FFI (Fund Fee Index): Useful?

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:

FFI = \frac{MER}{gross\ return + MER} \times 100 = \frac{MER}{gross\ return} \times 100

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 \left( \frac{1+0.1}{0.1}=11 \right). 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 \left( \frac{20+2}{2}=11 \right). 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.

Ask Dave: How Do Bond Indexes Work?

A reader named Charles asks a very good question about how bond indexes work?

Quick question for you. I, of course, know how TIPS and bond works but what about a short-term bond indexes (XSB or XRB or TD e-Series) for instance? Does an investor actually gets coupon payment? (I dont think so…). Because the market value of the bond doesn’t change much, so the investor basically gets its return from the quarterly dividends only?

I have a good understanding about how bonds work myself although I don’t know much about the details of how bond indexes work although I sort of just imagine it as a basket of bonds with different dates of maturity, different coupon rates, and different face values, and that buying an index fund is just as if I had bought all the underlying bonds at their current face value. I will also receive all of the interest payments on the bonds in the index, or some of it will be reinvested into purchasing other bonds. That’s just my idea or assumption of how it must work.

Here is a short summary of how bonds work and how bond funds (mutual funds in this case, but an index should be no different in theory) from some website, but it is reprinted from American Century Investment Services, Inc.:

It’s easier to understand how bond funds work after you know how individual bonds work.

An individual bond pays interest at a rate set by the issuer. Usually, the issuer agrees to pay interest on a regular basis such as quarterly or semiannually. The current yield on a bond, which is the amount you earn, is calculated by dividing the amount of annual income by the bond’s price.

For example, if a $1,000 bond provides $80 in income, its current yield is 8% (80 divided by 1,000). Bonds pay interest income regularly and repay the face amount (principal) when the bond matures. Keep in mind that the price of a bond can change after it’s issued, which could change the current yield even though the interest rate stays the same.

With bond funds, the current yield also is referred to as the distribution yield, and it is calculated using the daily dividend per share. This is what is used to distribute income to the funds’ investors.

Another website called Quamut had a pretty good explanation of How Bond ETFs work:

Bond ETFs track indexes that contain individual bonds. Bond ETFs don’t have a face value or a coupon rate, however. Instead, bond ETFs have a share price that’s determined by the prices (face values) of the individual bonds in the index that the ETF tracks—when the prices of those bonds rise, the ETFs share price also rises. In place of a coupon rate, bond ETFs have a yield (interest payment) that equals the average interest rate of the bonds in the index that the ETF tracks. Though the interest payment on an individual bond is fixed, the yield of a bond ETF can change as the individual bonds in the index tracked by the ETF shift. Generally, these interest rates change only in small degrees.

If anyone else can find a better explanation out there please pass it on. So far the Wikipedia article on Bond Market Indexes is not great.

CommunityLend Pre-Launch Site Revealed

CommunityLend is now closer to launch, with the unveiling of their new pre-launch website. CommunityLend is the Canadian version of Zopa (from the UK, but has now expaneded to other countries) and Prosper (from the US), which are P2P lending sites. In theory, by reducing the middle-man (the bank), lenders and borrowers alike should get better rates then they would through the bank.

Sigh…Another Report Shows That Mutual Funds Don’t Beat Indexes

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?

Ask Dave: What’s the Best ETF Allocation 15 Years Away from Retirement?

Our question today comes from Charles who asked me what he should do with his dad’s pension assets, which are currently invested in two mutual funds:

Hey Dave!

My name is Charles, and I am a Finance student at the John Molson School of Business in Montreal. Lately, I decided to take over my dad’s pension fund. His company provides my dad with $15,000/year to be invested with Desjardins Financial Security (I don’t think you have this Quebec bank in BC but it is popular here and in Ontario). His plan is a defined contribution plan and not a benefit plan. When I look at my dad’s assets, he had 2 funds: 1) Jarislowsky Fraser Balanced Fund 2) Jarislowsky Fraser Canadian Equity Fund — These funds are not beating the market (benchmark) often and if they do…well these funds MER are expensive so they perform worse than the market.

