This article from the New York Times, “The Index Funds Win Again,” talks about a study done by Mark Kritzman, president and chief executive of Windham Capital Management of Boston, which shows once again that index funds are incredibly hard, if not impossible, to beat. I found the link at the Canadian Capitalist and couldn’t resist re-posting it here.
Just found this great interview with John Bogle, “the father of index investing.” A must-listen for any investor, especially those who own mutual funds and those who have no idea what index investing is all about. If you already use indexes in your portfolio, they is still a lot of great information here, and it will help give you even more confidence that you are on the right track!
Rob Carrick recently did some analysis of mutual funds’ and ETFs’ MERs relative to their performance, which he calls FFI (Fund Fee Index) (see “How to get the skinny on your fund’s fat fees“). The FFI is supposed to be used as “a new way to measure the value you get from the fees you pay to your own mutual funds and exchange-traded funds.” It is calculated as follows:
Cute idea, but unfortunately it is a fairly meaningless measure since paying more expenses to a mutual fund company will not get you more gross returns (because returns are random). The big thing you will notice from the chart is that all the iShares ETFs scored far lower. In fact, as Carrick points out:
The best index score for a mutual fund was the 8.7 earned by the Phillips Hager & North Dividend Income. The worst score on the ETF side was the iShares Cdn Short Bond Index Fund at 4.8. Here, we have a vivid example of how the low fees of ETFs work to the advantage of investors. The ETF scoring worst on the Fund Fee Index beat the mutual fund with the best score.
That’s right, each of the 12 ETFs he chose beat the top 50 mutual funds of all types according to his FFI measure. He praises ETFs’ low fees, which is why the ETFs’ FFI scores are consistently lower than those of mutual funds, but stops short of making any grander conclusions. He says “it’s pointless to generalize about the value that investors get for the mutual fund fees they pay – some funds are outstanding, many are middling and some are pretty bad.” Maybe so, but we can definitely generalize and say that investors get much more “value” (I’m using Carrick’s definition of value here… a low FFI) out of ETFs than they do from mutual funds.
In general the FFI is a useless measure. Here’s an example. If a mutual fund or ETF had a 5 yr. annualized return of 1% and an MER of 0.1%, we get an FFI of 11 . Let’s say another fund or ETF had a 5 yr. annualized return of 20% with an MER of 2%. That gives the same FFI of 11 . So what does that tell us? That these two investments are equally “good”? The FFI hides the returns and in the end doesn’t tell us anything.
The only way in which the FFI is moderately useful is for comparing funds in the same sector or market. Then we can truly understand why the ETFs have lower FFIs than the mutual funds and what that actually means. The FFIs for the ETFs range from 0.9 to 4.8. These are ETFs such as iShares CDN Composite (XIC) with an FFI of 1.3 and the iShares CDN Short Bond Index (XSB) with an FFI of 4.8. The gross returns of the mutual funds should, on average, be equal to the gross return of the iShares ETF in the same category (because the gross return of the iShares ETF is the market average’s return). So when comparing ETFs and mutual funds in the same sector, the only variable affecting the FFI score is the MER. The higher the MER, the higher the FFI. So for this specific case, the FFI basically just becomes another measure for the net return, and as Rob Carrick says “The ETF scoring worst on the Fund Fee Index beat the mutual fund with the best score.” But what he is really saying here is that in any given sector, the iShares ETF for that sector had a higher net return than all the mutual funds in that sector that he looked at.
John Chevreau looks at the latest “the SPIVA (Standard & Poor’s Indices Versus Active Funds) scorecard for 2007” and it doesn’t look good. When will the average Canadian realize that investing in mutual funds is a loser’s game? Check out Andrew Teasdale’s interesting comments below the article. Here’s a snippet:
Mutual funds in general are products whose main objective is to earn returns for financial intermediaries and financial institutions and in many respects pander to the short term whims of the general investing public and the financial community at large. Sadly the mutual fund industry (as a whole) could be considered more of a game with the odds stacked against the investor than a serious attempt to deliver value and discipline. . . Canada however is one of the worst offenders when it comes to the value for money mutual funds offer the investor. When will Canadian investors as a whole start to realize that the odds, based on the current status quo, are more often than not stacked against them?
