Critics of index investing often argue that the strategy is not sensitive to valuation. They feel that a simple strategy of buy, hold and rebalance is folly: there are times when the market is cheap or overvalued, and it makes sense to shift toward or away from equities accordingly.

It’s hard to argue with that principle. There are certainly periods when markets appear frothy and others that look like excellent buying opportunities. The problem is, whose valuation should you believe?

On April 2, Vanguard’s chief economist Joseph Davis went on BNN and said that valuations are right around their historical averages, so expected stock returns over the next several years should also be near their historical averages, which in the US is about 9% a year.

Three days later, The Globe and Mail ran an article about Prof. Robert Shiller’s method for valuing the market. According to Shiller, the earnings yield of the S&P 500 is currently 4.5%, compared with the historical median of 6.3%, which means the market is significantly overvalued. This translates to expected returns of 2.6% annually over the next 10 years.

What is the average investor to make of this? Of course, investment firms (even Vanguard) have a vested interest in being bullish on equities—I get that. But traditional valuation measures are easily quantified: the trailing P/E ratio of the S&P 500 today is about 16.2, compared with the historical average of about 15. So it’s indeed pretty close to average.

And while Shiller is an academic with fewer conflicts of interest, that doesn’t necessarily mean he’s right. While his predications have a good track record, his data were also saying equities were overvalued last fall, yet since October the US market is up about 25%. If you made a tactical shift away from stocks based on his valuation, you missed an enormous rally: 2012 saw the best first quarter for US stocks since 1998.

Diversify, rebalance and stop guessing

This is my concern about making tactical moves based on valuation, which is really just a form of market timing. First, you need to base your actions on data that can tell conflicting stories. I don’t know how you decide which criteria to use with any confidence, since all of them will be right during some periods and dead wrong during others. (Ken Fisher’s The Only Three Questions That Count includes a lengthy discussion about why P/E ratios don’t always have predictive value.) Then you need to execute your strategy consistently and unemotionally. I suggest that’s much easier said than done—especially after a couple of your moves backfire.

Simply owning a broadly diversified portfolio can go a long way toward making all of this less important. If you’re holding government bonds, corporate bonds, real-return bonds, stocks from around the world (with a mixture of value and growth, large and small), real estate and several currencies, chances are that there will always be both overvalued and undervalued assets in the mix, whatever yardstick you want to use. And a disciplined, rules-based rebalancing strategy is a self-correcting mechanism that ensures no asset class has too much or too little influence for very long. It’s not a valuation tool, but it does help you build in a measure of “buy low, sell high” without resorting to forecasts.

Update: Couch Potato returns

I have just uploaded the up-to-date returns data for the Couch Potato model portfolios with a new feature. Many readers asked me to include returns for the TD e-Series funds, and I’ve obliged. As it happens, this has the added benefit of allowing us to look at longer-term returns for the Global Couch Potato, since the e-Series has been around much longer than most of the ETFs on the list. As of March 31, the 10-year annualized return of the Global Couch Potato (using non-hedged funds for the US and international components) is 4.17%. The three-year return is 9.99%.

The humble Global Couch Potato portfolio, first recommended by MoneySense eight years ago, is an excellent way to get started with indexing. So when ING Direct launched its Streetwise Balanced Fund in 2008, I thought it would be perfect for new investors, since it’s a single fund with the same target allocation: 40% Canadian bonds and 60% equities, divided equally between Canadian, US and international.

The one problem with the Streetwise Funds was cost: with an original MER of 1% (now 1.07% with HST added) they were more expensive than I would have liked. After all, banks already offered index mutual funds with fees in that neighbourhood, and the TD e-Series Funds are dramatically cheaper: you can build the Global Couch Potato for a total cost of just 0.37%.

But four years after the launch of the Streetwise Balanced Fund, it’s worth taking a closer look at how it fared in comparison with the with TD e-Series. Here are the returns:

As you can see, the Streetwise Balanced Fund underperformed the TD e-Series by 70 basis points annually, which is exactly the difference in MER. But that’s not the whole story. Dig a little deeper and you’ll see that ING Direct’s simple index fund actually fared better than you would think at first blush.

It turns out that almost half of the performance lag can be explained not by cost, but by a subtle difference in asset allocation. The Canadian equity component of the Streetwise Balanced Fund is pegged to the S&P/TSX 60 Index, which includes large-cap stocks only. The TD Canadian Index Fund, on the other hand, tracks the S&P/TSX Composite Index, which includes mid and small caps as well. In each of the last three years, the latter index has outperformed—in both 2009 and 2010 the excess return was well over 3%.

