In researching the plight of Mr. and Mrs. Smith, something kept popping out at me. The financial industry has us all convinced that they can provide value with their services. If we give them our money, they will spin it into gold. That is the whole point of mutual funds and mutual fund managers. They are so utterly intelligent and prescient that they can beat the millions of other individual and institutional investors whose millions of investment decisions made every second of every trading day determine the returns of the market.
That is what we are led to believe. But a unique group of funds put the lie to this whole line of reasoning.
I mentioned before that I chose TD for all my research. It's a company I know well, they have a broad portfolio of mutual funds, and they've been around for awhile so there is plenty of data available. TD, like many other banks and investment firms, offer bundled mutual funds. An example of one of these funds is TD Managed Balanced Growth.
Bank advisers offer these funds to thousands of investors every day across the country. How do I know this? Besides personal experience of course, the evidence. Of the myriad of funds TD sells, the TD Managed Balanced Growth portfolio is eighth in total assets held. Otherwise known as $2.9 billion. And as you'll see below, the other 7 above it are held within many of these packaged funds so their asset ranking really only proves the point further.
These funds are actually funds of funds. By that I mean the overlying fund does not purchase individual companies to match the investment style of the fund. They purchase other FUNDs.
I looked at the four different categories of packaged funds for which TD has 10-year return data. There are four different types of packaged fund with five different investment styles in each.
Types:
Managed: a fund purchasing other funds from within TDs portfolio of funds.
Fundsmart Managed: same as above but purchasing funds within TD and from other companies.
Managed Index: meeting the benchmark objectives of the fund merely by purchasing TD index funds.
Managed Index-e: same as Index but using the e-Series index funds instead of the run-of-the-mill index funds. The only difference is that the e-Series funds are ONLY available online and thus have lower operating costs.
Investment Styles:
Max Equity Growth: 0% fixed income. 100% stocks (35% CDN, 32% US, 35% Intl)
Aggressive Growth: 20:28:25:27 (as above)
Balanced Growth: 40:20:20:20
Income & Moderate Growth: 55:15:15:15
Income: 70:10:10:10
If you believe the financial industry hype and were to rank the returns of these funds since 2003 (the investment horizon of our Mr. & Mrs. Smith) you would rank them in the following order by type, descending by return:
Fundsmart Managed, Managed, Index, Index-e.
Here's why. The Fundsmart Managed are Smart after all. They have access to the whole fund universe, so their genius money managers can use their highly developed skills to find the best funds out there and make scads of cash. The Managed fund managers can pick the best funds, but only within TD. The Index funds, well all they do is follow the whole market. Ha! What kind of loser would hop on board a ship with no captain at the helm? And the e-Series funds? The lowly individual investor can purchase these, on their own, with no help from any professionals and only needing the assistance of branch staff to setup the account, never to interact with them again? Good luck.
Too bad for the fund industry. The ranking, in ALL FIVE investment style classes, is the exact opposite. That is, the one with the most amount of fund industry involvement had the lowest return, and the e-series Index fund had the highest return.
Two other conclusions jump out from this study. The first is found by comparing between investment styles. Within a given fund type, that is Managed or Fundsmart Managed, the return went in lockstep with the percentage of assets allocated to fixed income. This makes sense since the last 8 years have been marked by incredible equity volatility. So as you went from Balanced Growth to Income and Moderate Growth, your return increased because more of your assets were protected in fixed income instruments.
The second conclusion leaps out at you from the page when comparing WITHIN investment styles. Here you compare Managed Income vs Fundsmart Managed Income vs Managed Index Income vs Managed Index Income-e, for one example. As said before, -e wins and the most heavily managed fund loses. What is the relationship here? It turns out that in all 5 investment style groupings, the main contributor to return is EXPENSE, the management expense ratio, or how much it costs to operate the fund. The correlation is -0.86, which is INCREDIBLY STRONG. This means that as the MER goes up, the return on investment goes down.
The fund industry's argument has always been that you pay a higher MER in return for market-beating returns. Obviously not. In every case, the highest ranked fund was the Managed Index e-fund, which had the lowest MER. The inverse can be said for the Fundsmart Managed fund in each group.
But now here's the kicker. In the case of the Managed Index e-funds, all TD is doing is what you can do yourself from home. The fund managers do nothing more than purchase units of the TD e-series index funds at percentages aligned with the asset allocation prescribed by the investment style of the fund. Thus, if your investment style, and that of the fund, is conservative, you might buy 55% in TD Canadian Bond Index-e, and 15% in each of TD US Index-e, TD Canadian Index-e, and TD International Index-e. It would take you a whole of 10 minutes to set this up and you could never look at it again.
If you did this, your average MER is 0.47%, while the MER of the Managed Index Income & Moderate Growth Fund-e, where they do the EXACT same thing, is 1.25%. They charge you 0.78% of your investment for 10 minutes of work once a year. In my case, I invest roughly $10000 per year. That's $78, or a whopping $468 an hour. Wow. That might not sound like much, but the solo approach won with 4.93% annualized return versus 3.92% for the Managed e-fund. A $100000 lump sum investment in 2003 would have foregone over $12 000 in gains. $12 000 for the privilege of pushing a few buttons for 10 minutes every year. That works out to $9000/hr. No wonder people give the financial industry a hard time.
Oh, and in case you're wondering the difference between DIY and TD Managed Balanced Growth, the most popular balanced fund in their arsenal? $18000 over 8 years from $100000. More poignantly, if you gave up the returns sacrificed to the management expense of the fund over a 40-year investment horizon, you would suffer dearly. Investing $5000 per year for 40 years at a rate of 3.04% (Managed) versus 4.66% (DIY) would cost you..........$175 000.
Wednesday, August 24, 2011
Investment Manifesto Appendix I: The GIC Approach
This is a followup to my previous post. I mentioned there that the clients in question were so distraught with the failure of their money to grow in the market that they wanted to move everything to GICs. It just so happens that someone else has thought of this already. His name is David Trahair, and he wrote an intriguing book called Enough Bull, that highlights just such an approach. Trahair, disgusted with the financial industry and the impact on investors of the Lost Decade (as 2000-2010 is now being called in financial circles), outlines, as the subtitle states, How to Retire Well without the Stock Market, Mutual Funds, or Even an Investment Advisor.