Rob Carrick recently “gathered 10 of our favourite bits of investing advice, on topics ranging from stock-market risk to which mutual funds to buy” and called it the 10 Commandments. A commandment is “a command or order,” so something like “thou shalt not use the word commandment incorrectly” is a commandment. “Commandment” #10 is “Investors repeatedly jump ship on a good strategy just because it hasn’t worked so well lately, and almost invariably, abandon it at precisely the wrong time.” C’mon that’s not even a commandment! So what is the order here, that we should not jump ship on a good strategy that goes bad? or should we not use strategies? or should we abandon them at precisely the right time instead of the wrong time? The longer explanation does not leave things any more clearer, offering such advice as “ignore the slumps or use them as a buy-low opportunity,” or ” judge whether your fund manager has what Dreman calls a good strategy.” For what’s it’s worth, the only words of advice in there I thought were useful were Buffett’s (use low-cost indexes) and Malkiel’s (less fees are better).
A while ago a guy named Alan Haft (he wrote a book called “You can never be too rich”) made up his own 10 Commandments of Investing and it’s been in my drafts folder ever since I saw it. I think he sums up the most important things that people should do with regards to investing, they are well written, and they make sense. Here they are:
- Stick with the indexes
- Watch those fees
- Create a bond ladder
- Watch your money
- Don’t rush in
- Don’t take the risk if you don’t need the return
- Get out if something isn’t working
- Understand tax consequences
- Keep it simple
Here are some highlights:
1. Stick with the indexes
Leave the individual stock picking to gamblers and speculators. Very few people really understand how to successfully pick individual stocks, and if they do, the news that drives markets today is totally unpredictable, making individual stock picking a highly risky venture. Reams and reams of statistics prove index investing almost always outperforms the financial advisors, money managers, and stockbrokers. Stick with the indicies and you’ll likely wind up far ahead of the game. Care to speculate a bit on some individual stocks? Do it with a small portion of your money, but certainly not the bulk of it.
2. Watch those fees
Wall Street loves investors that don’t watch their fees. For those investing in funds, check out www.personalfund.com. You might be shocked to find out the total cost your funds are charging you to own them year after year. Especially over the long haul, fees can destroy your returns. Minimize fees as much as possible by investing in low-fee, highly diversified investments such as one of my personal favorites, Exchange-traded funds such as those offered by www.ishares.com
7. Don’t take the risk if you don’t need the return
Many people would do perfectly fine getting 7-10% returns on their money, yet their portfolios are invested in things that strive for well beyond that. Especially if you’re a retiree, if you doubled or tripled your money overnight, would you go out and buy a fancy new sports car? A mansion on the hill? Few of us would. And for that reason, always ebb towards the safer side of investing as much as you possibly can
Check out the original article for the rest!
- UK Housing Hurting – The British Housing bubble, “spurred by a borrowing spree, thanks to interest rates at 40-year lows from 2001 to 2006” may be in its last days after the “average home almost tripled in value in the past decade.” It looks like properties bought as investments are going to be the hardest hit (just as they will in Vancouver): “Gabay says so-called buy-to-let properties, which investors acquire for rental income, are more vulnerable to a fall in prices . . . As interest rates rise, buy-to-let investors are making less profit on rental property, which may drive down housing demand and prices.” There are already many properties in Vancouver where the owners are not making up their mortgage payments with the rent (a few searches on MLS and Craigslist are all it takes to verify this, in addition to my own research while looking for a new place for rent in July ’07.
- Buyers get real returns” – Apparently “if you’re purely interested in accumulating wealth, it’s hard to beat homeownership over the long term, according to a discussion paper (Are Renters Being Left Behind? Homeownership and Wealth Accumulation in Canadian Cities“) completed earlier this year by UBC real-estate professor Tsur Somerville and student research assistants Li Qiang and Paulina Teller.” The results vary by city, but even in “in those cities where it is even possible to accumulate more wealth than owners, renters must be extremely disciplined. They must invest on average nearly 80 percent of the difference between the annual cost to owners and the cost to renters . . . this is approximately equivalent to 9% of a person’s gross income.” 9% of gross income does not seem that bad. If one looks at Table 4 of the study it is not that bad for renters especially if they invest the difference between rent and a mortgage (100% in this case) in lower cost investments. They would have achieved 77% of “owner wealth” if invested only in GICs and 124% of owner wealth if invested in the only the TSX index with 0.75% annual expenses (ie. MERs). I noticed some possible bias in this study and that is that they used the years between 1979 and 1996 as starting years and 25 years OR 2006 as the ending year, then averaged all these scenarios. The later years are thus weighted more heavily in their average. The year 2004 is used in each scenario but 1979 is only used in 1.
