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Surprise! Mutual fund cheerleaders fault indexing

August 25th, 2008 ·

Sometimes, the active versus passive debate is a bit like the movie Rashomon, in which different characters recall wildly different versions of the same incident. Take the S&P Passive versus Active (SPIVA) report card on mutual fund returns during the last bear market from August 2000 to December 2002. The report points out that just 39% of active funds beat the TSX Capped Composite Index but concedes:

A bright spot for active funds was equal weighted and asset weighted returns over the period. Active Canadian Equity funds exceeded the S&P/TSX Capped Composite returns. This would imply that a few funds were able to beat the index by a large margin thereby pulling the average equal and asset weighted returns higher. However, given that investors are limited to investing in a small number of funds, the outperformance figures better represent replicable performance by the average retail investor.

An indexer wouldn’t be surprised even if majority of funds beat the index during a bear market. After all, the cash held by mutual funds provides a cushion in falling markets (and it must be said, a drag in rising ones). But active funds and their cheerleaders make a virtue out of this necessity. In a recent column in The Toronto Star, Rudy Luukko, an investment funds editor for Morningstar Canada writes:

But active managers, according to both S&P’s numbers and Morningstar’s, generally fared better than the Canadian index funds during the 2000-2002 study period. Active managers were able to build cash reserves if they couldn’t find any bargains. And the active funds were less likely to risk holding 10 per cent or more in a single stock.

First, there is no evidence that active managers are any good at building cash reserves in anticipation of bear markets. If anything, evidence suggests that mutual funds cash holdings are low at market peaks and high at troughs. Second, regulations restrict mutual fund holdings in a single stock to 10%, to which Mr. Luukko retorts: “However, in looking at historical holdings, I found that many actively managed funds were either holding much less than 10 per cent in Nortel, or not holding any of it. This risk-reduction decision paid off”. Mr. Luukko’s argument is meaningless because he doesn’t quantify how many of the 90 mutual funds that S&P counts as Canadian Equity he looked at (how many is “many”?).

None of the objections to index funds are valid: yes, a majority of active funds may occasionally beat the index but John Bogle estimates the odds of an index outperforming an active fund at 85% over 5 years, 91% over 10 years, 95% over 20 years and 98% over 50 years. A carefully diversified portfolio holding some bonds and cash will provide the “smoother ride”, if that’s what investors are looking for. And yes, index investors should pay attention to costs too and pick the cheapest available fund with the lowest tracking error.

The trouble with active management isn’t that a few funds beat the index some of the time. It’s picking the fund that will outperform the index ahead of time and telling the difference between skill and luck after the fact. Of course, there is no shortage of vendors to help us pick the good managers. Like, Morningstar, for instance.

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18 responses so far ↓

  • 1 Big Winner // Aug 25, 2008 at 10:48 pm

    David Swensen (who manages the Harvard Endowment) also agrees that indexing is the best choice. And, unless you’re a Yalie, who could disagree with that : )

  • 2 Big Winner // Aug 25, 2008 at 10:48 pm

    Actually, I found out he manages the Yale endowment. Boy, do I have egg on my face.

  • 3 WhereDoesAllMyMoneyGo.com // Aug 25, 2008 at 11:01 pm

    I am dumbfounded with how much inertia there is on this issue from within the industry. Given the compelling and ever growing mountain of data to support the merits of indexation, I’m wondering if advisors who don’t bring it up will be held accountable in the future.

    Good analysis CC.

  • 4 Four Pillars // Aug 25, 2008 at 11:02 pm

    I got a laugh when I read that article. Of course Luukko is going to defend managed funds since his career is based on evaluating them.

    I guess everyone who works for a living has a conflict of interest with something… :)

  • 5 Michael James // Aug 25, 2008 at 11:59 pm

    Great post. This whole debate reminds me of a quote whose origin I can’t remember. It goes something like this: “it is difficult to make a man understand something if his livelihood depends on not understanding it.” Financial advisors who are paid by commissions need high-cost active management for their livelihoods.

  • 6 Dillon // Aug 26, 2008 at 1:18 am

    Michael, the quote is from Upton Sinclair . John Bogle paraphrases this quote in The Little Book of Common Sense Investing by saying “it’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.”