To make a fairer comparison, I re-ran the performance numbers on the Global Couch Potato substituting the Altamira Canadian Index Fund, which tracks the S&P/TSX 60. This time the four-year annualized return fell to 0.81%, resulting in a lag of just 41 basis points for the Streetwise Balanced Fund. For every $1,000 invested, 41 basis points is $4.10 a year.

Notice that the Streetwise Balanced Fund slightly outperformed the Global Couch Potato in 2008: that’s because large caps did better in Canada that year—in fact, they trumped the overall market from 2004 through 2008. Had ING Direct launched its fund in 2004, it likely would have beat the Global Couch Potato over its first five years.

It’s also worth recognizing the Streetwise Balanced Fund’s relatively low tracking error. According to its Management Report of Fund Performance, since its inception four years ago, the fund’s 0.40% annualized return compares with a blended benchmark return of 1.13%. That’s a tracking error of 73 basis points, which is much lower than you would expect from a fund that has an MER of 1.07%, and it closes some of the gap between the Streetwise and TD e-Series funds.

An ideal first step

There’s no question that an experienced index investor can build an ETF portfolio that is far more diversified and much cheaper than the Streetwise Funds, and the TD e-Series are still my first choice for Couch Potatoes who want to use mutual funds. But there is a lot to be said for ING Direct’s simple solution. Unlike TD, which has actively discouraged investors from investing in their index funds, ING Direct makes it extremely easy to open an account, never charges account fees, and imposes no minimum balance, so you can start from zero. And because you’re dealing with one fund instead of four, you can make a single monthly contribution and ignore rebalancing, since that’s done automatically every quarter.

Based on the emails I receive, new index investors face two main obstacles. The first is philosophical: they need to move past the idea that successful investing is about picking the right securities and identifying the “right time” to get in or out of the markets. The second is practical: they need to build a diversified portfolio without incurring fees and transaction costs that will eat up their small account. The Streetwise Funds solve all of these problems. Would I recommend them to someone with investing experience and $50,000? Probably not. But they’re an ideal first step in a lifelong investing plan based on low cost, global diversification, and smart behaviour, and a reminder why MERs are not the whole story.

Disclosure: A member of my household has a small holding in the Streetwise Balanced Growth Fund.

Spring is a time for renewal, so I am happy to announce that I have freshened up some of the permanent pages on the blog to make them more useful.

When I launched this blog more than two years ago, there were just few dozen Canadian ETFs, so it was practical to catalogue them on a single page. No longer. Today there are more than 300 exchange-traded products on the TSX, with so many being added that it is impossible for me to keep the page up to date.

Moreover, I feel that I can do far more service by helping readers navigate the dizzying array of choices. So the new ETFs page includes a small number of recommendations for each of the major asset classes. I have also included US-listed ETFs among these recommendations, where appropriate.

The situation is different with index mutual funds. The sad truth is that most index funds in Canada are so expensive that they’re not worth recommending to anyone. So my new Index Funds page includes only those that are genuinely useful, as well as some guidance about which fund family may be appropriate for different circumstances.

Finally, I have deleted the Cheapskate’s Portfolio from my Model Portfolios page. The appearance of Vanguard in Canada has made this portfolio mostly obsolete. I’ve also come to believe that any portfolio large enough to be meaningfully affected by a few basis points in cost should be more diversified anyway. The Complete Couch Potato would be a better choice.

You’ve got an RRSP with your employer, another with a discount brokerage, and your spouse has a couple of his or her own. You both have TFSAs, too, plus an online savings account where you park your cash. If all of these accounts are intended for the same purpose (such as to fund your retirement), you should think of them as one large portfolio. But how can you keep track of them all?

The ever-industrious Justin Bender, portfolio manager at PWL Capital in Toronto, has come to the rescue again. He’s created a custom spreadsheet to help Couch Potatoes keep track of their asset allocation across multiple accounts. Download the spreadsheet here, fire it up in Excel, and follow these instructions:

1. On the “Allocation” worksheet, enter your overall target asset allocations in the white cells of Column C. The subcategories will automatically be totalled in the black cells.

2. Now click the tab at the bottom left of the screen to switch to the “Input” worksheet. In the green cells at the top, enter the type and owner of each investment account: e.g. RRSP Homer, or TFSA Marge. You can enter up to 10 separate accounts.

