{"id":372,"date":"2015-11-06T13:29:13","date_gmt":"2015-11-06T21:29:13","guid":{"rendered":"https:\/\/chaltenadvisors.com\/blog\/?p=372"},"modified":"2015-11-06T13:29:13","modified_gmt":"2015-11-06T21:29:13","slug":"were-getting-duped-its-not-just-about-returns","status":"publish","type":"post","link":"https:\/\/chaltenadvisors.ca\/blog\/were-getting-duped-its-not-just-about-returns\/","title":{"rendered":"We’re getting duped! It’s not just about returns…"},"content":{"rendered":"

\"Turkey\"<\/a><\/p>\n

We and many others spend a lot of time and effort trying to educate people about\u00a0the importance of keeping costs low as part of a sensible long term investment strategy. \u00a0The evidence of the importance of costs is so overwhelming that you really have to take your hat off to the marketing departments and sales forces of the Canadian mutual fund companies, banks and other advisors\u00a0selling high-fee and inefficient investment solutions for overcoming this evidence.<\/p>\n

The underperformance of active funds (those that try to beat the market by either making market-timing bets or by stock-picking) is mainly due to the fact that they charge higher fees than passive or index funds (those that try to deliver market-like returns). \u00a0Fund management is effectively a zero sum game. \u00a0This was highlighted very nicely a long time ago (1991) in a concise\u00a0paper<\/a> by Nobel Laureate Bill Sharpe:<\/p>\n

“If “active” and “passive” management styles are defined in sensible ways, it must<\/em> be the case that<\/p>\n

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(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and<\/p>\n

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar<\/p>\n<\/blockquote>\n

These assertions will hold for any <\/em>time period. Moreover, they depend only<\/em> on the laws of addition, subtraction, multiplication and division. Nothing else is required…….To repeat: Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”<\/p>\n

In the words of WSJ columnist Jason Zweig, “Over the long-term the superiority of indexing is a mathematical certainty.”\u00a0 In other words, fund management is a zero sum game. \u00a0The chart below from Vanguard illustrates this point.<\/p>\n

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Not only does the average<\/em> active fund have to\u00a0underperform the market and\u00a0passive funds by the amount of fees charged but, overtime, most individual<\/em> funds will underperform the market and it is nearly impossible to determine in advance which very small proportion of funds will survive and\u00a0be one of the few outperformers. \u00a0The following chart\u00a0from Dimensional Fund Advisors using data from the Standard & Poor\u2019s Indices Versus Active Funds Canada Scorecard<\/em>, Year-End 2013\u00a0<\/em>shows\u00a0the percentage of Canadian mutual funds\u00a0that outperformed the market over one, three and five year\u00a0periods.<\/p>\n

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This data is not new nor is it hard to come across, and you get similar results looking at different time periods. \u00a0In fact all of this data is continually highlighted\u00a0in the financial press in Canada – so it’s amazing to us\u00a0that the adoption of low cost index funds and ETFs is still so small in Canada compared to other countries. \u00a0Why? \u00a0Because a lot of people make a lot of money selling active fund management and while the funds and strategies sold by many banks, mutual fund companies and other advisors are poor performers, their sales and marketing tactics are great performers!\u00a0 In fact the securities regulators in Canada are so concerned about the ongoing duping of the retail investor (you and I) that they are considering fairly severe measures to curtail certain selling practices and charges. \u00a0I wish rather than relying on protection from regulators that Canadians\u00a0would simply choose the better alternatives currently available on the market and force more of the expensive underperforming alternatives out of the market but somehow we continue to be fooled\u00a0and the regulator feels they have to step in for our own good. \u00a0So be it, we need help. \u00a0As Vancouver Sun reporter Don Cayo put it in an article<\/a> earlier this year, “The bottom line —\u00a0my words not Morningstar’s\u00a0—\u00a0is these funds actually tell us what they\u2019re going to do to us, then go ahead and do it when we give them our money anyway.”<\/p>\n

And the underperformance\u00a0is only half the story – \u00a0the return side of the story. The important other side of the story is that\u00a0\u00a0with index funds you not only get higher average investment performance over time, you get it with near certainty. \u00a0By definition, index funds give you the market return. \u00a0Of course tracking error and some costs means you may deviate slightly and some index fund \/ ETF providers are better and lower cost than others but you can generally be comfortable that you’ll get very close to the market return. \u00a0With active funds you not only have to accept lower expected returns, you have to accept the risk that you won’t even get that! \u00a0The following chart from Vanguard illustrates this quite nicely.<\/p>\n

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As fees go up for both index and active funds, returns relative to the market go down, but at least with index funds the\u00a0relationship between costs and returns is fairly well defined and predictable. With active funds you still have to face the fact that you could underperform the market substantially<\/em>. \u00a0When it’s nearly impossible to tell in advance which funds will outperform, this presents additional and unnecessary risk. \u00a0Hardly anybody talks about this – a fair amount of google searching got me a lot more evidence on average returns but not much on the impact of return dispersion. \u00a0Good old Vanguard to the rescue again!<\/p>\n

John Bogle, Vanguard founder, says, \u201cWhat happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding costs. It\u2019s a mathematical fact.\u201d<\/p>\n

The other side of the story is that what\u00a0happens in the fund business is not only do you get lower average returns but the added risk that you could do even worse.<\/p>\n

So again we give you our\u00a0evidence-based principles:<\/p>\n