  • 7 mjw2005 // Aug 26, 2008 at 1:59 am

    I am going to play devils advocate here…and no I am not an advisor and no I don’t work for a mutual fund company, but I just find this blind faith in indexing by all the financial bloggers worrisome….not everyone wants to buy an index. I know that the vast majority of funds are junk but there are a few decent funds…finding them is difficult and the chances of someone investing in them at the right time is even smaller, but they are out there…for me personally, who went through the crash of 2000 - 2002 are hestitant to invest in an index….I don’t expect index smashing returns from my funds I just want a simple easy low cost (less than 1.5% MER) consistant performer that maybe gets me 7%-9% over the long term…like the Mawer RRSP Balanced fund…It doesn’t smash records..The S&P/TSX destroys it over 5 years but it hardly lost any money between 2000-2002….but it has slowly and steadily earned 7-9% over many years…I can plop in a $100 every month, all the dividends and interest are automatically reinvested for me and I can just sit back and cash out….maybe It didn’t beat a portfolio of world indexes but I don’t care I got my 7-9%….and I’m happy…..

    Oh and I invest some money in individual stocks as well….so I am not just a fund person…..

  • 8 strikershank // Aug 26, 2008 at 6:15 am

    I also am against a post like this and the blind faith people have in indexing. there is a large problem of comparing active returns to a benchmark like the S&P/TSX that is comprised mainly of financials, oil and gas, and commodity based returns. Most active funds don’t follow a mandate that would replicated following those sectors and therefore should show tracking error. If you want to invest in O&G or something similar, then index - but if you want bricks and morter businesses, comparing your fund to the TSX is probably only going to leave you lagging, even if the fund performs on a risk/return perspective as you want.

    I’m an advocate of both active and passive investing. I believe more studies should be done to find out what an appropriate benchmark is to compare active investing to as simply saying a fund out or underperformed the tsx isn’t good enough. The right asset allocation for an investor should and must be taken into account.

  • 9 Four Pillars // Aug 26, 2008 at 7:14 am

    MJW - I’d like to point out that not all index funds are equity. If I want to replicate a balanced fund I can buy some equity and some bond.

    Striker - you make a good point that not all funds should be compared to a broad index but the fact is that most of the largest equity funds in Canada are index-huggers so if you own one of those - then index funds are a good alternative.

  • 10 Canadian Capitalist // Aug 26, 2008 at 9:46 am

    mjw: Indexing is supported by logic and overwhelming evidence. If any thing, you need blind faith in active management. You raise good points about the narrow and shallow nature of the TSX but that can be easily addressed with a diversified portfolio. My benchmark Sleepy Portfolio has just 20% in Canadian stocks, out of the 70% devoted to equities. Indexing also doesn’t mean putting 100% in the TSX - it is simply using the broad market to capture exposure to the Canadian equity portion of the portfolio.

    strikershank: In theory, yes, an active fund could be more broadly diversified than the TSX index, which as you point out is concentrated in three sectors. And deviating from the index, by definition, means tracking error. But, that’s not the only source of tracking error. The fees form a high hurdle that precious few funds manage to overcome and it’s hard to tell which ones will in advance.

  • 11 venter // Aug 26, 2008 at 11:57 am

    As an advisor that has only been building my business for a little under 2 years I can tell you that I couldn’t afford to put all my clients in index funds even if I wanted to. I make less than 25k a year now! If I had a large client base with that had been built up over the years I would not hesitate to move the core of many portfolios into indexes and use some of the better managed funds to capture themes and further diversification. As some posters have pointed out, many investors are not comfortable with index funds in lieu of the Nortel effect.

  • 12 The Investment Reporter // Aug 26, 2008 at 11:57 am

    OK here’s the third point of view. If you’re willing to invest in individual stocks, you will come home with much better returns than you will with active or passive mutual funds.

    A portfolio of high quality stocks — conservative, fundamentally sound, dividend-paying stocks for the most part — will knock them all off. Active equity funds or indexed funds. Admittedly, this is our bread and butter as a Canadian stock advisory, but our experience has born this out over the years.

    The question is: are you an active investor or a passive investor? If you want to be active, you have to trust your advice, trust your judgment and trust your broker. And why not? Most fund managers seem to be following each other around the mulberry bush, anyway.