3. Enter the names (Column A) and tickers (Column B) of the index funds or ETFs you use to get exposure to each of the asset classes. The spreadsheet has been preset with the funds in my Model Portfolios, but you can easily change these if you use different funds. (Important note: if you enter an actively managed fund, your computer will explode.)

4. Grab your most recent statement for each account and enter the current value of each fund in the appropriate cells.

5. Now toggle back to the “Allocation” worksheet by clicking the tab at the bottom left. You’ll see that this worksheet combines all of the fund values you just entered, treating all of your accounts as one large portfolio.

6. Compare your overall asset allocation with your target. Column E tells you the dollar amount you will need to add or subtract to each asset class in order to bring it back to its target.

Justin and I used Excel’s “Protect” function to lock all cells that contain formulas to ensure that you don’t accidentally delete or modify something important. However, if you’re an experienced Excel user and you want to customize the spreadsheet, right-click on the worksheet tab, select “Unprotect sheet…” and type the password: potato. Be advised that this voids the warranty.

Experiment with the spreadsheet, and let us know what you think.

By the way, if you prefer a simpler rebalancing spreadsheet for a single account, you can download one here.

Q: How do I use the Couch Potato strategy across multiple accounts?  We have a taxable investment account, my RRSP, a spousal RRSP and two TFSAs (one for me, and one for my spouse). Should we hold all of the ETFs in each account—which seems cumbersome—or treat them all as one large portfolio? — B.H.

In most cases, you should think of your assets as one large portfolio and manage it accordingly. If you’re using the Complete Couch Potato, for example, it doesn’t make sense to hold all six ETFs in each of your individual accounts. This just increases trading costs and complexity. However, it is often impossible to avoid at least some overlap when you’re investing across multiple accounts. Here are the important factors you need to consider as you figure out the right plan for your household assets.

The purpose of the accounts. This is the most important consideration of all: you should only treat your accounts as a single portfolio if they are intended for the same purpose. If you have a group RRSP through your employer and a self-directed RRSP with a discount brokerage, these are both clearly designed to fund your retirement. So you might hold all the fixed income in one account and all the equities in another, for example. If you plan to use your TFSAs to fund your retirement as well, you should include these in the mix, too.

However, it you plan to use your TFSAs for short- or medium-term savings unrelated to retirement, then you need to think of these separately from your RRSPs. Because they have a different time horizon, they will likely require a different asset allocation.

Differing amounts of contribution room. Tax-sheltered accounts have contribution limits that can vary widely. Everyone gets the same $5,000 of contribution room in their TFSA every year, but RRSP contribution room  is based on your earned income. Moreover, in most cases TFSAs can’t be much larger than $20,000, whereas many people have hundreds of thousands of available contribution room in their RRSPs. (Unregistered accounts, of course, have no contribution limits.)

If you’re investing in both tax-sheltered and fully taxable accounts, you clearly want to hold the least tax-efficient asset classes (such as bonds and REITs) in your RRSP or TFSA. And if you need to keep some of your investments in non-registered accounts, it’s wise to make these the most lightly taxed asset classes (usually Canadian stocks). However, you may not have enough contribution room in your tax-sheltered accounts to divvy things up this neatly.

Limited ability to rebalance across accounts. If you’re holding part of your portfolio in a taxable account and part of it in an RRSP, rebalancing becomes problematic. You may want to sell some bonds and use the proceeds to buy more equities, but you can’t take money out of your RRSP to do this (not without tax consequences, anyway).

Likewise, if you and your spouse are approximately the same age and planning to retire together, you might think of your combined RRSP assets as a single portfolio. But rebalancing is a problem here, too, since you can’t transfer money from your RRSP to your spouse’s.

The bottom line, then, is that you should start by thinking of your assets as a single portfolio and keep your number of individual holdings to a minimum. But you will need to spend some time considering the practical obstacles you’ll face as manage your portfolio across multiple accounts.

Later this week, I’ll be offering a useful spreadsheet that readers can download to help them with this important but confusing task.

Your eyes open slowly, and the light stings your retinas. Your mouth is burning with thirst, your muscles hopelessly weak. You’re in a hospital room, surrounded by an anxious medical team. “Welcome back,” says the doctor with an uneasy smile.

“What happened?” you manage, the words catching in your parched throat.

“You were in a terrible car accident: you were hit by a bus,” the doctor says gently. “You’ve been in a coma.”

“How long?”

The doctor glances nervously at her colleagues. “A long time, I’m afraid.” She pauses again. “Three years.”