Therefore, I wanted to take over his asset allocations but I have no choice but to deal with Desjardins since his company deals with them but of course I or my dad can choose its asset allocations.

I am a strong believer of index funds and ETFs. Desjardins offers great Barclay’s (iShares) ETFs: 1) Active Canadian Equity fund, 2) EAFE Equity Index, 3) Universe Bond Index Fund, and 4) S&P/TSX Composite Index Fund.

My dad is currently 48yrs old and wants to take its retirement when he his 63 – 65 years old. Therefore, a good 15 years of investment.

Here’s my question…what should be my weights in each asset class?

I was thinking 70% equity; 25% bonds and 5% T-Bills. Is having all of the 25% bonds in the Universe Bond Index Fund good? As for the equities, is 60% in S&P/TSX Composite Index Fund and active Canadian Equity fund and 40% for EAFE Equity Index any good? If I have the S&P/TSX index..is Active Canadian Equity relevant?

You can find all the info for each fund on Desjardins‘ website:

Again, thanks for your help and thanks for your great website!

First of all, it’s too bad that Desjardins does not publish the MER of those funds, although it is pretty much a given that they are going to be higher than any Barclays (iShares) ETF.

Although Charles says that “these funds MER are expensive so they perform worse than the market” it seems that over the last 10 years the Jarislowsky Fraser Canadian Equity Fund has outperformed the S&P Composite Index (16.3% to 9.5%). Although that probably says more about your dad’s reasons for choosing this fund over the others and this fund’s longevity, than it does about the fund’s prospects of “beating the index.”

Currently Charles’ dad is invested in 77.5% equities (50% from JF Canadian Equity Fund and 27.5% from JF Canadian Balanced Fund) assuming that he is invested equally in both of these two funds. My first recommendation would be not to deviate too much from what his dad was invested in before. This isn’t Charles’ portfolio, and if things turn ugly (or uglier?) for either stocks or bonds he doesn’t want to be the one to blame for shifting him more or less into either category. So I don’t see anything wrong with going with 70% equities in his new ETF based portfolio. I really don’t have a precise answer on what allocation of bonds/equities is right for your dad. I would try to stick with a balanced approach, and by that I mean that he should be invested 25-75% in equities and 25-75% in bonds (neither all bonds or all stocks). Risk assessments on banks’ websites (like TD Canada Trust’s Retirement Strategy Tool) are somewhat useful, not to come up with a precise answer, but to give you something that is in the ballpark. If anything, psychologically they can give Charles and his dad some comfort.

The Bond Universe fund is a good way to capture the bond market.

I don’t see anything wrong with his allocations within the equity class. I would not bother with the Active Canadian Equity as he will just get poorer performance (on average) than the index itself (after MERs). The only other thing that I noticed is that there is no exposure to the US market here as it looks like Desjardins does not offer Barclays’ (iShares) S&P 500 Index. I assume his dad has other investments besides this pension? If so, then I hope Charles will look at his entire portfolio (pension + RRSP + spouse?) as one, rather than each individually and hold a US index outside of his pension.

Ask Dave: US Dollar ETFs

Another question (or should I say several questions) from a reader about US dollar ETFs. Paul wrote:

Thanks for the great blog – as a relatively new investor interested in building an ETF portfolio, I have found a great deal of useful information on your site – its much appreciated. I wanted to ask you a few questions regarding the use of the Vanguard ETF’s especially in light of the soaring loonie which is nudging US$1.06 these days.

Do you think that the strong loonie should be an extra incentive for Canadians to buy the Vanguard ETF’s to diversify their portfolios? I feel that the strong loonie offers us an opportunity to buy these US$ based shares at a discount given that historically the CAD has been weaker than the US$. But I have read some blogs that warn that that may all be changing and that with increasing global demand for Canadian resources and with the problems in the US economy, we may see our dollar at least on a par with the US$ for a while to come.