He introduces the concept of a GIC ladder and there is beauty in its simplicity. Let's say you have $100 000 to invest in 2003, like our fictional Mr. & Mrs. Smith. You take $20000 and buy 5 GICs, each maturing 1 year after the other. So you buy a 1-year, 2-year, 3-year, 4-year and 5-year GIC. For those who don't know, GICs are Guaranteed Investment Certificates, which, as they say, are guaranteed to pay you the stated interest rate each year for the term of the GIC. Typically, the longer the term, the higher the interest rate. The catch is you can't redeem it without penalty until the end of the term, but the bank rewards you for your delayed gratification by sweetening the interest rate.
Now, when the 1-year GIC matures, you sell it and purchase a 5-year with it. You do the same for the 2-, 3-, 4- and 5-years when they mature. Eventually you have five 5-year GICs. And every year, one of them matures. You sell it and purchase another 5-year GIC every year. This way, each year you are locking in a portion of your portfolio at the prevailing interest rates for that year.
How would such an approach work for Mr. & Mrs. Smith? I found the historical GIC rates from 1970-2011 and backtested such an approach. Of course the results are slightly boosted by the heady interest days of the 80s. But I don't imagine anyone was celebrating 17% GICs when they were paying 20% on their mortgages.
Again, I tested a $100 000 lump sum investment and compared it to a theoretical conservative index portfolio started in the same year. The results were rather surprising.
The index portfolio gained an impressive 9.6% per year, turning $100 000 into $4.3 million in 41 years. The GIC approach fared nicely as well though, coming in at 8.31% per year. While this may seem like a small difference, the magic of compounding ensures that the final result is drastically different. The final portfolio is valued at $2.6 million. Thus, the couple forgoes $1.7m in gains. Some might consider this a small price to pay for sleeping soundly for 41 years. And in case you're wondering, the GIC portfolio outpaced inflation which clocked in at 4.4% per annum.
What if this approach was taken by our fictional couple in 2003? No crazy interest rate spikes to rely on in this period. Did it still produce respectable results? Indeed it did.
$100 000 invested in 2003 in such an approach would net roughly 2.92% per annum, versus about 5% in a conservative index portfolio. They forgo about $25000 in gains. But they still beat inflation, although barely, at 2.05% per annum.
So if you are interested in GICs, I recommend reading Mr. Trahair's book...and treading cautiously. In the markets, nothing is never free. And that goes for risk and safety as well. With risk you pay with volatility. With safety you typically pay in the form of unrealized gains. But it all comes down to what you can live with. Just don't sell yourself short and follow two VERY important rules.
Rule #1: DO NOT buy GICs from the big banks. Their rates are AWFUL. Use INGDirect, Ally, or Achieva Financial. TDs current 5-year non-cashable GIC rate is 1.65%. Achieva is offering 3.5%, Ally 2.75%.
Rule #2: Don't run scared to GICs. Do it because it makes sense for you. If you still think investing in a broad-based portfolio of stocks and bonds is the way to investment success, then d it. Don't put your money in a GIC mattress because your adviser screwed you. Fire your adviser.
He introduces the concept of a GIC ladder and there is beauty in its simplicity. Let's say you have $100 000 to invest in 2003, like our fictional Mr. & Mrs. Smith. You take $20000 and buy 5 GICs, each maturing 1 year after the other. So you buy a 1-year, 2-year, 3-year, 4-year and 5-year GIC. For those who don't know, GICs are Guaranteed Investment Certificates, which, as they say, are guaranteed to pay you the stated interest rate each year for the term of the GIC. Typically, the longer the term, the higher the interest rate. The catch is you can't redeem it without penalty until the end of the term, but the bank rewards you for your delayed gratification by sweetening the interest rate.
Now, when the 1-year GIC matures, you sell it and purchase a 5-year with it. You do the same for the 2-, 3-, 4- and 5-years when they mature. Eventually you have five 5-year GICs. And every year, one of them matures. You sell it and purchase another 5-year GIC every year. This way, each year you are locking in a portion of your portfolio at the prevailing interest rates for that year.
How would such an approach work for Mr. & Mrs. Smith? I found the historical GIC rates from 1970-2011 and backtested such an approach. Of course the results are slightly boosted by the heady interest days of the 80s. But I don't imagine anyone was celebrating 17% GICs when they were paying 20% on their mortgages.
Again, I tested a $100 000 lump sum investment and compared it to a theoretical conservative index portfolio started in the same year. The results were rather surprising.
The index portfolio gained an impressive 9.6% per year, turning $100 000 into $4.3 million in 41 years. The GIC approach fared nicely as well though, coming in at 8.31% per year. While this may seem like a small difference, the magic of compounding ensures that the final result is drastically different. The final portfolio is valued at $2.6 million. Thus, the couple forgoes $1.7m in gains. Some might consider this a small price to pay for sleeping soundly for 41 years. And in case you're wondering, the GIC portfolio outpaced inflation which clocked in at 4.4% per annum.
What if this approach was taken by our fictional couple in 2003? No crazy interest rate spikes to rely on in this period. Did it still produce respectable results? Indeed it did.
$100 000 invested in 2003 in such an approach would net roughly 2.92% per annum, versus about 5% in a conservative index portfolio. They forgo about $25000 in gains. But they still beat inflation, although barely, at 2.05% per annum.
So if you are interested in GICs, I recommend reading Mr. Trahair's book...and treading cautiously. In the markets, nothing is never free. And that goes for risk and safety as well. With risk you pay with volatility. With safety you typically pay in the form of unrealized gains. But it all comes down to what you can live with. Just don't sell yourself short and follow two VERY important rules.
Rule #1: DO NOT buy GICs from the big banks. Their rates are AWFUL. Use INGDirect, Ally, or Achieva Financial. TDs current 5-year non-cashable GIC rate is 1.65%. Achieva is offering 3.5%, Ally 2.75%.
Rule #2: Don't run scared to GICs. Do it because it makes sense for you. If you still think investing in a broad-based portfolio of stocks and bonds is the way to investment success, then d it. Don't put your money in a GIC mattress because your adviser screwed you. Fire your adviser.
Tuesday, August 23, 2011
An investment manifesto
Two investors, Mr. and Mrs. Smith, who I know well, were bemoaning the performance of their mutual fund investments the other day. Back in 2003 they had a lump sum of money they wanted to invest. This money was by no means meant to sustain them in retirement as they were well away from it at that point. From speaking to them it's clear they wanted their money to grow a bit but deep down they are very conservative investors, evidenced by the fact that their desired approach now is to go all-in to GICs (I will discuss this in my next post). I've heard this story a ton of times from other colleagues, friends, and family members and the background info I collect is always the same.