It takes a few seconds for this to sink in. Three years? Your mind is filled with just one urgent question. “I gotta know, Doc. Give it to me straight. How have the markets been doing?”

Again the doctor looks nervously at the rest of the medical team, and they avert their eyes. “I’m sorry,” she says. “It’s been an absolutely terrible time to invest—the worst I’ve ever experienced. Europe is on the verge of collapse. The U.S. government is a financial basket case—it even had its credit rating downgraded. Japan had a devastating tsunami that caused a nuclear disaster. Iran may go to war with the U.S. Interest rates are at all-time lows. People are saying gold will hit $10,000 an ounce. And it looks like the Leafs will miss the playoffs again this season.”

You’re floored by the news. The last thing you remember before that bus struck your car on March 8, 2009, was listening to a radio report about how “investors are potentially standing on the precipice of another Great Depression.” In fact, you were planning to sell your whole Couch Potato portfolio and move to cash as soon as you got home. But you never made it, and now it’s too late: the nightmare has come true. You must be wiped out.

Pulling yourself up in the bed, you demand that someone hand you a laptop, and you go online to read the bad news for yourself. You go to the iShares website and check the three-year annualized returns on several of your index funds, and here’s what you find:

That can’t be right, you think. The doctor said that the last three years have been the most difficult in recent memory. But these returns look like they’re right out of the 1990s bull market. “I guess Canada made it through unscathed,” you think. Then you tap the keyboard and visit Vanguard to see how the international markets did, expecting to see blood spill from the screen. But what’s this?

“Doc, you must have been mistaken,” you say. But when you glance up from the screen you see the doctor is frantically trying to resuscitate the patient in the next bed. “Clear!” she shouts as she zaps him with the defibrillator. His body jerks violently, then slumps motionless. “Again!” she shouts, hitting the patient with another charge. But the heart monitor shows a flat line—it’s too late. “He’s gone,” the doctor intones.

“Who was that guy?” you ask.

“That was Byan Hold. I’m afraid he’s dead.”

You take one more look at your laptop screen, still trying to reconcile the numbers with the doctor’s account of the past three years and the corpse in the next bed. Finally, it comes to you in a moment of clarity—you’ve figured out the secret of investment success.

“Hey, Doc,” you say. “Do me a favour, will you? Put me back in the coma.”

One of the most gratifying things about writing this blog is getting emails from young people who are just getting started in Couch Potato investing. “Without you,” a 23-year-old wrote this week, “who knows what I would have continued to do with my money.” I wish I could say I got started that young.

New Potatoes are often full of questions about the ideal asset allocation (“Should I include 10% in emerging markets?”) and how they might save a few basis points by choosing Vanguard ETFs instead of the TD e-Series funds. But when it comes to new investors who are starting small, I think these decisions are almost immaterial.

If I could send one message to young people who are just beginning their investing journey, it would be this: stop worrying about squeezing out incrementally higher returns and concentrate on saving more money. Because when your portfolio is small, the size of your monthly contributions has a much a greater effect than your rate of return.

When savings are more important than costs

To illustrate this idea, let’s look at two investors at different stages of life. Christopher is in his early 20s and has just started his first full-time job. He’s saved $5,000 in his RRSP and plans to sock away another $100 a month. Christopher is trying to determine the perfect asset mix and keep his fees as low as possible. But what if instead of trying to optimize his portfolio he instead made an effort to increase his monthly contribution to $150, or even $200?

As you can see in the table, at $100 a month and a rip-roaring annual return of 9%, Christopher would have $31,753 after 10 years. But if he increased his contribution by 50% to $150 a month, he would only have to earn 5% to wind up with the same amount. If he were able to dig deep and double his monthly contribution to $200, he wouldn’t even have to take any market risk: a savings account earning just 1.5% would leave him with an almost identical $31,717.

It seems clear that at this stage of his investing career, Christopher is far better off finding an extra $50 to $100 in his budget rather than trying to get an extra percentage point out of his portfolio’s performance—let alone 10 or 20 basis points by choosing ETFs instead of index mutual funds.

When low costs are paramount

Now let’s consider Nicole, who is in her 50s and has accumulated $200,000. Nicole is well along in her career and is now contributing $500 a month to her account. She wants to get an extra 1% out of her portfolio to ensure that she retires with a comfortable nest egg, and she is considering making some changes that will lower her costs by that amount. She wants to compare this cost savings to the alternative of raising her monthly contribution to $750, or even $1,000:

Because Nicole’s portfolio is so much larger than Christopher’s, lower costs (or higher investment returns) now mean thousands of dollars every year. Increasing her returns by one percentage point over 10 years would have a greater effect than increasing her monthly contribution by 50%. And two percentage points—the approximate MER difference between a typical portfolio of actively managed mutual funds and ETFs—accomplishes more than doubling her contribution. It adds up to about $100,000 over 10 years.