    If you go out and corral a bunch of speculative stocks, you’re liable to get whacked, of course. But with a conservative portfolio of stocks you should feel perfectly confident in any contest with index funds, and even more so with the vast majority of active funds.

  • 13 WhereDoesAllMyMoneyGo.com // Aug 26, 2008 at 12:50 pm

    Venter - you are basically saying that you aren’t willing to make the recommendations you would like to until a later date. This conflicts with your fiduciary duty in which you are supposed to act in the clients’ best interest above your own. If you truly believe that you would make these changes, but can’t because of personal financial reasons, then you should look to joining a larger team who shares your philosophy. Join them as an associate so you have a base and then slowly you can branch off when you are financially able to, or you can acquire their book later on. Otherwise, you are subject to sanctions and could lose your license.

    Re: the Nortel effect - a null and void argument these days with the ETFs that tracks the capped composite indices - not allowing for more than 10% exposure to any one security.

  • 14 venter // Aug 26, 2008 at 1:35 pm

    WDAMMG- I appreciate your comments but nothing is that simple. I was just making the point that it would be difficult for new advisors to make a living on index funds alone, this was not my motivation for my clients investments . I should also point out many of my choices were initially influenced by recommendations I received from my peers, advisors at my firm who had many years of experience. None of them ever suggested index funds when I started. I have debated the index vs active for a while and have only recently started to consider using index funds. Most of my clients were transfers and had DSC’s. I used LL funds to rebate their fees and placed many of them into portfolios that I felt were best for them at the time. I will likely use more index funds going forward as a core and perhaps move some existing clients when their DSC schedules expire. I currently have no access to ETF’s (MFDA only). I would also point out that I have no index funds in my own portfolio yet ( stocks, bonds, REITs, GIC’s, active mutual funds).

  • 15 WhereDoesAllMyMoneyGo.com // Aug 26, 2008 at 2:04 pm

    Venter - You are correct in that it is not simple. I am also an advisor and also looked to more experienced advisors for guidance - it is a hard thing to think for yourself when successful peers and mentors are following the herd, but my guess is that newer advisors are more inclined to listen to the debate between active versus passive. But being paid on commissions and being expected to do what’s in someone else’s best interest is a structural paradox that most advisors have to deal with. Even salaried advisors are pressured into promoting certain products or hitting quotas. The industry is… funny.

    I started at an MFDA firm myself, and switching to IIROC (IDA) was well worth it. I felt a bit handcuffed by being restricted in what I could advise on. But many firms allow advisors to offer fee-only planning - my old MFDA firm did and so does my current IDA firm. Again, paradoxically, not many people opt for it even though it may be the best option from a numbers point of view. People are funny too! :)

  • 16 Fred // Aug 26, 2008 at 7:56 pm

    There is yet another approach that hasn’t been raised in this discussion thus far: using ETF’s and market timing as I am. Buying ETF’s doesn’t necessarily mean buy-and-hold forever (aka buy-and-forget-to-sell). I have gone a step farther and buy double exposure ETF’s when my timer goes long. The backtested results are on my blog but the time-frame is short given the recent introduction of double exposure ETF’s. Any yes I know, studies have shown that you can’t time the market. Fact of the matter is that you don’t have to be right all the time. According to Ken Fisher a 60% success rate will put you well ahead of buying and holding the market. Also, you don’t have to short the market when a timer goes short - you may be more comfortable in a bond ETF as I am.

    As for the comments from the advisors, it is too bad that most investors will not pay for a fee-only service. I think people prefer hidden fees (e.g. hidden excise tax versus exposed GST) and that’s unfortunate.

  • 17 Dillon // Aug 26, 2008 at 8:56 pm

    The Investment Reporter @ 12 and Fred @ 16 suggest stock-picking and market-timing/leverage, respectively, as ways to beat an indexing strategy.

    While I don’t discount these strategies (since I accept that there are inefficiencies in markets that can be exploited), the problem with both of these approaches is that they require not insignificant amounts of skill and effort in order to be effective.

    If you can consistently beat the market by engaging in stock-picking, market timing, sector rotation, technical analysis or whatever, then good for you. I think I’ll stick with indexing, though.

  • 18 Friday Linkstuff // Aug 29, 2008 at 5:01 am

    [...] Capitalist wrote a post commenting on a study written by a mutual fund analyst that apparently proves that index funds are [...]

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