No, I don’t think that the fact that the Loonie is extra strong (relative to the past) should be any extra incentive to buy Vanguard ETFs (read: US dollar ETFs). You are right, with pending problems in the US economy and increasing demand for Canadian resources the Canadian dollar may go even higher, or the Canadian dollar may fall back (or the US dollar may rise) to it’s historical norm relative to the US dollar. It is difficult to predict. It is good to own Canadian dollars if you plan on spending the proceeds of you investments in Canada. On the other hand if inflation ever became very bad in Canada and the Canadian dollar fell against the US dollar it would be nice to have US dollars. Also, if the Canadian dollar fell against all other currencies and you planned to spend your retirement savings travelling, then it would be nice if some of those investments were in something other than Canadian dollars. I think it’s important to have a balance and to not put all your eggs into one basket. He continued,

Also, I read your post about the exchange rate spread issue when buying US based ETFs and how if you do not plan to keep these ETF’s for a long time, the MER is essentially boosted by the costs associated with converting CAD to US$ and then eventually back again. Would this issue not lend more argument to buying ETF’s like XIN or XSP which have higher MER’s but at least you do not have to pay a chunk of change when you convert back to CAD?

Of course you would have to do some calculations yourself to see which is better (or see my post about foreign exchange costs). There are a bunch of variables involved: the foreign exchange rate spread, the MERs of XIN/XSP, the MERs of the Vanguard US$ equivalents, and the length of the time the investments were held. In general you’ll probably see that as the length of time increases, the lower MER investment will become more attractive. As the length of time decreases, the investment without the foreign exchange fees will become more attractive.

Lastly, I have read a lot about the exchange rate risk Canadians face buying ETF’s like VWO, VEA, VPL or VGK. How much of an issue is this? Surely as long as the ETF grows and we are buying these ETF’s now with a strong loonie, the risk must be fairly small and one could do well when the CAD eventually returns to a more realistic level with the US$.

I try not to worry about it too much because if you look at the long term historical trend, the Canadian dollar and the US dollar have not diverged substantially, although they do encounter some pretty big swings, as we have recently witnessed.

Right now I am inclined to overweight my portfolio with VTI, VWO, VPL and VGK to take advantage of the buying power of the loonie and then rebalance it with more XIC later when the CAD weakens a bit. Would this make sense right now or is there serious risk to assuming the CAD will weaken in the next few years?

Personally I wouldn’t assume the CAD will rise of fall in the next few years. Plan for a probability of either situation happening. Stick with an allocation of CAD and an allocation of USD that you are comfortable with, no matter what the current state of the loonie/dollar is, and the stick to that allocation. If you want to speculat, that’s up to you, however, but if you’re talking about a retirement portfolio I would just pick an allocation and go with it. If one currency rises substantially above the other you’ll find yourself buying the cheaper currency just to keep the portfolio balanced.

Anyway, thanks for you help and I look forward to reading your thoughts on these issues.

Thanks for your question Paul, and sorry for the delay in responding to it.

Why It’s Nice to Own Bonds

I have been checking my portfolio quite a bit lately (although it is getting a bit boring and the performance of my holdings has been predictably bad). The only part of my portfolio that has showed an increase in market value vs. book value were my two bond ETFs (Short-Term Bond Index ETF (XSB) and Real Return Bond Index ETF (XRB)). Makes me glad that 25% of my portfolio is made up of bonds. It helps me get through the night, so to speak. Even better is that it helps preserve capital during these bear markets and provides some holdings that are not so correlated with stocks for increased risk-adjusted return.

Ask Dave: Why Bonds Anyways?

A reader asked me:

I am 29 and am basically just getting started in investing. Since I am young-ish I have decided to start with an 80/20 mix of stock/bond in my portfolio. I’m pretty sure I want to buy bonds, but don’t know which short term bonds to buy. However, looking at expected returns for bonds (3%-6%), should I really get them in the first place?