They went to one of the Big Banks and used an in-house investment adviser. The individual seemed knowledgeable enough and showed them that with the specific fund he was recommending or the specific allocation created by the mix of funds he was using, they could expect a roughly 8% annual rate of return on investment. See my previous posts here and here to learn why this is only partially true. Then he invested their money and the rest is history. I'm not sure what funds he invested in or how often he changed the funds. But the fact that he was able to achieve 0% return on investment over an 8 year time frame is astonishing and pathetic. And exceedingly common.
What is the defense of advisers when questioned about these results? The Big Crash in 2008 did you in. When I heard this was the defense leveled in this particular case as well, I decided to dig a little deeper to answer 2 questions.
1. What was the return of a balanced portfolio of low-cost index funds with a lump sum investment starting in 2003 and ending today? Maybe this adviser merely matched the market.
2. Not knowing what funds he used, what is the likelihood of choosing such a poor portfolio given the investment needs and style of the clients?
Question 1:
Since the time period in question was marked by one of the largest stock market declines in history, it stands to reason that the more aggressively a portfolio invests in equities and less in fixed income funds, the lower the return should have been. The data bear this out. However, even the most aggressive mixed portfolio (35% Canadian equity, 32% US, 33% international) of low-cost index funds still yields a return of 4% annually. In order to achieve such dismal results, the adviser would have had to invest in 100% US equity which would have been absolutely idiotic. It is clear this was not the case but demonstrates the magnitude of failure.
Question 2:
What if the adviser knew nothing else than past performance? If he created a conservative portfolio of 60% bonds, 20% Canadian stocks, 10% US stocks, and 10% international stocks, as guided by the couple's investment style, he could pick funds in 3 ways as I see it. He could choose the top performing funds in each fund category for the years prior to 2003. Or he could choose the lowest performing funds (although this may seem ridiculous, in financial markets, battered investments usually rebound quite nicely). Finally, he could just recommend a balanced fund. This is one of those prepackaged funds made for investors with different styles. The Big Banks sell them and so do all the big investment houses. I've used TD in all my examples but only to make the data field manageable. But tellingly, back around 2003 I was in a similar situation to this couple and was recommended something similar by a TD adviser. More recently I was recommended the newest rendition of this product by a different adviser so it seems this approach is popular.
If the adviser chose the top-performing fund his company sold in 2003 based on past performance in each fund category (fixed income, Canadian, US, Intl) and purchased them and let them sit, he would have gained this couple 4.13% per year. If he picked the worst, only proving my previous point, he would have achieved 6.82%. And if he put them in TD Managed Income in 2003 and then switched it to the fund du jour in 2009, TD Comfort Conservative Portfolio, they'd be at 4.49%. Not too shabby in all cases. And the second example is quite remarkable given the market returns. But no bank adviser that I've ever met would try and sell a client on investing in the worst funds going even if it does make mountains of sense.
So here I was at an impasse. This man had clearly achieved the impossible. He had added no value to the investments for these clients. In fact, he had subtracted value. Could that be so? Could not some other reasonable selection method have led to this failure? What if he was cycling the portfolio? What if, every year, he reviewed the past year's performance in each fund category and changed what fund he had the money invested in based on which fund was tops, or conversely, which was in the can? Close, but no cigar. Selling everything and reinvesting in the top performing fund in each category from the previous year yielded a 5.65% annual return, 3.5% in the case of the worst funds. (This does not disprove my previous point as the performance he was assessing was only annual. Each time he purchased there was a good chance he was still riding a wave of success.)
But there must be a way to construct a conservative investment portfolio (assuming he cared even a little bit for his clients' investment style AND considering that even the most aggressive mixed index portfolio still didn't suck as bad as 0%) and completely strike out. Turns out there is....almost.
If I look in hindsight NOW at the worst funds performing over the last 10 years in each fund category for TD and construct a theoretical conservative portfolio with a $100 000 lump sum investment back on January 3, 2003 (as I did for all the projections noted through GlobeInvestorGold, of which I am a paid subscriber), I achieve a return of only 1.25%. Now this couple didn't tell me their return was 0%. They used the term "practically nothing". To many people, gaining only $10 000 on $100 000 (just using this for arguments sake) over 8 years would be considered just that, especially considering that the annual rate of inflation over the same time period was 2.05%. In real terms, they actually lost money.
But I digress. What are the odds of constructing such a disastrous portfolio? First of all, consider that there would have been nothing but chance guiding the purchase of these funds in 2003 as they were not really on the radar. Decidedly mediocre. Only in 2011 with the gift of hindsight can I truly see that they were awful.
Just for shits and giggles though, let's run the odds. To do this I must determine how many funds existed in each category with TD in 2003 and then multiply the odds together. For Canadian Equity it was 1 in 20, US Equity 1 in 16, International Equity 1 in 22, and Fixed Income 1 in 20. So to pick the lousiest 10-year fund in each category would require 1 in 140 800 odds. However, given the frequency with which I hear this story from other investors, this may well be one of the most common rare occurrences in our universe.
Either this adviser was incredibly unlucky, created a portfolio with an asset allocation that was so out of tune with the needs and desires of the clients, or churned the portfolio relentlessly to generate commissions. It might seem that in the first instance, the adviser could be forgiven. Sadly I'm not in a forgiving mood today. If he would have kept it simple by creating a conservative balanced portfolio with broad-based mutual funds (I won't be so daft as to suggest an in-house bank adviser would recommend index funds), purchased them once and just let them be, at absolute worst they'd be sitting at 4% annualized return. That is something I know that they could live with.
The important lesson from this story is that it really doesn't matter who Mr. & Mrs. Smith are, how much money they had to invest, their investment style, or which bank they used (or in a broader sense, with few exceptions, which financial adviser they used). The fact is that the same thing happened to thousands of Canadians in the last 8-10 years. But it all gets written off as normal. It's pushed aside as a natural result of investing in the equities market. "That's the risk you take with investments" we're told and we tell ourselves. But it's not. The fact of the matter is, not taking risk is just as, if not more likely to result in poor returns AND it is the very nature of the investment advice culture that creates poor returns. I hope to prove the last two points in two followup posts, so do please read on!
But what am I to do, one might ask. I don't have time to invest on my own. I don't have the knowledge. I vehemently disagree with both precepts on the basis of my own experience but I'm willing to concede the point because these topics interest me. Educating myself in these matters is not a chore, it's a hobby. That will not be the case for many. So here is my revolutionary manifesto for investors:
1. If you are relatively far from retirement or have a small portfolio, you may want to consider educating yourself. Or just do as little reading as is necessary to construct a Couch Potato Portfolio a la Money Sense (just Google Money Sense Couch Potato Portfolio and you'll be laughin'). The advice I give below would be so expensive for someone with a small portfolio, it would eat away most returns you may achieve. As well, many fee-only advisers won't look at small investors. Finally, in most cases, if the portfolio is small and/or the investors are far from retirement, there isn't a lot of complexity there and you should be able to figure out most of it on your own, with the help of some knowledgeable friends (none of whom sell mutual funds please).
