A cure for Potato performance anxiety

For almost a decade, MoneySense has recommended a simple portfolio of index funds called the Global Couch Potato. It’s the investing equivalent of flopping in front of the TV with a bag of Cheetos. The point is that portfolios don’t need to be complicated: the broad diversification, rock-bottom costs and disciplined strategy of the Global Couch Potato should deliver excellent long-term results — at least, that’s what we’ve always argued.

Well, those results are now in. I recently collected 10 years’ worth of data and calculated the returns of the Global Couch Potato using TD’s e-Series index funds. I assumed that you made a lump-sum investment at the beginning of 2001 and rebalanced the portfolio back to its target asset allocation at the beginning of each year. Had you done that annually through 2010, the Global Couch Potato would have delivered — drum roll, please — just over 4% a year.

I don’t imagine that you’re jumping for joy right now — I know I wasn’t when I learned the results. A 4% annualized return sounds dismal for a balanced portfolio of 60% stocks and 40% bonds. As one of my blog readers wrote to me: “I can get 3.5% from a five-year GIC with no risk and no fees. So why do you advocate investing instead of saving?”

It’s a fair question. But does a 4% return mean the Global Couch Potato was a miserable failure? Does it mean that mutual fund managers are right when they scoff that indexing delivers mediocre returns? Not so fast: the sad truth is that even with a 4% return, the Global Couch Potato still outperformed the vast majority of its peers. Before you mash the Potato, consider these facts that put its performance in context.

The markets performed terribly. During the last 85 years, portfolios with a mix of 60% stocks and 40% bonds have averaged well over 8% a year before costs. But during the period I looked at, from 2001 through 2010, market returns were nowhere near that. Canadian equities and bonds did reasonably well, with both delivering more than 6%. But U.S. and international stocks were a train wreck: both had negative returns during that period (as measured in Canadian dollars).

Couch Potato investors accept market returns, minus only small costs. But indexing cannot conjure returns out of thin air, and for the first time since the Great Depression, global market returns were negative for a decade.

Most actively managed funds did worse. Critics of the Couch Potato argue that active strategies work best during periods when the markets sputter. Money managers can get out of stocks during the worst periods, and they can identify opportunities to outperform the indexes. Sounds great, but is it true?

I contacted Morningstar to ask for the 10-year returns of comparable Canadian mutual funds, and here’s what they found: the 54 funds in the Global Equity Balanced category had an average annualized return of 1.76%. Just five funds earned more than 4%, meaning that the Global Couch Potato outperformed the other 91%. In the similar Global Neutral Balanced category, the average fund earned 2.98% and the Couch Potato beat 81% of them. So, yes, you might have picked an actively managed fund that did better. But your odds were rotten.

In addition, most of the individual TD e-Series funds were top-quartile performers over the last 10 years, which means they beat at least 75% of their peers. Active managers claim they can add value during difficult markets, and yet the humble TD U.S. Index Fund outperformed a shocking 93% of its category during a period when even my chequing account beat the S&P 500.

The winner is never obvious in advance. It’s easy to identify the best performing asset class in hindsight. If you could travel back in time to 2001, you would clearly have put all of your equity allocation in Canada, which blew away the rest of the world during the following 10 years. But you could never have been able to predict that at the time.

Everyone loves Canadian stocks today, but from 1991 through 2000, the S&P 500 returned almost 20% annually, and international stocks delivered almost 11%, while Canada brought up the rear with 9% returns. And don’t forget that our loonie — which is “obviously” a long-term winner today — was worth an embarrassing 65 cents U.S. in 2001 and was despised by investors. Could you have made a big bet on the previous decade’s loser? Absolutely. But few people did.

The future looks even brighter. Back in 2001, index funds and ETFs in Canada made slim pickings. With all of the excellent new products now available, investors can harness the returns of other asset classes, and they can do so at even lower cost. While we still love the simplicity of the Global Couch Potato, knowledgeable index investors can now build efficient portfolios that also include emerging markets, real-return bonds, real estate and small-cap stocks.

We have no way of knowing whether the next decade will see higher returns, but we do know that index investors are better equipped than ever to capture everything the markets have to offer.