John Bogle likes to call it the “the relentless rules of humble arithmetic”. William Sharpe showed how any purported superiority of active management as a group can only be “justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers”. It doesn’t matter if such arguments are logically sound or that there is a mountain of evidence supporting it — the fund industry tenaciously markets any shred of “evidence” that shows the alleged superiority of active management.

Let’s turn our attention to the “evidence” presented in a chart yesterday that shows 9 out of 10 largest Canadian equity mutual funds outperform the blended index. Sounds impressive, but is it really? Let’s have a look:

  1. As a reader pointed out in the comments section, the table compares the 10-year performance of the 10 largest funds today with a blended index. Since investors cannot enjoy past performance, a sensible comparison would be the 10-year performance of the funds that were the 10 largest ten years back.
  2. Any list of existing funds is likely to be rife with survivorship bias. The mutual fund industry has a habit of merging poorly performing funds with those showing better performance records. The performance records of the poorly performing funds then simply disappears and the better fund simply gets larger. Therefore, it shouldn’t be surprising that large funds have a good performance history.
  3. When a fund shows a good track record, it is heavily advertised. Columns appear in the financial press praising the stock picking skills of the fund manager. Investors reading the columns and advertisements pour money into the fund but the new money is simply chasing past performance and is likely to be disappointed.
  4. It is not clear that the comparisons use the correct benchmark. The funds in the list belong to two fund classes — Canadian Focused Equity and Canadian Dividend & Income Equity. I would guess that a 90% TSX Index/10% Fixed income mix and a 70% TSX Index/30% Fixed Income mix are appropriate benchmarks respectively. The 10-year performance of the two asset mixes would be 5.60% and 5.94% — both significantly better than the benchmark used.
  5. It is not even clear if the list is accurate. For instance, the list doesn’t mention the gargantuan Investors Dividend fund, which has $9.1 billion in assets under management and charges a MER of more than 2.5%. The fee generated by this one fund alone is reported to be larger than three quarters of all funds in Morningstar’s database! The fund is missing from the list presumably because it doesn’t have a 10-year history but the performance history it does have is nothing home to write about: -1.4% versus 0.6% for the index.

Interestingly, investors wanting to take the active management route might be better off avoiding the large funds because the larger funds cannot take meaningful positions in their “best” ideas and their performance would likely resemble that of an index. Why pay a steep MER when all you can get is beta less fund expenses?

Here’s the second table in the Mackenzie funds marketing material:

Largest Global Equity Mutual Funds vs Index over 10-Years (January 31, 2009)

  • 7 of 10 Largest global equity mutual funds match or outperform index, Including the #1 performing Cundill Value Fund and #2 performing Ivy Foreign Equity Fund – with lower volatility
Fund Assets $Millions 10 Year Annualized Return % 10 Year Outperformance vs Index 10 Year Standard Deviation
MSCI World($ Cdn) -3.3% 12.9
Mackenzie Cundill Value ‘C’ $4,291 6.6% 9.9% 12.4
Trimark Select Growth $2,429 0.8% 4.1% 13.7
MD Growth $2,077 -1.2% 2.1% 13.7
Templeton Growth Fund Ltd. $2,020 -1.0% 2.3% 14.2
Mackenzie Ivy Foreign Equity $1,911 2.5% 5.8% 9.8
Trimark Fund-SC $1,240 2.0% 5.3% 13.6
AGF Global Value $1,234 -2.1% 1.2% 15.6
Fidelity Global-B $919 -4.9% -1.7% 13.4
CI Global $632 -3.9% -0.7% 16.1
TD Global Select $511 -3.8% -0.6% 14.6

Source: Paltrak

This article has 13 comments

  1. Charles in Vancouver

    I am not sure where to find the information, but if you could locate a “largest funds” list from 10 years ago in each of these categories… perhaps you could paint us a picture of how investors would have performed in those 🙂

  2. Dave in Kanata

    Index investing isn’t necessarily inconsistent with Active investing, is it?? That it, if I only invested in Index funds or Index ETFs but traded them based on a some technicals scheme, wouldn’t I be an Active Index investor? Likewise, I could be a passive investor and invest in 3 stocks if I held them for a lifetime, right?

    I think this and the previous posts are comparisons of passive index investing vs. active investing via mutual funds. There are some (me included) who are using an active, indexing approach to investing.

    I guess my point is that by comparing passive index investing vs. active investing via mutual funds, you cannot really conclude passive index investing is superior to active investing, because you are only looking at the mutual fund world of active investing.

  3. Is the ‘index’ here 30% MCSI World and 70% cash? Or did I miss something?

  4. Ok….man you guys love to hate mutual funds…but I am going to say this again. ETF and investing in the index is not for everyone. I am no lover of mutual funds….but I do see value for the regular investor who might not want to invest in an index like the MSCI World that has hundreds of holdings of companies of various qualities and although it might out perform 95% of all the MF managers out there (I am making that stat up)…it might be too volatile for some people….The Mackenzie Foriegn Ivy funds (as an example) under performed the index for years….but that fund was not trying to beat the index it was trying to signifigantly outpace inflaction, give the investor a decent return and do so with less volatility than an index….it is currently doing better than the index but in the next bull market it will fall behind….

