Canadian Capitalist » Passive Investing

Why do ETF Investors do worse than Index Mutual Fund Investors?

Canadian Capitalist — Tue, 23 Jun 2009 03:53:19 +0000

Jon Chevreau recently blogged (see John Bogle says investors getting killed by ETFs) on John Bogle’s analysis of returns experienced by investors in Exchange-Traded Funds (ETFs) and the results are not pretty: In 68 out of 79 ETFs, the returns experienced by investors lagged that of the ETFs themselves by an average of 4.5%. Bogle also found that investors in ETFs did much worse than investors in index mutual funds. In some categories such as large-cap stocks and small-cap stocks, the gap was particularly large — more than 7%. And the shortfall was as much as 12% in REITs! These results mirror that of the famed DALBAR study, which consistently finds mutual fund investors earning lower returns than the funds themselves (see Investors Behaving Badly).

I think the comparison of index mutual fund investors to those of ETFs is a bit simplistic. Unlike mutual funds, which are purchased by retail investors with the intention of holding for the long-term, the motivation for buying ETFs varies according to the type of investor. Some are passive investors who intend to hold ETFs in an indexed portfolio for the long-term. But most ETF buyers and sellers are traders who hope to profit from short-term movements. The popularity of ETFs with traders can be seen in the contrast in volume between Vanguard and iShares ETFs that track the same index. Despite charging less than half in fees, Vanguard ETFs such as the Emerging Markets ETF (VWO) and Europe Pacific ETF (VEA) have much lower trading volume than their corresponding iShares ETFs. Long-term investors would care more about the lower fees but traders would be primarily concerned with liquidity and low bid/ask spreads, not a MER difference of a few tenths of a basis point. Therefore, it shouldn’t be entirely surprising that, as a group, the returns from trading badly trail the overall market.

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“Pitfalls” of Indexing

Canadian Capitalist — Thu, 04 Sep 2008 03:40:06 +0000

Million Dollar Journey made an interesting post last week in which he listed some points that in his opinion, are the disadvantages of indexing. While I made a detailed comment on that post, I couldn’t resist biting the juicy bait dangled in front of me. So, let’s examine his claims closely:

No downside protection: Investors wanting a smoother ride should allocate a portion of their portfolio to assets that are less volatile than equities such as bonds and cash. There is little evidence that money managers are able to provide downside protection either. Their returns in bear markets is, at best, mixed compared to their benchmarks. Neither are they able to add value through market timing and if anything, the evidence points the other way — mutual funds have low cash levels in bull market peaks and high cash levels in bear market bottoms.
No control over your holdings: It is true indexing doesn’t allow you to overweight Royal Bank and underweight BMO. But, we all know how well control is working out for mutual fund managers, eh?
An indexed portfolio will always be average: It depends on what is meant by “average”. John Bogle estimates that the odds of an index fund outperforming any mutual fund is 95% over 20 years. If that’s average, I’ll take it.
It’s boring: I used to own AIG (NYSE: AIG) (as an aside, luckily, I sold it last year when indexing most of our portfolio) and every year, I try to read the annual reports. It is usually 250 pages long filled with financial arcana — not exactly what most people would consider interesting.

The bottomline for an investor is to earn enough returns to achieve their financial goals — not some arbitrary score of how many indices they beat over their investing career. Jason Zweig recounts an encounter with a group of retirees in Your Money & Your Brain. Mr. Zweig asked the retirees how much returns they earned to retire to Florida and their answer: “Who cares? We earned enough to retire here”. Passive investing gives most people the best odds of doing just that — achieving their financial goals.

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Indexing Canadian Equities through XIU / XIC

Canadian Capitalist — Mon, 07 Jul 2008 23:31:30 +0000

Canadian investors who want to passively track our equity markets through ETFs have two choices – the iShares CDN Large Cap 60 Index Fund (XIU) or the iShares CDN Capped Composite Index Fund (XIC). As the name suggests, the XIU tracks the performance of a capitalization-weighted index of 60 large, liquid stocks that trade on the TSX. The MER for the ETF at 0.17% is the lowest for a Canadian equity fund. The XIC tracks the performance of the broader TSX Composite index, which is composed of more than 250 stocks, and is slightly more expensive, charging a MER of 0.25%.

Either ETF would be a fine choice for the Canadian equity portion but, in my opinion, the XIC is a slightly better choice as it tracks a broader index and the weight of a single stock is capped at 10%. The XIC allows passive investors to avoid the “Nortel effect” or concentration in a single stock. Recall that in 2000, at its 52-week high, Nortel (TSX: NT) alone accounted for 34.2% of the TSE 300 Index. On the downside, the XIC is far less liquid and the bid-ask spread could be as much as 10 times larger when compared to XIU. However, this shouldn’t be a huge concern for long-term, buy-and-hold investors as the cost will be negligible when spread over the entire holding period of XIC, which could be decades.

XIC was introduced to track the capped version of the Large Cap 60 Index but in the fall of 2005, the mandate for the fund was changed to track the TSX Capped Composite Index. XIC is the appropriate benchmark for tracking the performance of active management, whether it is mutual funds or a portfolio of Canadian stocks.

Useful links
S&P/TSX 60 Factsheet from Standard & Poors.
S&P/TSX Capped Composite Index Factsheet from Standard & Poors.
Standard & Poors versus Active (SPIVA) reports.
Shakespeare’s Primer — Canadian Content chapter.

Note: Don’t forget to enter your name in the draw for one copy of The Intelligent Portfolio. Entries will be accepted until 8 P.M. EDT on Friday, July 11, 2008.

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Passive Investing lets you have a Life

Canadian Capitalist — Tue, 24 Jun 2008 00:36:44 +0000

I thought I’d share one of the less appreciated benefits of passive investing after reading Million Dollar Journey’s post on working hard for our money instead of doing the things we value more. Like most Canadians, we work extremely hard – between us we have two day jobs, write a blog, attend graduate school, raise two young children, all the while attending to the endless chores of a normal life – and find that time is a very precious commodity indeed. If finances aren’t your hobby, passive investing lets you get on with your life, whether it is gardening, photography, traveling, spending time with the family or whatever.

Regular readers know that I used to be an active investor. Active investing is definitely fun and perhaps even profitable but it does take a lot of work and research. For example, let’s say that you currently don’t have any exposure to health care in your portfolio and want to add some. Should you buy Pfizer (PFE) or Merck (MRK)? Or maybe, you should invest in a biotechnology stock like Amgen (AMGN) or Genentech (DNA) instead. How about the small biotech companies in the discovery stage? Perhaps, you think that with many prominent drugs coming off patent protection, a generic drug company like Teva (TEVA) or our own Biovail (BVF, for the masochist within us) would be a better holding.

Even after doing your research and picking one, you’ll have to keep track of your holdings. How is company doing with sales and earnings compared to its peers? Has the competitive position changed? Do you still trust the management? On and on it goes and that’s just for one stock position in your portfolio. Let’s say an investor needs 10 to 20 stocks for a fully diversified stock portfolio. Multiply the time needed by the number of stock positions and you’re looking at having a second job which may or may not turn out to be profitable.

As a mostly passive investor now, I find that there is very little demand on my time. Once I decided on an asset allocation and picked a handful of funds or ETFs to hold, the portfolio is more or less on auto pilot. The only thing I then do is rebalance occasionally when adding new savings to the portfolio and trying to be a bit more greedy when our major newspapers report on panic in the stock market in the front pages. The benign neglect benefits the portfolio as well as less activity means fewer opportunities to do stupid things.

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