. In the Canadian Equity category, for example, we find that fund investors earned an aggregate return of –10.42% in 2011, compared with the index return of –8.71%. That’s an underperformance of 1.71%, which is very close to the 10-year average.

Taking on the Couch Potato

To get an idea of how a diversified portfolio of active funds would have performed last year, I created a composite using the Morningstar indexes that correspond to the asset allocation in the Complete Couch Potato. The table below shows the composite MERs of these funds and the returns earned by investors in 2011:

Category index MER Return
Morningstar Canadian Equity 20% 1.50% -10.42%
Morningstar US Equity 15% 2.05% -0.67%
Morningstar International Equity 11.25% 2.00% -12.15%
Morningstar Emerging Markets Equity 3.75% 2.61% -19.63%
Morningstar Real Estate Equity 10% 1.57% 12.67%
Morningstar Cdn Inflation-Protected Fixed Income 10% 1.31% 14.87%
Morningstar Canadian Fixed Income 30% 1.42% 7.43%
1.64% 0.70%

Now let’s pit this performance against the ETFs in the Complete Couch Potato in 2011:

Exchange-traded fund MER Return
iShares S&P/TSX Capped Composite (XIC) 20% 0.26% -8.93%
Vanguard Total Stock Market (VTI) 15% 0.07% 3.22%
Vanguard Total International Stock (VXUS) 15% 0.15% -15.45%
BMO Equal Weight REITs (ZRE) 10% 0.62% 13.85%
iShares DEX Real Return Bond (XRB) 10% 0.39% 17.87%
iShares DEX Universe Bond (XBB) 30% 0.33% 9.38%
0.29% 2.36%

As you can see, the average dollar invested in actively managed funds trailed the comparable ETFs in every single asset class in 2011. The biggest difference, in US equities, reflects the fact that most Canadian mutual funds use currency hedging, while the Vanguard Total Stock Market (VTI) does not. Otherwise, the underperformance can be explained largely by higher costs and bad timing.

But here’s where things get interesting. Mutual fund companies, reasonably enough, argue that part of those MERs pay for ongoing financial advice, so it’s not necessarily fair to compare them to a do-it-yourself ETF portfolio. They also argue—again, with justification—that trading commissions apply to ETFs and not mutual funds.

However, note that the performance difference between the active funds and the Complete Couch Potato was 166 basis points (2.36% minus 0.70%). So a fee-only advisor who uses passive ETFs and charges another 1% to 1.5% for advice, and who incurs another 10 basis points for trading costs, would still outperform the typical mutual fund investor. As for those Canadians who are paying more than that aggregate cost of 1.64%—well, they need to start asking some questions.

The data are clear. The industry can always point to individual stars, and investors can cling to the hope that their fund manager will be one of the winners. But as the Nobel laureate William Sharpe argued more than 20 years ago, the average actively managed dollar must underperform the average passively managed dollar after costs. Canadian fund investors proved in 2011 that the math hasn’t changed.

24 Responses to Are Active Funds Adding Value?

  1. S February 8, 2012 at 11:27 am #

    I really enjoyed Sharpe’s “Arithmetic of Active Management”, I had read it awhile back from a link in a previous post. Simple math.

    For those who don’t want to read it.
    1) Before costs – active mgmt $ = passive $
    2) After costs – active mgmt $ passive fees

    This is all made true because before costs, passive return = return of the market. Since the “market” includes both passive and active managers the active return then has to be equal the market return as well.

    I hope that sums it up enough for everybody.

  2. Canadian Couch Potato February 8, 2012 at 11:35 am #

    @S: Glad you liked the link to that classic paper. It’s worth pulling out whenever people talk about how active managers are more valuable when expected returns are low. The math doesn’t change: active investors, as a group, must always lag the market by an amount equal to their costs, regardless of how high or low the absolute returns.