- Mishs Global Economic Trend Analysis: What Factors are Affecting the U.S. Dollar? – Just one paragraph here of note: “The housing bubble in the US is well known, but the bubble in Canada, the UK, China, and Spain is just as big (if not bigger) than the bubble in the U.S. In particular, the bubble in Vancouver is as massive as the bubble in Florida or California ever was. Vancouver housing prices are destined to crash. Don’t ask me when, but only fools are buying at these prices. The housing bubble in Australia was the first to start deflating.”
- Buy the fund, or buy the company? – Rob Carrick discusses buying stock of mutual fund companies. I found this comment amusing: “Investors can even take their cues from CI chief executive officer Bill Holland, Paul Desmarais, founder of Power Corp., which controls IGM Financial, and AGF CEO Blake Goldring who all have “the majority of their wealth” tied up in their stock as opposed to the funds, Mr. Almeida added.” These guys are smart, they know that it doesn’t make sense to buy mutual funds when 2% or more (on average) of the return is eaten up by MERs every year. Carrick also comes right out and mentions that “with mutual funds, investors typically get market-type returns minus the fees collected by their managers . . . The allure of fund companies is that their business model allows them to collect fees on assets under management during the good and bad times.”
- Who, in the real world, can afford to live here now? – Another housing story about Vancouver. I knew that the percentage of their income people are now spending on their home has gone up, but I was surprised to learn that “here in Metro Vancouver . . . In the second quarter of 2007, the average owner of a two-storey home spends 73 per cent of the family’s pre-tax income on financing and maintaining that home.” 73% of pre-tax income? How does this average Joe get approved for such a mortgage (or is it a variable-rate?). Or an ever better question, how does average Joe buy food after paying taxes?
According to Fidelity, we need 80% of our current income to retire (see Canadian Capitalist’s “Fidelity’s ‘Scary’ Retirement Findings“, where I found this story). Canadians on average have 50% of their pre-retirement income in retirement, but this is no different from other countries; United States: 58%, Britain: 50%, Germany; 56%, Japan: 47% (see “Want to play in retirement? Test your future income“). If those numbers are not adequate, it implies that the average senior in the United States, Britain, Germany, and Japan are all in dire need. I doubt that is the case. (My opinion is that people should save as much as they want. You might need only 50% but if you want to spend a lot in retirement and travel instead of just tinkering in your garden then maybe you need 80% of your pre-retirement income, or maybe 150%, just in case.)
The funny part is that even if you wanted to get to 80%, the hardest way to get there would be to use Fidelity’s products. All their MERs are above 2% (click on Facts & codes). It’s too bad their retirement calculator doesn’t have a slider bar for the MER or rate of return, then you would be able to see just how badly these management expense fees can affect the final value of your portfolio, and in turn, your annual income in retirement.
I just did a calculation and if you invest $8,500 annually starting from the age of 30 you end up with $2 million at the age of 65 if the contributions are indexed to inflation and the rate of return is 8% (the return you might get if you buy a low-MER (0.25%) investment, like an index ETF). Decrease that return to 5.75% (the return you’ll get if you pay a 2.5% MER on Fidelity mutual funds or their managed portfolios) and you’ll have only $1.32 million at age 65. Assuming $2.64 million is what one would need to keep the same income one enjoyed pre-retirement:
In the 2.5% MER case: $1.32 million is 50% of $2.64 million
In the 0.25% MER case: $2 million is 76% of $2.64 million.