I want to have 20% of my total portfolio in bonds. Honestly I can not decide between XBB or XSB and honestly don’t know how to pick one over the other or is there a mix of bond indexes I should buy into? However, if E*Trade is telling me their Cash Optimizer Investment Account is going to give me 4.15% why the heck would I even buy bonds (which fluctuate and introduce risk) when I can get 4.15% GUARANTEED on my money? What is the incentive (or logic) to buy the bonds? I have heard that if E*Trade went bankrupt – I might lose the cash I had in the Cash Optimizer Investment Account (since it was not technically invested in anything that is insured – is that BS or what?) – where as if I owned the bond index – that is a protected insured investment. Perhaps that is a reason I should actually buy the bonds? Comments?

First of all let me give the simplest answer possible: Don’t put all your eggs in one basket. I see the bond and equity markets as two very different markets. In a doomsday scenario, we could see second Great Depression (let’s call it the Greater Depression) and the stock portion of your portfolio could lose 70% of their value while the bonds will hold their value if held to maturity (obviously depending somewhat on the rating and such things but let’s assume we are talking about high-quality and government-backed bonds). Just as it would be foolish to invest only in one sector of the stock market, do not invest only in the stock market. Invest in bonds and invest in real estate too.

Benjamin Graham says a lot about bonds and bonds vs. stocks and asset allocation in The Intelligent Investor. His conclusion at the end of chapter 2 says much the same thing as above:

Naturally, we return to the policy recommended in our previous chapter. Just because of the uncertainties of the future the investor cannot afford to put all his funds into one basket–neither in the bond basket, despite the unprecedentedly high returns that bonds have recently offered; nor in the stock basket, despite the prospect of continuing inflation.

In case you are confused, before this Graham talked a lot about the inherent risk and uncertainty in the stock market (meaning that some bonds are necessary for safety) and persistent inflation risk (meaning that some stocks are necessary as a hedge against inflation, which be be disastrous for bonds). Chapter 2 is a great read, as is Chapter 4, which talks about bond-stock allocation:

We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.

He actually favours a 50-50 split for the “defensive investor”, shifting the balance when stocks are at “bargain levels” or when the market level has “become dangerously high.” I would warn against such market timing and stick to one allocation and re-balance when necessary. That allocation should be set to whatever is comfortable for the investor, as he says long-windedly in Chapter 2, “the more the investor depends on his portfolio and the income therefrom, the more necessary it is for him to guard against the unexpected and the disconcerting part of his life. It is axiomatic that the conservative investor should seek to minimize his risks.”

I don’t know where you get your expected returns for bonds from, but the 10 year performance of the TD Canadian Bond Fund is 5.8% and the return of XSB since inception (7 years ago) is 5.71%. I remember it being better before, so I guess recent poor performance has dragged them down a bit. For the amount of risk involved, that’s not a bad investment. There are equity markets that have performed worse over the same period according to TD’s mutual fund performance chart (Note TD International Equity at 1.4% over the past 10 years).

Of course the other advantage of having bonds in a portfolio has to do with diversification which can lead to less volatility in your portfolio. Chapter 8 of A Random Walk Down Wall Street explains this very well (to see the section I’m talking about, go Search Inside the book on Amazon and search for “the benefits of international diversification have been well documented” and you’ll get to page 192, then read on).

Personally I think bonds will beat any high interest savings account in general. And in my opinion you shouldn’t worry too much about E*Trade going bankrupt unless you have over $1 million with them. I’m not convinced that the Cash Optimizer wouldn’t be covered by the CDIC but I haven’t really looked into it so I’m not sure. Maybe another rule of thumb should be to not have all your assets at one brokerage?

As for XSB vs. XBB, Martin Gale of efficientmarket.ca complains that “the duration on these funds [XBB] was too high” making the risk-adjusted return too low compared to stocks:

Note the principle here: If you want to earn a higher return, you have to take a higher risk. Some investors try and earn the higher return by buying longer duration bonds, and taking on a higher interest rate risk. I think this is a bad idea: If you want to take on a higher risk, instead buy more equities and take on more market risk. Whatever risk/return ratio you achieved by buying longer duration bonds, you could achieve by holding fewer bonds and more equities. In general I think the equities have the better risk/return ratio. That could always change–but at least historically, it’s been the case that equities have been a better investment than long-term bonds.