Keeping costs low and choosing an appropriate target rate of return are important at every age. But the truth is, if you’re a young investor these factors matter a lot less than you think. In your 20s, it’s better to focus on spending less than you make and saving the difference. Once you have built significant wealth—and you will—then those basis points become much more important. Lay a foundation of good habits and by the time you enter your peak earning years you’ll be primed for success.

Turbo Tax winner

Congratulations to Paul G, who is the winner of a free copy of TurboTax Premier Online, and thanks to Intuit Canada for providing the software.

Here is part two of my interview with Scott Burns, the newspaper columnist and Chief Investment Strategist at AssetBuilder who created the original Couch Potato portfolio more than 20 years ago. You can read part one here.

You’ve said that anyone who can fog a mirror can be an index investor, but as I’m sure you have found, even people who accept the academic arguments often cannot bring themselves to trust the markets.

SB: Absolutely. There are basically two issues here. First, there are the people who say, “I like the Couch Potato approach, but can’t I tweak it a little bit?” The moment they start doing that they are saying that they can forecast the market. They think it’s just tweaking, but they are starting down a road that ends in trying to foretell the future. I think there can be enormous flexibility in an index approach, don’t get me wrong. But when people come with the mindset of liking the Couch Potato but wanting to tweak it, the tweaks get larger and larger and ultimately they become fortune tellers.

The other issue is trust. More people today are wondering about the end of the world, and more people today are frozen at the switch, not knowing where to invest at all. I have never seen a more paralyzed market for the average investor. They just want to go somewhere and hide. I don’t know what we can do to restore things. We had this collapse [in 2008], and nothing has happened to the industry that brought it on. The reforms that were made were not very powerful, and there are efforts every day to lift those restrictions and allow people to go on gambling in the financial sector with public money.

Given all of these problems and the lack of any obvious solution in the short run, how do you make the argument that index investing is still relevant? How do you answer the critics who say that “blind faith” in the market doesn’t work anymore?

SB: There are multiple answers to that. Let’s start with the people at the extreme who are predicting utter disaster: that the dollar will disappear in a puff of smoke, or that we will be carrying dollars around in wheelbarrows. That event has been predicted since the 1940s, and it has been wrong for all of that time. It may come to pass, but you can’t run a portfolio or a financial plan based on black swan events, which by definition are unpredictable. As appealing as the whole black swan idea is, it is fundamentally not workable, because the other 99% of the time you’re going to be earning at least a reasonable return in conventional investments.

The other side of it is that we live in a world of unintended consequences. We never know exactly what the consequences of an action will be, but it is usually a surprise. Inventions come from out of the blue. We still can’t predict. So what is the only thing we can do? We can be as diversified as possible. And in that respect, the financial services industry has actually helped us, because since the start of the Couch Potato, when you could basically only invest in two asset classes, you can now get very broad diversification. The best we can do is diversify and hope that some asset classes will compensate for losses in the others.

One of my favourite model portfolios is called Six Ways from Sunday. It captures all of the basic asset classes without taking slices of value and growth: it’s two-thirds equities, and one-third fixed income. It’s simple, it uses the lowest cost instruments available, and you have complete representation of the major asset classes in the world. It’s not perfect, but if you’re after perfect you’re going to fail. The Couch Potato is about being good enough.

Index investors have far more opportunities today than they did five or six years ago, let alone 20 years ago. But I wonder if you agree that the huge number of choices that investors have today can overwhelm them and cause them to make poor decisions.

SB: You’ve put your finger right on it: Wall Street is creating yet another smokescreen that is highly profitable for them. There is a proliferation of funds that are entirely speculative vehicles. If you are buying an ETF that is premised on tripling the gain of the S&P 500, then you’re a speculator. If you are trying to make money with an ETF that rises in value when the world ends, you’re also a speculator. You’re not an investor. It’s hard for many people to get to the basic idea of simple.

The biggest problem isn’t necessarily product proliferation: I think the biggest issue we are facing now is the lack of income. It doesn’t matter where you go, in what asset class, there is essentially no income. But this is probably a great time to be an accumulator, even if it doesn’t feel that way. You know, 20 years from now people who are putting money in retirement plans today are going to feel just as good as the people who kept doing so throughout the 1970s. They will have accumulated assets that eventually take off, and they will do well.