So by simply not using a company like Fidelity and going with a competitor like Vanguard or iShares and buying index ETFs (with far lower MERs) instead, you can easily get closer to that 80% figure and increase your nest egg from to $2 million from $1.32 million without even having to save any more money. By the same token, it could probably be argued that one of the main reasons that Canadians do not have 70-80% of their pre-retirement income in retirement (and only have 50% instead) is because of the amount of MERs, fees, and commissions they pay every year to the financial industry.
In last Saturday’s Globe & Mail (finally got around to reading the paper today), Rob Carrick compared the performance of Canadian equity funds to a low-cost index ETF that covers the entire Canadian market, iShares CDN Composite Index Fund ETF (XIC). It is the one I own to capture the Canadian market and it makes up the entire Candian equity portion of my portfolio. He went five years back because the ETF has not been around for 10-years yet. He compared this ETF to the “100 or so funds in the Canadian equity category that have been around for the five years to Sept. 30.” Surprise, surprise, only 5 mutual funds beat the index over that period. Here are some of those funds, sorted by 5-yr % return:
|Fund name||MER||5-yr % return||5-yr beta|
|Acuity All Cap 30 Canadian Equity||2.85||27.96||1.385346|
|imaxx Canadian Equity Growth||2.76||24.54||0.986167|
|Altafund Investment Corp.||2.72||22.02||1.042311|
|TD Canadian Equity||2.09||21.39||1.145336|
|iShares CDN LargeCap 60 Index||0.15||21.39||0.980728|
|TD Canadian Equity-A||2.09||21.09||1.130500|
|iShares CDN Composite Index||0.25||20.94||1.002607|
|Altamira Precision Cdn Index||0.53||20.45||0.983078|
|iShares CDN MidCap Index||0.55||20.45||0.983592|
|Hartford Canadian Stock D||1.88||20.43||0.949451|
|Integra Canadian Value Growth||2.24||20.04||0.906116|
|TD Canadian Index – e||0.31||19.93||0.987276|
|National Bank Canadian Index||1.14||19.84||0.983619|
|Leith Wheeler Canadian Equity B||1.50||19.72||0.720842|
|Manulife Sector Rotation Fund||2.69||19.55||1.012749|
|RBC Canadian Index||0.71||19.55||0.996493|
|GGOF Canadian Lrg Cap Equ Mutual||2.39||19.54||0.878637|
|Hartford Canadian Stock B||2.60||19.53||0.952128|
|Acuity Social Values Canadian Equ||2.85||19.52||1.178193|
|Sceptre Canadian Equity – A||1.69||19.42||0.939199|
|TD Canadian Index||0.85||19.41||0.997669|
|FMOQ Canadian Equity||0.95||19.34||0.933744|
|CIBC Canadian Index||0.97||19.30||0.995622|
|Scotia Canadian Stock Index||1.03||19.20||0.997593|
|BMO Equity Index||1.01||19.12||0.994472|
|PH&N Canadian Equity-A||1.13||19.09||0.870502|
|Fidelity Cdn Disciplined Equity-B||2.24||18.98||1.019771|
|Fidelity Cdn Disciplined Equity-A||2.45||18.85||1.021164|
|Meritas Jantzi Social Index||1.94||18.81||0.872850|
|PH&N Community Values Cdn Equ-A||1.39||18.65||0.815829|
|Fidelity Cdn Disciplined Equ Cl-B||2.30||18.65||1.019219|
|Fidelity Cdn Disciplined Equ Class||2.50||18.52||1.020240|
|Manulife Canadian Equity Fund – A||2.23||18.38||1.046150|
60+ more funds to go on this list…
Note that some funds that started 5 years ago probably got canned due to poor results (or other reasons) and are thus excluded from the “100 or so equity funds” that Carrick mentions. See Survivorship Bias.
These results should come as no shock to anyone. If it does surprise/shock you, I recommend reading A Random Walk Down Wall Street as Burton Malkiel explains the reasons why index funds do much better far better than I can. You don’t even have to believe in efficient-market theory. According to Malkiel (and others of course):
But even if markets were not efficient, indexing would still be a very useful investment strategy. Since all the stocks in the market must be owned by someone, it follows that all the investors in the market will earn, on average, the market return. The index fund achieves the market return with minimal expenses. The average actively managed fund incurs an expense ratio of about 1.5 percent per year [ed: in Canada I think this is higher]. Thus the average actively managed fund must underperform the market as a whole by the amount of the expenses that are deducted from the gross return achieved.