You can read the full article here: “Changes To Barclays iShares: XSB and XRB” article. He was so strongly in favour of XSB and against the longer duration XBB that I went with XSB instead, along with some XRB (real-return bond index) as well (there’s also a mention of XRB in the Martin Gale article).

I hope that helps!

The Real 10 Commandments of Investing

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:

  1. Stick with the indexes
  2. Watch those fees
  3. Create a bond ladder
  4. Diversify
  5. Watch your money
  6. Don’t rush in
  7. Don’t take the risk if you don’t need the return
  8. Get out if something isn’t working
  9. Understand tax consequences
  10. 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!

Indexes Have the Advantage in Bear and Bull Markets

There was yet another Rob Carrick disaster in the Globe & Mail this week, a newspaper that I am losing respect for all the time. After reading the headline,
ETF advantage fades in down market, I knew it was going to be a beauty. He starts off by explaining that index funds and ETFs “clean up” in a bull market.

One of the top no-brainer investing moves is to put money in an exchange-traded fund or index fund if you want to clean up in a bull market.

But why just in a bull market? It is unfortunate that he doesn’t give any reason why indexes might perform better in a bull market (or bear market). The most obvious reason is that index funds or exchange-traded funds represent “the average” but have lower MERs. This same logic should apply to bear markets right? His whole argument that ETFs and index funds “beat” actively managed mutual funds in bull markets but perform poorly in bear market is weak. It rests completely on being selective about what past periods to look at and a belief that mutual fund managers are “market pros [that] are using their training and experience to pick the best stocks.” Couple that with reporters’ tendencies to write about both sides of the story, in this case searching for advantages and disadvantages to both index ETFs and mutual funds even if it means leaving readers with an unfair and inaccurate picture.

In the second paragraph, he mentions that ETFs did not perform that well between Sep. 1, 2000 and Oct. 31, 2007 but from 2002 onward they performed much better than actively managed mutual funds. He thinks he has it all figured out; index ETFs perform poorly in a period that includes a bear market.

. . . the advantage of ETFs isn’t so clear over a longer period that includes a down market. The past seven years are a good example. If you bought ETFs at the peak of the last bull market on Sept. 1, 2000, and held until this past Oct. 31, your returns would look puny compared with many popular Canadian equity mutual funds.

He even suggests that investors consider “investing in the Canadian market, but through mutual funds rather than ETFs” because “the S&P/TSX composite is looking shaky right now after a five-year bull run.”

He describes accurately how the S&P TSX Large Cap index did poorly after Sep. 2000 and explains one of the reasons for this: the fact that Nortel made up close to one third of the index whereas mutual funds were limited to about 10% exposure for each stock. So when Nortel lost almost all of its value after 2000, the index, with more Nortel exposure, would have faired much worse than actively managed mutual funds (in fact, the index performed so badly that the “capped” S&P/TSX 60 index was created after the Nortel debacle). The index would have also faired much better than the actively managed funds between 1997 and 2000 because of Nortel’s gains thus compensating for the loss from 2000-2002; however, he conveniently leaves out the 10-year figures (1997-2997) and only uses a “seven-year comparison prepared especially for this Portfolio Strategy column.” His reason for not using 10-year data is that “a 10-year slice is of little use because many funds and ETFs haven’t been around that long.” I find that rather odd because the TSE/S&P TSX Composite has been around since 1977 and the TD Canadian Index mutual fund have been around for 10 years! Of course I agree that “many funds and ETFs haven’t been around that long,” but since we’re only looking at Canadian equities here, isn’t one Canadian index enough? After all, he only looked at one index for the 7-year period.