2. If you are closer to retirement or have a large portfolio, or your retirement investments consist mostly of assets you will sell, you need professional help. I rail against traditional financial advice, but even I will be seeking help as I creep over 50. If you have a large portfolio, you can likely afford a professional fee-only planner. These people strictly offer financial advice. They sell no products so their advice is unbiased. Even if your portfolio is meek, if you are closer to retirement, you need assistance. Planning becomes much more complicated as you near the time when you will need to use your retirement funds. There are tax considerations, annuities, RIFs, estate planning, etc. etc. As well, as you get closer to retirement, you need to think about protecting what you've already built. All of this should be done with professional, knowledgeable, and unbiased advice. I'm willing to bet you'd miss out on at least 2 of those factors if you search for it at the bank. So don't. Check MoneySense for directories of fee-only planners. Or call around and find some. They're out there, though not in droves yet.
3. If you are at any stage, consider a sober second opinion. This is the option offered by Weigh House Investor Services. Check them out. They basically take a look at your portfolio and investment plans and tell you (although not literally) whether you are off the rails and need to fire your adviser or whether he's a damn genius and you should bring him brownies. Even if you are a DIYer like myself, they have a nifty DIY coaching program where they are there to help when you need it and review everything with you once a year, just to make sure you don't think you know more than you actually do.
Regardless of which option you choose, do yourself a favor. Either go it alone or hire someone whose paycheque does not depend on or is not partially composed of commissions and trailer fees from the products they sell. It's your money. You earned it. So don't let someone else piss it away.
They went to one of the Big Banks and used an in-house investment adviser. The individual seemed knowledgeable enough and showed them that with the specific fund he was recommending or the specific allocation created by the mix of funds he was using, they could expect a roughly 8% annual rate of return on investment. See my previous posts here and here to learn why this is only partially true. Then he invested their money and the rest is history. I'm not sure what funds he invested in or how often he changed the funds. But the fact that he was able to achieve 0% return on investment over an 8 year time frame is astonishing and pathetic. And exceedingly common.
What is the defense of advisers when questioned about these results? The Big Crash in 2008 did you in. When I heard this was the defense leveled in this particular case as well, I decided to dig a little deeper to answer 2 questions.
1. What was the return of a balanced portfolio of low-cost index funds with a lump sum investment starting in 2003 and ending today? Maybe this adviser merely matched the market.
2. Not knowing what funds he used, what is the likelihood of choosing such a poor portfolio given the investment needs and style of the clients?
Question 1:
Since the time period in question was marked by one of the largest stock market declines in history, it stands to reason that the more aggressively a portfolio invests in equities and less in fixed income funds, the lower the return should have been. The data bear this out. However, even the most aggressive mixed portfolio (35% Canadian equity, 32% US, 33% international) of low-cost index funds still yields a return of 4% annually. In order to achieve such dismal results, the adviser would have had to invest in 100% US equity which would have been absolutely idiotic. It is clear this was not the case but demonstrates the magnitude of failure.
Question 2:
What if the adviser knew nothing else than past performance? If he created a conservative portfolio of 60% bonds, 20% Canadian stocks, 10% US stocks, and 10% international stocks, as guided by the couple's investment style, he could pick funds in 3 ways as I see it. He could choose the top performing funds in each fund category for the years prior to 2003. Or he could choose the lowest performing funds (although this may seem ridiculous, in financial markets, battered investments usually rebound quite nicely). Finally, he could just recommend a balanced fund. This is one of those prepackaged funds made for investors with different styles. The Big Banks sell them and so do all the big investment houses. I've used TD in all my examples but only to make the data field manageable. But tellingly, back around 2003 I was in a similar situation to this couple and was recommended something similar by a TD adviser. More recently I was recommended the newest rendition of this product by a different adviser so it seems this approach is popular.
If the adviser chose the top-performing fund his company sold in 2003 based on past performance in each fund category (fixed income, Canadian, US, Intl) and purchased them and let them sit, he would have gained this couple 4.13% per year. If he picked the worst, only proving my previous point, he would have achieved 6.82%. And if he put them in TD Managed Income in 2003 and then switched it to the fund du jour in 2009, TD Comfort Conservative Portfolio, they'd be at 4.49%. Not too shabby in all cases. And the second example is quite remarkable given the market returns. But no bank adviser that I've ever met would try and sell a client on investing in the worst funds going even if it does make mountains of sense.
So here I was at an impasse. This man had clearly achieved the impossible. He had added no value to the investments for these clients. In fact, he had subtracted value. Could that be so? Could not some other reasonable selection method have led to this failure? What if he was cycling the portfolio? What if, every year, he reviewed the past year's performance in each fund category and changed what fund he had the money invested in based on which fund was tops, or conversely, which was in the can? Close, but no cigar. Selling everything and reinvesting in the top performing fund in each category from the previous year yielded a 5.65% annual return, 3.5% in the case of the worst funds. (This does not disprove my previous point as the performance he was assessing was only annual. Each time he purchased there was a good chance he was still riding a wave of success.)
But there must be a way to construct a conservative investment portfolio (assuming he cared even a little bit for his clients' investment style AND considering that even the most aggressive mixed index portfolio still didn't suck as bad as 0%) and completely strike out. Turns out there is....almost.
If I look in hindsight NOW at the worst funds performing over the last 10 years in each fund category for TD and construct a theoretical conservative portfolio with a $100 000 lump sum investment back on January 3, 2003 (as I did for all the projections noted through GlobeInvestorGold, of which I am a paid subscriber), I achieve a return of only 1.25%. Now this couple didn't tell me their return was 0%. They used the term "practically nothing". To many people, gaining only $10 000 on $100 000 (just using this for arguments sake) over 8 years would be considered just that, especially considering that the annual rate of inflation over the same time period was 2.05%. In real terms, they actually lost money.
But I digress. What are the odds of constructing such a disastrous portfolio? First of all, consider that there would have been nothing but chance guiding the purchase of these funds in 2003 as they were not really on the radar. Decidedly mediocre. Only in 2011 with the gift of hindsight can I truly see that they were awful.