  3. Brian February 8, 2012 at 2:16 pm #

    I have just recently discovered your webpage and this article makes a very compelling argument (backed up with numbers) for the ‘complete couch potato’ portfolio. After some reading (and the fact that I am relatively new to investing on my own) I am thinking of a setup like the ‘global couch potato’ with the TD e-series index funds for starters. I tried to do a similar breakdown for that portfolio and came up with a return of 0.64% for 2011 – pretty much on par with the Morningstar return even without the REIT component and of course a much lower MER.

  4. Canadian Couch Potato February 8, 2012 at 2:24 pm #

    @Brian: Welcome to the blog. Yes, the Global Couch Potato underperformed the Complete Couch Potato significantly in 2011 because real-return bonds and real estate (not included in the Global CP) were the two best performers of the year. The Morningstar portfolio did have access to these two top performers, but still lagged overall because of higher fees.

  5. Jon Evan February 8, 2012 at 3:23 pm #

    It is a truism: active funds add value. Not to you and me but to the companies who sell them! As you say Dan “the data are clear” and so the only reason active funds exists is to employ all those advisors and executives to make them rich. Take BlackRock. Do they really have any interest in good investing? If there was any alturism with that company they would sell only passive products but no they sell both and say that a mixture of the two can be good investing! Not only that, but the advise they offer is over the top. Take BlackRock Larry Fink’s call yesterday to say the hell with asset allocation everyone should be 100% equities! So glad you’re here Dan to bring us the science and common sense in investing.

  6. Lake Superior John February 8, 2012 at 10:54 pm #

    Once again ( and I gladly repeat) another great post of reality interspersed with guess what, more reality. This must hurt or aggravate Joe Broker the investment advisor. Keep her going Dan, if anything for the common man ( I mean an investor who hates to part with their hard earned after tax dollars).

  7. Canadian Couch Potato February 8, 2012 at 11:03 pm #

    @Jon and John: Thanks for the kind words. Jon, you’re right that we’re seeing more companies now offering both passive and active products, and their message is usually along the lines of “passive core, active explore.” Even Vanguard offers both in the US, although their active funds are cheaper than Canadian index funds. 🙂

  8. Jerry February 9, 2012 at 6:35 am #

    Thanks for all the good stuff, Dan – it is hugely beneficial.

    I think I may have asked this before but I can’t find the response: I am entirely an ETF investor but would there not be a portfolio size which, once reached, would make it more beneficial to seek out an advisor account and then stretch out to individual bond and stock holdings? I believe one could negotiate management fees of 1.3 and .6 on equities and bonds respectively. Would not one gain more flexibility in asset allocation and also have the ability to hold specific bonds to maturity? There is also usually a substantial number of cost-free trades permitted.

  9. Dan Hallett February 9, 2012 at 9:53 am #

    Good post Dan. You may have linked to this before but Vanguard put out a paper last year making the case for indexing in Canada https://www.vanguardcanada.ca/documents/case-for-indexing.pdf

    One question on your return comparison…

    When you quote the Morningstar fund indices as “…the returns earned by investors in 2011” is this simply an asset-weighted average or is this a calculation of investor returns based on both assets and flows into and out of funds (i.e. IRR or internal rate of return)? If it’s the former, the comparison is fine. But not if it’s the latter.

  10. Justin Bender February 9, 2012 at 10:05 am #

    Hi Dan H,

    Morningstar has informed me that the index returns are asset-weighted averages (not simple averages) – as far as I understand, the calculation does not take into account flows into and out of the funds, so this would appear to be a fair comparison.

    Justin

  11. Canadian Couch Potato February 9, 2012 at 10:10 am #

    Thanks for the comment, Dan H.

    As I understand it, the returns are dollar-weighted, which means they do indeed take into account inflows and outflows. I acknowledge in the post that comparing these with the time-weighted returns of ETFs is not strictly apples to apples, because ETF investors can and do make bad timing decisions—although truly passive investors should make far few of them. I wish I could get my hands on some dollar-weighted returns data for ETFs to quantify this, but I am not aware of any.

    However, the larger point is still valid: investors in active funds are, in aggregate, trailing market returns badly, even after subtracting MERs. Given that most people in active funds are buying them through in an adviser, that’s not very encouraging.