I decided to get my own figures from Morningstar’s Fund Selector:

  Number of funds that beat the TD Canadian Index Fund Total number of Canadian Equity funds % of funds that performed worse than the TD Canadian Index Fund
3 yr. 90 279 68%
5 yr. 25 218 89%
10 yr. 23 68 66%

My Method: Using Morningstar’s Fund Selector I searched for funds in the “Canadian Equity” category that have a 10-year return greater than -50%. This allowed to me to find out how many funds have been around for the past 10 years. Then I searched for funds that had performed better than the TD Canadian Index fund over that same 10 year period to determine how many funds beat this index fund. I then repeated the same procedure for 5 yr. and 3 yr. periods. The TD Canadian Index fund’s performance over the 3, 5, and 10 years periods was 19.8%, 20%, and 9.2% annualized, respectively.

As you can see from the table, the indexes beat a large percentage of actively managed mutual funds over the past 3, 5, and 10 year periods. Note also that there is some survivorship bias in these figures. Presumably, in 1997 there were more than 68 mutual funds in the “Canadian Equity” category but only 68 “survived” until 2007. One can assume that the ones that did not survive were more likely to have performed worse than the index, hence their reason for being discontinued, retired, or merged with other funds. So the percentage of funds that performed worse than the TD Canadian Index Fund is likely to be higher than 66% if we could somehow include funds that existed in 1997 but no longer exist in 2007.

Indexes can do even better than this if only the MER was lower. The TD Canadian Index fund has an MER of 0.85% but the iShares CDN S&P/TSX Cap Composite Index (XIC) has an MER of 0.25%. XIC does go back 5 years; however, it wasn’t always tracking the TSX Composite; it used to track the TSX/S&P LargeCap 60 index so I will not look at its performance values. Let’s assume that if XIC (in it’s present form) had existed 10 years ago, it would have performed 0.6% better than the TD Canadian Index Fund over that same period due to its lower MER, or 20.4%, 20.6%, and 9.8% annualized over the past 3, 5, and 10 year periods, respectively. This approximation is consistent with the fact that in 2006 the TD index returned 16.4% but XIC returned 17.0%, a difference of exactly 0.6%. I re-ran my fund searches on Morningstar and here is what the performance would be if XIC existed 10 years ago in its present form with an MER of 0.25%:

  Number of funds that beat the hypothetical iShares CDN S&P/TSX Cap Composite Index (XIC) Total number of Canadian Equity funds % of funds that performed worse than the hypothetical iShares CDN S&P/TSX Cap Composite Index (XIC)
3 yr. 63 279 77%
5 yr. 14 218 94%
10 yr. 20 68 71%

As we see once again, the S&P/TSX Composite Index with a 0.25% MER has outperformed over 71% of all actively managed mutual funds in the “Canadian Equity” category in the last 10 year, 5 year, and 3 year periods ending in Oct. 31, 2007. I have not cherry-picked any period and I have shown three different periods, not just one. I have not thrown out any periods based on whether or not they include or don’t include either bull markets or bear markets. The original article only looks at one bear market and concludes that indexes perform worse than active management in bear markets. I am not at all convinced that this is a consistent truth or “rule.” There is lots of data from the US for example that shows that over long periods of time (which include more than just one bear market) indexes handily beat actively managed mutual funds. In A Random Walk Down Wall Street, Burton Malkiel quotes a Lipper study (2007 edition, pages 267-268) that found that from Dec. 31, 1985 to Dec. 31, 2005, the S&P 500 index beat 82% of mutual funds and on average performed 1.5% better than the average fund per year. I would find it very hard to believe that one could increase performance even more by switching from indexes to mutual funds at certain times, or even holding some balance of mutual funds and indexes. Even if we looked at more than one bear market and it turned out that indexes did perform worse in every bear market, without being able to predict when future bear markets start and end, would this information be helpful? How would you know when to switch to mutual funds and then back into index ETFs for the next bull market? You would be guessing and in the end you would lose out due to commissions spent on buying and selling the ETFs and the higher MERs on mutual funds.