Just for shits and giggles though, let's run the odds. To do this I must determine how many funds existed in each category with TD in 2003 and then multiply the odds together. For Canadian Equity it was 1 in 20, US Equity 1 in 16, International Equity 1 in 22, and Fixed Income 1 in 20. So to pick the lousiest 10-year fund in each category would require 1 in 140 800 odds. However, given the frequency with which I hear this story from other investors, this may well be one of the most common rare occurrences in our universe.
Either this adviser was incredibly unlucky, created a portfolio with an asset allocation that was so out of tune with the needs and desires of the clients, or churned the portfolio relentlessly to generate commissions. It might seem that in the first instance, the adviser could be forgiven. Sadly I'm not in a forgiving mood today. If he would have kept it simple by creating a conservative balanced portfolio with broad-based mutual funds (I won't be so daft as to suggest an in-house bank adviser would recommend index funds), purchased them once and just let them be, at absolute worst they'd be sitting at 4% annualized return. That is something I know that they could live with.
The important lesson from this story is that it really doesn't matter who Mr. & Mrs. Smith are, how much money they had to invest, their investment style, or which bank they used (or in a broader sense, with few exceptions, which financial adviser they used). The fact is that the same thing happened to thousands of Canadians in the last 8-10 years. But it all gets written off as normal. It's pushed aside as a natural result of investing in the equities market. "That's the risk you take with investments" we're told and we tell ourselves. But it's not. The fact of the matter is, not taking risk is just as, if not more likely to result in poor returns AND it is the very nature of the investment advice culture that creates poor returns. I hope to prove the last two points in two followup posts, so do please read on!
But what am I to do, one might ask. I don't have time to invest on my own. I don't have the knowledge. I vehemently disagree with both precepts on the basis of my own experience but I'm willing to concede the point because these topics interest me. Educating myself in these matters is not a chore, it's a hobby. That will not be the case for many. So here is my revolutionary manifesto for investors:
1. If you are relatively far from retirement or have a small portfolio, you may want to consider educating yourself. Or just do as little reading as is necessary to construct a Couch Potato Portfolio a la Money Sense (just Google Money Sense Couch Potato Portfolio and you'll be laughin'). The advice I give below would be so expensive for someone with a small portfolio, it would eat away most returns you may achieve. As well, many fee-only advisers won't look at small investors. Finally, in most cases, if the portfolio is small and/or the investors are far from retirement, there isn't a lot of complexity there and you should be able to figure out most of it on your own, with the help of some knowledgeable friends (none of whom sell mutual funds please).
2. If you are closer to retirement or have a large portfolio, or your retirement investments consist mostly of assets you will sell, you need professional help. I rail against traditional financial advice, but even I will be seeking help as I creep over 50. If you have a large portfolio, you can likely afford a professional fee-only planner. These people strictly offer financial advice. They sell no products so their advice is unbiased. Even if your portfolio is meek, if you are closer to retirement, you need assistance. Planning becomes much more complicated as you near the time when you will need to use your retirement funds. There are tax considerations, annuities, RIFs, estate planning, etc. etc. As well, as you get closer to retirement, you need to think about protecting what you've already built. All of this should be done with professional, knowledgeable, and unbiased advice. I'm willing to bet you'd miss out on at least 2 of those factors if you search for it at the bank. So don't. Check MoneySense for directories of fee-only planners. Or call around and find some. They're out there, though not in droves yet.
3. If you are at any stage, consider a sober second opinion. This is the option offered by Weigh House Investor Services. Check them out. They basically take a look at your portfolio and investment plans and tell you (although not literally) whether you are off the rails and need to fire your adviser or whether he's a damn genius and you should bring him brownies. Even if you are a DIYer like myself, they have a nifty DIY coaching program where they are there to help when you need it and review everything with you once a year, just to make sure you don't think you know more than you actually do.
Regardless of which option you choose, do yourself a favor. Either go it alone or hire someone whose paycheque does not depend on or is not partially composed of commissions and trailer fees from the products they sell. It's your money. You earned it. So don't let someone else piss it away.
Sunday, August 7, 2011
R.I.P. Active Fund Management
As I promised in my previous post, I've analyzed whether the average investor can use mutual funds to produce market beating returns. You have to understand that most individual investors will rely on the advice of an investment advisor, whether through a bank or insurance company, to purchase their retirement mutual funds. Both my experience and the evidence presented in the previous post show that investment advisors are good at 2 things: chasing past performance and failing to pick winning funds.
So if it were 2004 and I were listening to an advisor, s/he might suggest I invest in one of the top 10 funds in each asset class based on the last 3 years performance. This of course assumes this advisor has at their disposal the whole universe of Canadian mutual funds, which would be a very rare thing indeed. Most advisors, particularly those at banks, sell only their company's mutual funds. That goes for insurance companies as well. If you deal with an investment house like Edward Jones, they have a slightly broader offering, but not the whole universe. In fact, to access all the funds I researched, you'd have to be with a high price broker or use an online discount broker. You'll see why that would make no sense though because you'd be better off just using the very small and easy to understand universe of index funds.
Here's my methodology. I analyzed the rolling 3-year returns of mutual funds in the following 4 asset classes: Canadian equity, US equity, international equity, and Canadian fixed income. I used the data at FundLibrary for this purpose. I then identified the top 10 mutual funds in each rolling 3-year period. For the period starting 2004 (3-year average of 2003, 2002, 2001), I looked at the rank of the top 10 funds for the 10-year return ending 2010. For the top 10 funds in the 10-year return, I looked at where they ranked back in 2004. So I'm looking for 2 things here. If you invested in the top performers in 2004, did they end up performing big over 10 years? Also, looking at the top 10 funds based on 10 year performance, would there have been a way for you to easily identify them back in 2004?
The main conclusion from my research is that playing the mutual fund game is like rolling at the craps table. For example, of all the asset classes, the exact average ranking of the top 10 funds is 5.5. What is the average ranking in the 10-year performance measure? 16.33. The whole group as an average moves down 11 ranks. But when you look at the distribution of the rankings you see how much of a mess it is. While they start from 1-10 in 2004, they end up ranging anywhere from 1-72 on 10-year return. And it's no different when you look in reverse.
The top 10 funds based on 10-year performance, if past performance is a true predictor of future performance, should have been very easy to pick out among the universe of funds in 2004. While the top 10 over 10-years are by necessity ranked 1-10, they started out ranked anywhere from 1-88. Not quite as bad odds as the lottery but worse than some casino games.
But what if you just invested in the top funds based on highest 3-year performance? I did as such using GlobeInvestorGold. I made a hypothetical portfolio with equal weighting for each of the aforementioned asset classes. I invested $10 000 each year for 8 years. In the end, I had a personal rate of return of 1.71% per year, or a dollar growth of $5797.