  12. Dan Hallett February 9, 2012 at 11:40 am #

    Based on what I’ve seen from Morningstar Canada in the past (don’t have their stuff currently) and on both of your replies, I think these are time weighted returns that have been weighted by assets held in each fund – but not incorporating flows into and out of funds. I believe that those mutual fund indices also control for survivor bias – i.e. include past returns for funds that no longer exist.

    In that case, the comparison is quite meaningful. And I’m not surprised that such a large universe of funds underperforms an ETF portfolio. If you think about it like a giant mutual fund portfolio, it’s “di-worsification” taken to the extreme. You have what amounts to an indexed portfolio with active management fees because any potential value-added has been completely diluted by the sheer number of funds.

    That is a big reason why I think investors are generally disappointed with returns.

  13. Eric February 9, 2012 at 11:41 am #

    @ccp: inception date for VXUS is 01/26/2011 ….

  14. Canadian Couch Potato February 9, 2012 at 11:48 am #

    @Dan H: Here’s a link to the Morningstar methodology. According to this document, the returns “are dollar-weighted, so more accurately reflect the actual experience of investors than simple category averages or medians.”
    http://www.morningstar.ca/industry/articles/Fact_Sheet_Morningstar_Fund_Indices_Eng.pdf

    @Eric: For the first 25 days of 2011, we’ve used the returns of the equivalent Vanguard index fund, of which the ETF is simply one share class.
    https://personal.vanguard.com/us/funds/snapshot?FundId=0113&FundIntExt=INT

  15. Dan Hallett February 9, 2012 at 12:02 pm #

    Great – thanks DanB. That document explains exactly the kind of indices I remembered. Notice the heading – “A Better Indication of How Funds Have Fared”. The good news is that the returns you’ve posted above for mutual funds are a good comparison because the returns are time weighted. But the returns each month are weighted by the dollars HELD in each fund. This is just a more accurate fund category average, as the document says, than simple averages or medians.

  16. Justin Bender February 9, 2012 at 12:52 pm #

    @Eric – You are correct. In order to compare a full year’s data, Dan and I substituted the returns of the Vanguard Total International Stock Index Mutual Fund (VGTSX) for the month of January 2011 (and converted it to Canadian dollars). The fund is exactly the same as VXUS except for a higher MER (0.26%).

  17. New Investor February 9, 2012 at 5:18 pm #

    Hi Dan,

    I am a new investor who is interested in the “Complete CP Fund”. However, as I have a 30 year time frame I would like my equity to account for 85-90% of my portfolio. I have had a 90% equity, actively managed fund (2% MER) for the past 5-6 years and am able to handle the volatility. With so little room for bonds is it acceptable to just have my 10-15% allocated to XBB?

    My Portfolio:

    Canadian equity 25% (XIC)
    US equity 25% (VTI)
    International equity 25% (VXUS)
    Real estate investment trusts 10% (ZRE)
    Canadian bonds 15% (XBB)

    Would 10% bonds and an increase to 15% REITs perhaps be better for someone such as myself who is seeking maximum growth? Or maybe just add the 5% to Canadian equity.

    Thank you for the information.

  18. John Buchanan February 9, 2012 at 7:21 pm #

    Got me thinking about comparing my mutual funds to an appropriate index. Difficult. One seldoms buys on Jan 1, How do index’s handle re-invested dividends, what index for each different fund, even finding index numbers for a particular date is difficult. Many questions but few answers. Some mutual funds do publish comparsions to index’s but most don’t. Could you point me to where to start looking for index number not just the performance over various time periods.

  19. Canadian Couch Potato February 9, 2012 at 9:23 pm #

    @New Investor: Modifying the Complete Couch Potato to suit your own risk tolerance is perfectly fine. Your suggested allocation of 15% bonds sounds about right. Personally, I would tend to keep at least that much on the fixed income side. One of the surprising findings of Modern Portfolio Theory is that 15% or 20% allocation to bonds is likely to lower the volatility of a portfolio without lowering its long-term returns by much at all.