    My point is, is that passive index investing is not the solution for everyone as is so often portrayed on these blogs…..Also remember that no one can invest directly in an index, you do so via an ETF or index MF…both of which have small MERs…so everyone should subtract the index returns by an ETFs MER plus a little more to account for commissions. Finally no index is static, companies are added and subtracted every year from an index, so there are always some taxes paid….

    I just want to be at least one voice for the other side of the argument…and yes I do believe MF fees should be lower….and no I am not a Financial Advisor…

  5. I recently heard about the Medallion Fund by Renaissance Technologies. Apparently this fund has averaged 35% returns since the early 80s. Surely this kind of return over a relatively long period of time needs a better explanation than luck. Has Jim Simons (the owner of the fund), figured out a sure-fire way to beat the markets?

    mjw2005 : I think index investing is *for everyone*. The risk in index funds can be managed by proper asset allocation. If you’re close to retirement or risk averse, simply make sure bonds, cash, and gics comprise a large percentage of your portfolio. If you take the time to identify the amount of risk you’re comfortable with and plan out a strategy, you’ll be doing essentially the same thing as MF managers, but without the 2-3% MER.

  6. Canadian Capitalist

    @charles: I don’t have access to any database that will provide me a list of 10 largest funds from 1999. It would be an interesting exercise, for sure.

    @Dave in Kanata: I’ve been carefully wording these posts as “active management” which implies mostly stock picking. In that sense, these two posts compare the benchmark index with an actively-managed mutual fund. But if active investing is widened to include timing/tactical allocation, there is little evidence that it works as a group over the long-term.

    @Geron: The 30% is an error from a cut & paste job. I’ll fix it.

    @mjw: I can readily accept the thesis that not everyone wants to index and even mostly passive investors want to add a bit of alpha to their portfolio, say in a core and explore manner. But investors wanting to lower portfolio volatility can do so by the asset allocation policy, not picking active mutual funds. I agree that passive investors pay some fees that should be accounted for in any fair comparison but mutual funds typically have a lot more turnover than passive indexes.

    Daniel: By active management, I mean mutual fund managers as a group. That doesn’t preclude the existence of skill and I’m sure there are very talented managers out there. It’s just that by the time there is a long track record that could be put down to skill, it is usually too late to ride the coat tails. I must confess that I haven’t heard of the Medallion Fund.

  7. Daniel: I believe I’ve heard of this fund being limited to a few billion dollars because the market isn’t large enough to support more – some quick calcuations show that $1M invested at the beginning would fill that quota. So if it does perform that well it’s very hard to get in, and those who are investing it in already would be forced to withdraw their gains each year. That’s not too bad as an income investment but over a longer period not having compounding returns would affect you. If it was open to everyone the performance would quickly drop to the average. This is another reason to avoid active management – you want the funds that have performed well and won’t accept new investments so they only way you can get in is if you make a lucky guess early on or people lose faith in the manager.

    Dave: As shown earlier (or maybe it was somewhere else, but this is brought up a lot) the average result of any type of attempt to beat the market has to be the same as the market return. This means every winner creates a loser – not to mention that as bad as active fund managers may be, a lot of individual investors know even less. There are clear instances where market timing would have worked in the past and it may be possible to see them coming in the future, but only if you really do guess what will happen before everyone else. Most people would lose at this.

  8. Great post CC. Another great argument against actively managed mutual funds. Throughout my research, I havn’t found many arguments for active management that have any substance.

  9. Your right Daniel….everyone could do no wrong by just investing in the indexes….but if everyone did just invest in indexes it would be a disaster….

    For me I own a low fee fund that has 20-30 holdings of stocks that I like….it works for me and I’m happy with it.

  10. Canadian Capitalist

    @mjw: If I go the active management route that is how I’d go about it: a low-cost, low-turnover, concentrated mutual fund that invests in a handful of “best” ideas. In fact, I chose such a fund for my Group RRSP, which has a limited set of funds available.

    I wouldn’t worry too much about everyone being indexed. It ain’t going to happen for a long, long time.

  11. James Simons is not that well known considering he:

    A) Earned $1.7 Billion in 2006
    B) Guided his hedge fund to an annualized net rate of return of 36% for the 19 years ending 2006

    First let’s explain how his 2006 pay packet was derived. His hedge fund charges a management fee of 5% plus a performance fee of 44%. That’s pretty steep. What’s even more astonishing is that the fund earned a gross return of 79% in 2006. The fund, the Renaissance Technology Corp. Medallion fund, is closed to new investors and was managing roughly $6 billion in 2006.

    Some other information that is worth noting:

    Simons earned a bachelor’s degree in math from M.I.T. and later a Ph.D in math from the University of California, Berkeley. He has taught math at M.I.T. and Harvard, and once worked as a code-breaker for the Department of Defense. He is the co-developer of the Cherns-Simons theory (a mathematical theory). His hedge fund management company employs over 80 Ph.Ds. It has been rumoured that the trading algorithms of Medallion can be responsible for 10% of the daily trading volume on the NASDAQ.

    When asked by Alpha Magazine if anyone asks him about Cherns-Simons Theory he replied, “All the time, by potential investors.” When further pressed to know if the investors understood it, he then replied, “No, I don’t even try.”

    If memory serves, his firm is about 80% math Ph.D.s. All the above was taken from a blog post that I wrote about a year ago, hence the older data.

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