Saturday, February 21, 2009

Blowing smoke

Rob Carrick, financial journalist extraordinaire, interviewed the president of Mackenzie Financial Services, one of the biggest sellers of mutual funds in Canada. In the article, Mr. Feather extols the virtues of mutual funds and how they are apparently so much better than exchange-traded funds. Aside from the inherent bias he has against an investment vehicle that has drawn millions of investment dollars away from traditional actively managed mutual funds, his arguments just don't hold water. Mr. Carrick does a fine job of pressing him for rational answers, but Mr. Feather seems to be trying to convince himself, if not the readers, that the funds in which he invests are a much better place to put his money than ETFs.

Let's evaluate his arguments. For comparisons I will compare funds of similar asset classes offered by Mr. Feather's company to TD e-series index funds. I'll stick to Canadian equity, US equity, international equity, and fixed income to keep it simple. I will only compare these to the no-load funds offered by Mackenzie Financial Services as Mr. Feather claims in the article, despite evidence to the contrary, that "the vast majority of investors" are not paying front-end loads or rear-end loads. This will also give a hand up to Mr. Feather's team, because it will only consider the management expense ratio (MER) of funds, and not the sales loads which many investors would be hit by in reality, because many do not know any better and get suckered into them by dishonest fund salespeople. As well, we will consider TD e-series index funds because they can be purchased at no commission using TD EasyWeb which will eliminate Mr. Feather's argument about trading commissions with ETFs. Here goes.

1. The active management approach leads to a steadier course of investing. Verdict: Bogus

One need not look at individual funds to debunk this notion. If you compared a diversified portfolio of 60% stocks and 40% fixed income to a portfolio consisting entirely of a 4% GIC, you'd say based on this logic that the GIC is much better because it has a steadier course, ie. less volatility. That is absolutely true. But the diversified portfolio would have returned 10% per year from 1970-2008, instead of 4% for the GIC. Return is almost always positively correlated with risk. If you want better returns, you have to take on a bit more risk.

2. It's not true that mutual funds perform worse than ETFs/index funds. Although they lag the index, this is not fair because the index cannot be purchased. Index funds and ETFs still have a cost. Verdict: Bogus

The core of the argument is sound. Merely showing that mutual funds lag the index on average is no indication of their appropriateness as an investment. Index funds and ETFs usually lag the index a bit too. But Mr. Feather does not consider what one might find if you did compare apples to apples, to draw from his response.

Asset Class: Canadian Equity: 5-Year Annualized Return

BMO Equity: 2.7%
TD Canadian Index-e: 2.5%

Asset Class: US Equity: 5-Year Annualized Return

BMO US Equity: -3.5%
Mackenzie Universal US Blue Chip Class: -4.2%
TD Dow Jones Average Index-e: -5.3%

Asset Class: International Equity: 5-Year Annualized Return

Mackenzie Focus International Class: -1.2%
TD International Index-e: -2.8%

Asset Class: Canadian Fixed Income: 5-Year Annualized Return

TD Canadian Bond Index-e: 4.5%
Mackenzie Sentinel Bond Series M: 4.0%

It appears there are actively managed funds that do beat the TD e-Series funds. But there are two problems. First of all, in the above examples, the actively managed funds listed are literally the only ones I found on the list that beat TD. If you can pick these winners out of the vast crowd, be my guest. The other thing one notices when doing this research is that when you rank the available funds by annualized 5-year return, index funds crowd out the top spots. One or two active funds make an appearance, but the majority don't show up until you've run through all available index funds. That should tell you something. Besides, the whole argument disregards the vast body of evidence showing that passive funds regularly outperform active funds, usually by a figure eerily similar to the difference between the operating expenses of the respective funds. Finally, just as a poke against Mackenzie, although their funds seemed to do strangely well in this experiment, all of the funds mentioned above only have no-load as an option. Most people buying these funds through advisors would wind up paying a load. This would eliminate any apparent advantage.

3. Most investors are not paying sales charges on funds. Verdict: Bogus

All available open-ended funds of all asset classes on 6972
Same as above but with no-load: 1919

Therefore, almost 3/4s of available funds have a load.

What about ones the average joe can afford ie. minimum investment of less than $1000?
5058 in total, of which only 1244 have no sales charges. And those 1244 would include funds that have no-load as an option, not as a given.

4. Cost is not the most important variable when selecting an investment. Verdict: Bogus

A study done by Morningstar showed that from 1995 on, funds with the highest costs compared to their peers were almost twice as likely to cease to exist. Funds in the cheapest quintile were twice as likely to beat the average in their category than those in the priciest quintile. There was a direct inverse correlation between cost and performance. As you went up each quintile of cost, you continued to decrease your chances of beating the average. Bond funds were the most stark with the cheapest being 5-6 times more likely to succeed than the most expensive. The study also compared performance to the lowest cost index fund. Interestingly, the cheapest active funds beat the index fund 29% of the time, while the most expensive beat it only 17% of the time. This supports two points: cost is one of the most important variables to consider when selecting an investment, and the majority of active funds, even the cheapest, can't beat index funds.

5. I would challenge people to find a meaningful global equity fund in this country that over the past 10 years has not beaten the index. Verdict: True, if you remove the word 'not' near the end of the sentence.

Challenge accepted. Of the 282 international equity funds on, only 12 have beaten the MSCI EAFE index over 10 years. Of those, 9 have sales charges, without the option of no load. Goodbye advantage. Of the remaining 3, 2 have an initial investment of more than $5000. That leaves CIBC International Small Companies, producing a 3.2% annualized return over 10-years versus the index average of -1.8%. How about global equity? 908 are listed on Morningstar. The MSCI World 10-year annualized return is -0.8%. A whopping 34 beat the index. Only 1 of those has no sales charges: TD Entertainment and Communications.

There you have it. Obviously the president of a major mutual fund company would have you believe they're a superior investment. The data just does not support it. So stick to low-cost index investing and you can't really go wrong.

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