    @John Buchanan: One of the best places to find index returns is on the performance pages of individual iShares ETFs. These pages list the funds’ returns, of course, but also the returns of the benchmark index, and you can change the end dates. Many iShares ETFs track major third-party benchmarks, such as the S&P/TSX Composite, and DEX Universe Bond Index. For example:
    http://ca.ishares.com/product_info/fund/performance/XIC.htm
    http://ca.ishares.com/product_info/fund/performance/XBB.htm

    All fund benchmarks are “total return indexes,” which means they assume that all dividends are reinvested as soon as they are paid. However, the widely quoted index numbers in the media (e.g. “the TSX was up 15 points today…”) are price-only indexes. They do not include dividends.

    All mutual funds publish annual Management Reports of Fund Performance, which give the fund’s return and usually the return of the benchmark index as well. You should receive these from the fund companies by the end of March. They are also available at http://www.sedar.com.

    Hope this helps!

  20. Canadian Couch Potato February 12, 2012 at 11:42 am #

    @Jerry: Sorry for being so slow to reply to your comment. If you are planning to use a fee-based adviser anyway (and that’s key), then it might make sense to use, for example, a ladder of individual bonds rather than a bond ETF with an annual management fee. If you are already paying for the advice, the transaction fees on the bonds are likely to be extremely low. (By contrast, if you are buying individual bonds through a discount brokerage, you are probably paying a very high markup.)

    As for equities, it may also make sense for an investor with a large account to “unbundle” an ETF that has only a small number of holdings—for example, a REIT or dividend ETF may only have 12 to 30 stocks, which could be purchased individually to avoid the fund’s MER. However, in most cases I think the benefit would be very small once you consider the trading costs (not just commissions, but also bid-ask spreads) and the rebalancing.
    http://www.ndir.com/SI/articles/0508-Unbundling-Canadian-ETFs-2008.shtml

    I don’t think using individual securities would allow you to gain more flexibility in yur asset allocation. with specialized ETFs, you can already tune your asset allocation to very a resolution.

  21. InsureCan Inc. February 17, 2012 at 2:43 pm #

    With an article titled “Are Active Funds Adding Value?”, you could’ve just posted “No”
    and concluded the article. But I guess that’s no fun :).

    >>If you are planning to use a fee-based adviser anyway (and that’s key),
    I disagree entirely with this premise. It’s always presented based on emotion, not fact. Consumers begrudge paying commission, calling someone’s paycheque something else sits better with them. In fact, if there’s any sales job here, it’s the propagation of the myth that fee based financial planners are automatically better than commissioned.

    1) Fee based planners are hustling for customers just the same as any commissioned rep. In fact, one could probably make the case that fee based planners are typically just commissioned reps who couldn’t make it in the real world – they don’t know enough about their product to show people that their commission is worth it. You’re kidding yourself if you think fee based planners are any less hungry for your money than a commission based – in fact, you just bought into an emotional schtick.
    2) Show me where fee based planners provide better advice or have more knowledge. You can’t, not without starting out with the emotion that commissions are always bad and no commissions are always good. There’s nothing about ‘how’ someone gets paid that says their advice is any better or they know more.

  22. Canadian Couch Potato February 17, 2012 at 3:18 pm #

    @InsureCan: The important point here is, what are you paying for? If investors want advice about how to plan for retirement, manage risk, build an appropriate asset allocation, lower taxes, etc., then they should pay directly for those services. They should not pay for them indirectly through product commissions.

    It’s not as simple as saying that all commission-based advisors are evil and all fee-based advisers are Gandhi. The point is that the business model should separate the advice from the products, because otherwise the adviser is in a direct conflict of interest. Low-cost funds, by definition, are bad for advisers and good for clients.

    Vanguard’s index funds have some of the best track records in the entire industry, and yet the number of commission-based advisers who recommend them is zero. Do you think that’s a coincidence?

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