I then created a similar portfolio but using only low cost TD e-series Index Funds mimicking the same asset classes. The result? 2.12% per year, or a dollar growth of $7275.
Now you might be saying, what's 0.5%? Well, over a 40-year investment span investing $10000 per year, it'll cost you about $53 000. And, the above projection significantly underestimates the underperformance of the actively managed approach for a few reasons.
1. Investment advisors often convince investors to sell and buy frequently in order to churn up commissions. This increases fees and reduces returns.
2. As documented in John Bogle's book mentioned in my previous post, most investors (and their advisors for that matter) don't have the discipline to stay on cruise control. Trying to time the market and chase performance always leads to diminished returns.
3. The projection above used No-Load funds when possible because the database seemed to have more data for them. Most of the time, if individuals are purchasing these funds through investment advisors, whether they know it or not, they are either paying a front-end load (pay a % fee when buying the fund) a back-end load (pay when you sell) or a deferred-sales charge. This would reduce returns further.
4. The top performing funds in many cases had fairly high initial investments so are unavailable to many individual investors.
5. I'm willing to bet MOST Canadians get their mutual funds through one of the big banks. There were a remarkably small amount of top performing mutual funds sold by the big banks. If I did a separate study showing just funds offered by those banks, it would not be pretty.
6. A good portion of the top performing funds were index funds. They actually skewed the performance higher. If I were to remove them, it would push the cumulative returns lower. I decided not to for 2 reasons. 1, I was tired of looking at data. 2, realistically, those funds are part of the pool from which an investor has to choose. Unlikely an advisor would recommend them, but you never know. Stranger things have happened.
7. Finally, survivor bias. By definition, all the funds I looked at still exist today. That means they are at least semi-respectable at performing or they would have been sacked. In John Bogle's similar study to mine, of 350 or so funds that started out the study, roughly 75% of them ceased to exist by the end of the study. But in hindsight, I can't include their performance because the data to which I have access no longer lists them. Their presence would significantly skew the returns downward. The other notable finding from my research is how few mutual funds on offer in each asset class even have 10 years of data under their belt. That's because the industry has to keep coming up with new and improved funds to draw in investors.
The final obvious conclusion from this little experiment is, even if you assume none of 1-7 to be true, and the performance difference is only 0.5%, the fact that there is a performance difference at all in favor of passive investing should put the whole argument to rest. And I repeat: I literally spend 5 minutes of my time each month managing my e-Series index portfolio. No meetings with investment advisors. No sales pitches for tied-in insurance products. I have asset diversification and low cost investing all in one package. Plus, every comparison I've ever run on my investments against those recommended to me by investment advisors have come out in my favor. (And yes, some of those comparisons have run from the time the investor made the recommendation, not looking in hindsight.) And no, it's not something of which only I'm capable. All you need is a little bit of knowledge, some patience, and some discipline when the market starts doing funky stuff.
As a final note, given how terrible the investment climate has been since I started investing in 2007, one would think my portfolio should be in the red. Well, it's nothing to write home about, but it is sitting at a respectable 2.8% per year. The total market has seen a decline over that same period. However, my superior performance is clearly due to dollar cost averaging. If you simply look at $10000 invested in November 2006 in index funds versus the theoretical market, the market is up 1.90% (this "market" being 25:25:25:25 as above) while the indexing is down 1.26%. How powerful then that simply investing a set amount of money at regular time intervals can increase my annualized return from a negative to a positive? Don't try and time the market. Let the ups and downs fall where they may.
There you go. Average is within your grasp. And you don't need a financial planner to get there. You may need one for other financial matters, but most certainly not for the majority of your retirement investing. And if and when you do need one, stick with a fee-only planner. You work hard for your money, so why should you be so quick to hand it over to someone else to take care of that knows little more about investing than what you can read in books?
Educate yourself. It's honestly not that hard. Just subscribe to MoneySense Magazine and you'll be set. Seriously. I've done a lot more reading than just that but for most people MoneySense will completely enlighten you and help you take control of your financial future.
So if it were 2004 and I were listening to an advisor, s/he might suggest I invest in one of the top 10 funds in each asset class based on the last 3 years performance. This of course assumes this advisor has at their disposal the whole universe of Canadian mutual funds, which would be a very rare thing indeed. Most advisors, particularly those at banks, sell only their company's mutual funds. That goes for insurance companies as well. If you deal with an investment house like Edward Jones, they have a slightly broader offering, but not the whole universe. In fact, to access all the funds I researched, you'd have to be with a high price broker or use an online discount broker. You'll see why that would make no sense though because you'd be better off just using the very small and easy to understand universe of index funds.
Here's my methodology. I analyzed the rolling 3-year returns of mutual funds in the following 4 asset classes: Canadian equity, US equity, international equity, and Canadian fixed income. I used the data at FundLibrary for this purpose. I then identified the top 10 mutual funds in each rolling 3-year period. For the period starting 2004 (3-year average of 2003, 2002, 2001), I looked at the rank of the top 10 funds for the 10-year return ending 2010. For the top 10 funds in the 10-year return, I looked at where they ranked back in 2004. So I'm looking for 2 things here. If you invested in the top performers in 2004, did they end up performing big over 10 years? Also, looking at the top 10 funds based on 10 year performance, would there have been a way for you to easily identify them back in 2004?
The main conclusion from my research is that playing the mutual fund game is like rolling at the craps table. For example, of all the asset classes, the exact average ranking of the top 10 funds is 5.5. What is the average ranking in the 10-year performance measure? 16.33. The whole group as an average moves down 11 ranks. But when you look at the distribution of the rankings you see how much of a mess it is. While they start from 1-10 in 2004, they end up ranging anywhere from 1-72 on 10-year return. And it's no different when you look in reverse.
The top 10 funds based on 10-year performance, if past performance is a true predictor of future performance, should have been very easy to pick out among the universe of funds in 2004. While the top 10 over 10-years are by necessity ranked 1-10, they started out ranked anywhere from 1-88. Not quite as bad odds as the lottery but worse than some casino games.
But what if you just invested in the top funds based on highest 3-year performance? I did as such using GlobeInvestorGold. I made a hypothetical portfolio with equal weighting for each of the aforementioned asset classes. I invested $10 000 each year for 8 years. In the end, I had a personal rate of return of 1.71% per year, or a dollar growth of $5797.
I then created a similar portfolio but using only low cost TD e-series Index Funds mimicking the same asset classes. The result? 2.12% per year, or a dollar growth of $7275.
