Indexing’s Dirty Little Secret

“Most actively managed mutual funds underperform the market.” Couch Potato investors sing this refrain all the time in defense of ETFs and index funds. I’ve done it many times myself — a bit smugly, I confess. My FAQ page points out triumphantly that 92.6% of actively managed Canadian equity funds have trailed the S&P/TSX Composite over the last five years, according to Standard & Poor’s, which issues a quarterly report on active funds versus the indexes.

But here’s the part that S&P and most indexing advocates usually leave out: the vast majority of ETFs and index fund underperform their benchmarks, too. So it’s not fair for index investors to imply that they earn market returns, because they almost never do. Call it indexing’s dirty little secret.

This inconvenient truth is discussed in an excellent article by Scott Ronalds, published in this month’s Canadian Money Saver. Ronalds is manager of research and communications with Steadyhand Investment Funds. His article doesn’t disparage indexing, nor does he pull out the red herrings that Mackenzie Financial and others use to criticize ETFs. He simply points out that a true apples-to-apples comparison would pit actively managed funds against ETFs and index funds in the real world, not against hypothetical benchmark returns. “The all-in costs of ETF investing are not immaterial. Yet, they are often downplayed, if not completely ignored, in most comparisons of passive vs. active investing… The S&P scorecard exaggerates the outperformance of passive investing by ignoring the issue of fees.”

Ronalds is right. After all, the MERs on index funds are much lower than the average mutual fund, but they’re not zero. The trading expenses aren’t zero either. There are a host of other factors that can be a drag on returns, too, as I’ve discussed in several recent posts. And, of course, buying and selling ETFs incurs commissions. All of this means that it’s typical for a Couch Potato portfolio to underperform the broad-market indexes by 0.5% to 1% every year, and sometimes by much more.

I don’t agree with all of Ronalds’ arguments. While he’s right that the S&P scorecards ignore the cost of index investing, they also ignore some of its benefits. The greater tax-efficiency of ETFs, for example, isn’t measured by S&P’s survey, but it can have a big effect on net returns. Neither do the scorecards account for the corrosive front-end loads and deferred sales charges levied by many active funds. Indeed, the real problem with actively managed mutual funds is not their investment strategy: it’s that they’re hawked by commissioned salespeople who are in an inherent conflict of interest because of this fee structure.

I still believe that the Couch Potato strategy is the best hope that investors have for earning close-to-market returns over the long term. But all index investors should acknowledge and learn from Ronalds’ arguments. I took away three important points:

Tracking error is the enemy. Couch Potato investors should never assume that index funds and ETFs deliver market returns minus only the MER. That’s just not true. Many passive funds that track the broad Canadian equity and bond markets do so extremely well. But Canadian ETFs that track the US and international indexes are dragged down by factors such as currency hedging, withholding taxes and poor sampling. Couch Potato investors should therefore choose their international funds carefully: US-listed ETFs from Vanguard and iShares have a much better record of tracking their indexes than their Canadian counterparts.

Advisors who use passive strategies may be just as expensive. Do-it-yourself Couch Potatoes can easily keep their annual fees well below 0.5%, including fund MERs and a few trades a year. But DIY investing requires knowledge and commitment that not everyone has: there is a role for advisors, and if you need one, she deserves to be paid. Many advisors embrace ETFs and passive strategies, but once they add their own fees to the MER of the portfolio, any cost advantage over active management may disappear. If a fee-based advisor builds you an ETF portfolio that costs 0.5% but then adds another 1% annually for her own fees, is that fundamentally better than using active funds that charge 1.5%? Maybe, but I would challenge the advisor to justify it.

What is clear, of course, is that paying MERs in the range of 2.5% to receive cookie-cutter services from an “advisor” who is nothing more than a salesperson is always a bad deal. So is paying front-end loads or deferred sales charges, which are never justified. No exceptions.

The key is sticking to the strategy. Successful investing is not just about choosing the right strategy: it’s about sticking to that strategy. Active investors can do just fine if they stick to no-load, low-MER funds (like those offered by Phillips Hager & North, Mawer and Steadyhand) and hold them for the long term, through all market conditions. By the same token, investors who build so-called passive portfolios but then try to time the market are probably doomed to fail. I get emails all the time from investors who call themselves Couch Potatoes because they use ETFs, but then they talk about using leverage, chasing hot sectors and altering the strategy based on predictions about where the markets are headed in the next six months. A passive strategy only works when it’s truly passive.

Filed under: ETFs, Index funds, Research