The only way mutual funds will do you any good is if you can predict beforehand which mutual funds will be one of the handful that do outperform the indexes (good luck). He goes on mention that this claim is actually borne out in the data from the US market in the past 20 or so years,
Between 1974 and 2006, for example, the S&P 500 outperformed more than three-quarters of the public equity mutual funds–the average annual total return for the S&P 500 was more than 1.5 percentage points better than that of the media fund
Again survivorship bias plays a role here. If we included some of the funds that existed in 1974 but did not make it to 2006, the S&P 500 would most likely have outperformed an even larger fraction of the public equity mutual funds from 1974 to 2006.
I haven’t blogged in a while but over the past week I collected a few interesting links I present them to you now in my first “Link Fest” post. Enjoy!
- The Worst Recession in 25 years? – A guy named Robert P. Murphy talks about the Fed’s recent rate cut and how it will not only “pave the way for much higher price inflation than Americans have seen in decades, but it will also exacerbate what could be the worst recession in twenty-five years.”
- Vancouver’s big squeeze: Unreal estate – This article in the National Post profiles the Vancouver real estate market and its absurdly overpriced it is. Apparently a “psychologist in private practice” with income well above the norm cannot even afford a home.
- Dodge warns of inflated housing market – Bank of Canada Governor David Dodge is raising a red flag about housing prices in Canada, saying that increasingly loose lending rules may be helping overheat the country’s real estate market.
- Cake Financial – An interesting new website that (by the sounds of it) will calculate your portfolio’s performance based on the transactions you make through your broker. It does so by connecting to you broker’s website. That’s right, no more manually entering transactions manually into some piece of software. Unfortunately I am at E*Trade.ca and it looks like it only works with E*Trade.com. I am not surprised as I literally had to enter a fake zip code just to get into the site.
- Give a cheer for these index-beating mutual funds – Or… not. Instead give a cheer for random chance and probabilities. Rob Carrick fails to mention that 1) the performance of these top achievers is most likely due to random chance (just like if 1000 people flip a coin 25 times there is a high probability that at least one person will flip heads 20 times in a row). 2) Survivorship bias means that of all the funds that have lasted 15 years, the ones that actually last that long are quite likely to have beaten the index because the ones that didn’t were killed off. Returning to the coin-flipping example, if you also tell any coin-flipper that flips 5 tails in a row to quit flipping, by the end, the field will be smaller and thus the 20-head flipper will appear to be all the more impressive. As Rob Carrick said himself in his article, “just because a fund beat the index over the past decade and a half doesn’t mean investors can count on it to do so in the future. Again, too true.” So why write the article in the first place? Why celebrate past performance? Still not sure.
Firstly, I wish to compliment you on your excellent blog. Your posts are simple and they have certainly helped me navigate towards a passive portfolio. Please keep up the excellent work.
Why thank you! Keep reading, tell your friends. And sorry for taking so long to respond to this, I’ve been quite busy.
I know that you are not in the business of giving financial advise, but I was wondering whether you could provide some guidance, or post on subjects related to my current situation. I am a relatively young investor, like you, (25) who now has a steady job and am looking to invest for the long term. I have been investing for a while now and have built up savings of, let us say a fictional $100,000, primarily of mutual funds, including some index funds. I currently use TD Waterhouse’s self-directed brokerage.
My portfolio is as follows:
TD Canadian Index-e
TD Monthly Income
TD Balanced Growth
TD Dividend Growth
Canadian – 12%
TD International Index currency neutral
Cundill International Value
Trimark Fund SC
International – 26%
Vanguard Total Market E.T.F. – VTI
RBC O’Shaughnessy US Value
US – 13%
TD Latin American Growth
Emerging Markets – 2%
GIC (one year, 3.75% matures in Dec. definitely can cash this earlier)
Corporate Bond ($160 a month)
Fixed Income, Bonds – 43%
Cash – 4%
Reminds me of my old portfolio at TD Mutual Funds (not Waterhouse, I had a mutual fund-only account at TD, used to be called TD Greenline Mutual Funds). Lots of funds with a lot of the same holdings; I had TD Canadian Index-e, TD Balanced Growth, TD Dividend Growth on the Canadian side. 3 International funds, 2 US Funds, etc… As my former advisor said to me “with so many mutual funds, what you’ve got is basically an index but with a high MER.”