Now you might be saying, what's 0.5%? Well, over a 40-year investment span investing $10000 per year, it'll cost you about $53 000. And, the above projection significantly underestimates the underperformance of the actively managed approach for a few reasons.
1. Investment advisors often convince investors to sell and buy frequently in order to churn up commissions. This increases fees and reduces returns.
2. As documented in John Bogle's book mentioned in my previous post, most investors (and their advisors for that matter) don't have the discipline to stay on cruise control. Trying to time the market and chase performance always leads to diminished returns.
3. The projection above used No-Load funds when possible because the database seemed to have more data for them. Most of the time, if individuals are purchasing these funds through investment advisors, whether they know it or not, they are either paying a front-end load (pay a % fee when buying the fund) a back-end load (pay when you sell) or a deferred-sales charge. This would reduce returns further.
4. The top performing funds in many cases had fairly high initial investments so are unavailable to many individual investors.
5. I'm willing to bet MOST Canadians get their mutual funds through one of the big banks. There were a remarkably small amount of top performing mutual funds sold by the big banks. If I did a separate study showing just funds offered by those banks, it would not be pretty.
6. A good portion of the top performing funds were index funds. They actually skewed the performance higher. If I were to remove them, it would push the cumulative returns lower. I decided not to for 2 reasons. 1, I was tired of looking at data. 2, realistically, those funds are part of the pool from which an investor has to choose. Unlikely an advisor would recommend them, but you never know. Stranger things have happened.
7. Finally, survivor bias. By definition, all the funds I looked at still exist today. That means they are at least semi-respectable at performing or they would have been sacked. In John Bogle's similar study to mine, of 350 or so funds that started out the study, roughly 75% of them ceased to exist by the end of the study. But in hindsight, I can't include their performance because the data to which I have access no longer lists them. Their presence would significantly skew the returns downward. The other notable finding from my research is how few mutual funds on offer in each asset class even have 10 years of data under their belt. That's because the industry has to keep coming up with new and improved funds to draw in investors.
The final obvious conclusion from this little experiment is, even if you assume none of 1-7 to be true, and the performance difference is only 0.5%, the fact that there is a performance difference at all in favor of passive investing should put the whole argument to rest. And I repeat: I literally spend 5 minutes of my time each month managing my e-Series index portfolio. No meetings with investment advisors. No sales pitches for tied-in insurance products. I have asset diversification and low cost investing all in one package. Plus, every comparison I've ever run on my investments against those recommended to me by investment advisors have come out in my favor. (And yes, some of those comparisons have run from the time the investor made the recommendation, not looking in hindsight.) And no, it's not something of which only I'm capable. All you need is a little bit of knowledge, some patience, and some discipline when the market starts doing funky stuff.
As a final note, given how terrible the investment climate has been since I started investing in 2007, one would think my portfolio should be in the red. Well, it's nothing to write home about, but it is sitting at a respectable 2.8% per year. The total market has seen a decline over that same period. However, my superior performance is clearly due to dollar cost averaging. If you simply look at $10000 invested in November 2006 in index funds versus the theoretical market, the market is up 1.90% (this "market" being 25:25:25:25 as above) while the indexing is down 1.26%. How powerful then that simply investing a set amount of money at regular time intervals can increase my annualized return from a negative to a positive? Don't try and time the market. Let the ups and downs fall where they may.
There you go. Average is within your grasp. And you don't need a financial planner to get there. You may need one for other financial matters, but most certainly not for the majority of your retirement investing. And if and when you do need one, stick with a fee-only planner. You work hard for your money, so why should you be so quick to hand it over to someone else to take care of that knows little more about investing than what you can read in books?
Educate yourself. It's honestly not that hard. Just subscribe to MoneySense Magazine and you'll be set. Seriously. I've done a lot more reading than just that but for most people MoneySense will completely enlighten you and help you take control of your financial future.
Saturday, August 6, 2011
Aiming for Average
There are very few instances in life where I aim for average. I most certainly do not want to be an average North American bodyweight. I don't want my pharmacy to provide average service. And when I was in school, I was not satisfied with average grades. But there is one area where not only do I want to be average, but it makes absolute sense. Sadly, because there is so much money and marketing behind convincing the "average" citizen to perform well above average in this regard, my outcome is likely to be anything but average, if you catch my drift.
I speak of course of investing. Anyone who invests in mutual funds for their retirement either on their own or more likely through an investment advisor, needs to read this post. And since the source of my inspiration is "The Little Book of Common Sense Investing" by John Bogle, it follows that they should read it as well.
The aim of most investors and the pitch made to them by their financial advisors is to "beat the market". But if you do enough reading you will learn that it is next to impossible to do just that. I have written before on passive index investing and its advantages so I refer you to an earlier post on the topic here.
What I want to do here is to highlight a few key points in Mr. Bogle's book that really jumped out at me. Even though the author is preaching to the converted when I read this book I still found it fascinating mostly because he insists on doing something of which I'm a big fan: backing up his assertions with data. Someone new to the beautiful simplicity of index investing will likely be quite skeptical because their investment advisors have always told them different. And these are individuals we should be able to intrinsically trust, right? Sadly, most investment advisors are either woefully uneducated OR they are making recommendations that mostly serve to benefit them. A good test to see if you have a good advisor is to ask him or her if they recommend index funds. If they say no, go find someone else. And the excerpts from Mr. Bogle's book below will help convince you why. If they don't, take the book out from the library. It's a quick read but it will change the way you save for retirement and while you'll be aiming to do "just as good" as the market, you'll end up trouncing the Joneses.
On buying funds based on past performance, an issue I've also addressed previously here.
1. "In short, selecting mutual funds on the basis of short-term performance is all too likely to be hazardous duty, and it is almost always destined to produce returns that fall far short of those achieved by the stock market, itself so easily achievable through an index fund."
2. Quoting Nassim Nicholas Taleb, author of Fooled by Randomness. "Toss a coin; heads and the manager will make $10 000 over the year, tails and he will lose $10 000. We run the contest for the first year for 10 000 managers. At the end of the year, we expect 5 000 managers to be up $10 000 each, and 5 000 to be down $10 000. Now we run the game a second year. Again, we can expect 2 500 managers to be up two years in a row; another year, 1 250; a fourth one, 625; a fifth, 313. We have now, simply in a fair game, 313 managers who made money for five years in a row. And in 10 years, just 10 of the original 10 000 managers. Out of pure luck...a population entirely composed of bad managers will produce a small amount of great track records.