“Allow me to introduce the Couch Potato Portfolio, a surefire formula to invest your money, enjoy a return that will put you in the top half of all professional investors, but expend virtually no effort or thought.”

That’s how Scott Burns began his column in the Dallas Morning News on September 29, 1991, and the Couch Potato strategy was born. Index funds, of course, had existed for some 15 years by that time, but it was Burns who helped popularize them with Joe and Jane Investor in countless articles that followed. In 2006, Burns left the newspaper to found AssetBuilder,  a firm that helps investors build low-cost, passively managed portfolios inspired by the original Couch Potato.

I recently had the opportunity to chat with Scott Burns about the early days of index investing. Here’s an excerpt from our interview.

During the 20 years since you created the Couch Potato portfolio, we’ve seen an enormous evolution in index investing. Can you take us back to 1991 and describe the investing climate back then?

SB: Let’s go back a little further. I have been writing about personal finance since the late 1960s. I became a newspaper columnist in 1977 in Boston, which was the heart of the mutual fund industry. I would get to interview these portfolio managers who had terrific records one year, and then the next year the fund would basically blow up—sometimes not that dramatically, but over time I realized that the odds were against actively managed funds.

The best exercise that I ever saw was done by a newspaper company called Media General. Its chairman in the early 1970s computerized the idea of the “monkeys throwing darts” portfolio. He used a mainframe to generate randomly selected portfolios, and then the computer would rank their performance, and this was published as a full page in The Wall Street Journal. I would check individual funds against these listings, and the majority were always below the 50th percentile of the randomly selected portfolios.

A whole body of research was soon being compiled around this idea: Charles Ellis had pointed out [in a 1975 paper] that active management was a loser’s game. And then John Bogle dared to start an index fund in 1975, and everybody thought he was going to just disappear. Well, he didn’t.

When Vanguard started its S&P 500 index fund they charged something like 45 basis points, which is very expensive compared with today, but it was way cheap compared to the average fund back then. It was about a third the cost. So for the fund companies, this was a nonstarter. As Bogle has pointed out many times, they wondered why they would want to start a fund that would earn only a third as much money. Somebody had to dare to build a model that would attract money in sufficient volume that would sustain a business with those low fees. Bogle took a gigantic gamble, and it was absolutely not an overnight success.

By the late 1980s and early 1990s, were people finally warming to the idea of index investing?

SB: Lots of people began to notice that they were paying a lot of money to have their investments managed, and their funds were not doing very well compared to index funds. But the issue is, how do you get people to actually do it? It’s one thing to ask questions; it is another thing to take action. Most people are simply too intimidated. All they need is a salesman talking to them and showing them a bunch of numbers, and most people want to leave the room.

So the idea for the Couch Potato was to simply put half the money in fixed income and half the money in equities. That was the simplest way—I mean, if you could fog a mirror, you could be a Couch Potato investor.

The early numbers showed that if you did it in a bear market, you would obviously beat the S&P 500, because you had half in fixed income. And if you did it in a bull market, you lost very little relative to an all-stock portfolio, and you got to sleep for the whole period. That first column in 1991 shows two major periods: a bull market and a bear market. The whole period of the 1970s was a bear market, and the 80s was a bull market, so it was pretty definitive.

I’m not surprised that the Couch Potato fell on deaf ears within the industry. But I’m interested in how individual investors reacted to it. Did people think you were nuts for recommending such a simple portfolio?

SB: The first reactions came about as a result of lies told by people who sell funds. Brokers lie. That’s one of the things we just have to deal with: the sell side lies. Their education, by and large, is a marketing education. They get trained in arguments that are totally untrue.

The other thing is that people want to believe that there is someone out there who knows the future. Because they want to offload the possible embarrassment that would come with making bad decisions.

There is a leap of faith that has to be made to become an index investor, and it’s fundamental. You have to accept the idea that although we’re miserable, grubby, money-seeking wretches, somehow on balance human beings are creating more value than they are destroying. You have to believe that even though there will be Enrons and WorldComs, companies like Apple and IBM and Johnson & Johnson will create more value than the failures destroy.

Once you get to that belief, you can have some peace with the idea of being an index investor. But that’s very difficult to do in the current environment: we would all really like to believe that there is some path to safety.

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 Canadian 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:

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

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.