Most of my portfolio is outside of an RRSP (20% is in RRSPs – I cannot really contribute much more to my RRSP). So if I wanted to switch my actively managed funds into ETFs, how should I do it? I am aware of the early redemption fees, but aside from that, do I just sell them and take that big chunk of cash and buy my proper allocations of ETFs? Are there tax consequences that need to be thought about? I know your thoughts on timing the market, so should I just buy everything I need on one day (the VTI I bought at $150 a couple weeks ago, and I know I shouldn’t even think about it)?
First of all you can do the switch to ETFs outside or inside, and you won’t incur any more costs either way. If you do it outside, you can transfer them into your RRSP later “in-kind” without having to sell them. As far as the tax consequences go, outside an RRSP you will have capital gains (losses) to pay taxes on if you sell anything, or when you transfer them into an RRSP. I think when I did it a long time ago, I sold them outside the RRSP and incurred a capital gain, and when they were sold they went into my linked bank account. I then moved that money into an RRSP cash account and then bought investments from there. I was selling and buying no-fee mutual funds outside and inside respectively so I didn’t incur any costs. I think the only tax consequence you should really worry about is to maximize your RRSP contributions every year and that’s about all you can control. Of course, since you are probably planning to keep VTI inside your RRSP, just transfer the VTI in-kind and you will incur a capital gain (loss) on any gains (losses) since you bought it.
Next, don’t switch all those things into ETFs if your commissions are going to be huge relative to the size of your portfolio. If you are going into 4-5 ETFs and the total commission is going to be about $100, I would say that if your portfolio is $10,000 or more, go ahead.
As for your timing try not to even worry about what the market is doing. Pick an asset allocation that you are comfortable with and then go with it. Switch all at once to a new allocation if you want.
With RRSP space that I do gain each year, which investments should be prioritized to be bought within an RRSP?
I guess if you don’t have the RRSP space for everything yet, it would make sense to put non-Canadian stuff into the RRSP first. The Canadian stuff doesn’t suffer from as much double-taxation as the non-Canadian stuff. I cannot remember what the difference in taxation is between dividends and capital gains (I don’t have any non-RRSP investments at the moment, just some debt :-)) but it’s probably not enough to worry about.
(Aside: when I say double-taxation, I mean that money outside an RRSP is taxed once (as income on your paycheque) and then again when it earns interest or realized capital gains, whereas inside an RRSP it is only ever taxed once (as income).)
It seems that my allocation for bonds/fixed income is too great, but that is only because I did not know exactly how to allocate it, in the end, I only want about 20% bonds.
How did you feel about the recent market downturn? Were you glad to have so much in bonds/cash? If so, keep your current allocation. If you didn’t care too much and think that you could have suffered more and not cared, go with less. Just don’t worry about timing. If you switched to more stocks now, the equities market could continue its fall over the coming year. If you keep your current allocation, the equities market could just as easily bounce back over the coming year as well and you might miss it. You cannot even hope to predict the future.
I recently thought about my emotions during the recent slide, and in retrospect I kind of wished I had a little bit more bonds/cash than the 20% I have (maybe 30%?). I am going to add 5% REITs to my portfolio eventually, so I will eventually have 25%.
I was doing a systematic investment plan where money was taken out and a number of the mutual funds were purchased on a biweekly basis. Now I have stopped the plan and will accumulate money until there is enough to purchase the right ETF (VTI, VEA, VWO, XIC).
I used to do what you did with mutual funds as well. Biweekly, and I would purchase several different funds. Now I also save up cash in my RRSP until I have enough to buy an ETF. I usually wait until. I have $2000. Since I pay commissions of about $20 that means the commission will be 1% of the purchase amount.
I know this is a long rambling post, but any guidance you might be able to share, even if not directly but through future postings, would be much appreciated.