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 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.