3. Quoting Ted Aronson, partner at money management firm Aronson+Johnson+Ortiz: "It takes between 20 and 800 years of monitoring performance to statistically PROVE that a money manager is skillful, not lucky. To be 95% certain...it can easily take nearly a millennium. Investors need to know how the money management business really works. It's a stacked deck. The game is unfair.
4. Quoting author Jason Zweig: "Buying funds based purely on their past performance is one of the stupidest things an investor can do." (To understand why this is so true, read my post linked at the beginning of this section, or do some reading on "reversion to the mean".)
On whether advisors add any value in choosing winning mutual funds:
1. A recent study by a research team led by two Harvard Business School professors concluded that, between 1996 and 2002 alone, "the underperformance of advisor-sold funds relative to funds purchased directly by investors cost investors approximately $9-billion per year."
2. Here's a real knockout punch from the same study listed in #1. "The study's conclusion: the weighted average return of equity funds held by investors who relied on advisers (EXCLUDING all charges paid up front or at the time of redemption [these are known as front-end or back-end loads, quite common in funds sold by advisors and would make the returns look even worse]) averaged just 2.9% per year compared with 6.6% earned by investors who took charge of their own affairs.
As an aside here, that percentage difference initially looks small. But let's assume for a minute that someone starts investing $10000 per year at age 25 and retires at 65. One individual trusts his advisor and invests in the funds they choose. They other goes it alone. Here is the difference in the value of their portfolios at age 65.
Advisor-assisted: $740 000
Self-directed: $1.8 million
So you essentially paid that advisor $1.06 million over 40 years to give you lousy returns. That's $26 000 a year. Not a shabby salary for him and the fund company but a real kick in the pants for you.
The last quote I leave you with is from the book discussing a unique study initiated by the New York Times in 1993.
"The editors asked five respected advisers how they would invest $50 000 in a tax-free retirement account holding mutual fund shares for an investor who had a time horizon of at least 20 years. The comparative standard would be the returns earned by Vanguard 500 Index Fund...By 2000, 7 years later, the Times reported their accomplishments. The hypothetical $50000 portfolios run by the advisers had turned in a profit, on average, of $88 500, ranging from $62000-$105000
...not one of these advisers was able to outpace the results of the Vanguard 500 Index Fund...$138 750. That is, the average adviser produced a paper profit on his portfolio of recommended funds that was about 40% less than the profit on the index fund...In mid-2000, the Times abruptly terminated the contest without notice."
Still not convinced? In my own experience, my simple portfolio of index funds purchased monthly and rebalanced annually that takes 5 minutes of effort every month has outpaced the recommendations of the adviser I fired 4 years ago by at least 5-10% in annual return. And when I went to setup an RESP for our newest addition I was confronted with the same old story by the in-house "adviser" (who has no more education than that offered by the bank and had less sophisticated knowledge about investments than myself). She was totally incredulous that I was using index funds and wanted me to switch to a Comfort portfolio, probably the worst form of mutual funds known as a Fund of Funds. That is, the fund itself holds various other funds sold by that company so you get hammered by the overarching fees of the fund itself and the hidden fees in the embedded funds. I politely declined and then she went on about its great past performance (which is pretty rich given that it was started at the nadir of the last stock market recession, so sure it looks damn good).
And finally, as a little thought experiment. What if I took the advice of MOST retail investment advisers to which most average individuals have access and purchased funds in my portfolio that have the best past performance? Starting in 2004, I'll identify the top 10 funds in each year for each of my portfolio asset classes, that is: Canadian Equity, US Equity, International Equity, Fixed Income. I'll then see where those funds rank in the subsequent year in terms of performance. My hypothesis is that they will show a stark and significant reversion to the mean. I will also run a hypothetical portfolio on Globeinvestor Gold to determine what would actually happen if I invested $10000, equally weighted into each asset class, each year and held the investments until present day. Stay tuned for the results.
I speak of course of investing. Anyone who invests in mutual funds for their retirement either on their own or more likely through an investment advisor, needs to read this post. And since the source of my inspiration is "The Little Book of Common Sense Investing" by John Bogle, it follows that they should read it as well.
The aim of most investors and the pitch made to them by their financial advisors is to "beat the market". But if you do enough reading you will learn that it is next to impossible to do just that. I have written before on passive index investing and its advantages so I refer you to an earlier post on the topic here.
What I want to do here is to highlight a few key points in Mr. Bogle's book that really jumped out at me. Even though the author is preaching to the converted when I read this book I still found it fascinating mostly because he insists on doing something of which I'm a big fan: backing up his assertions with data. Someone new to the beautiful simplicity of index investing will likely be quite skeptical because their investment advisors have always told them different. And these are individuals we should be able to intrinsically trust, right? Sadly, most investment advisors are either woefully uneducated OR they are making recommendations that mostly serve to benefit them. A good test to see if you have a good advisor is to ask him or her if they recommend index funds. If they say no, go find someone else. And the excerpts from Mr. Bogle's book below will help convince you why. If they don't, take the book out from the library. It's a quick read but it will change the way you save for retirement and while you'll be aiming to do "just as good" as the market, you'll end up trouncing the Joneses.
On buying funds based on past performance, an issue I've also addressed previously here.
1. "In short, selecting mutual funds on the basis of short-term performance is all too likely to be hazardous duty, and it is almost always destined to produce returns that fall far short of those achieved by the stock market, itself so easily achievable through an index fund."
2. Quoting Nassim Nicholas Taleb, author of Fooled by Randomness. "Toss a coin; heads and the manager will make $10 000 over the year, tails and he will lose $10 000. We run the contest for the first year for 10 000 managers. At the end of the year, we expect 5 000 managers to be up $10 000 each, and 5 000 to be down $10 000. Now we run the game a second year. Again, we can expect 2 500 managers to be up two years in a row; another year, 1 250; a fourth one, 625; a fifth, 313. We have now, simply in a fair game, 313 managers who made money for five years in a row. And in 10 years, just 10 of the original 10 000 managers. Out of pure luck...a population entirely composed of bad managers will produce a small amount of great track records.
3. Quoting Ted Aronson, partner at money management firm Aronson+Johnson+Ortiz: "It takes between 20 and 800 years of monitoring performance to statistically PROVE that a money manager is skillful, not lucky. To be 95% certain...it can easily take nearly a millennium. Investors need to know how the money management business really works. It's a stacked deck. The game is unfair.
4. Quoting author Jason Zweig: "Buying funds based purely on their past performance is one of the stupidest things an investor can do." (To understand why this is so true, read my post linked at the beginning of this section, or do some reading on "reversion to the mean".)
On whether advisors add any value in choosing winning mutual funds:
1. A recent study by a research team led by two Harvard Business School professors concluded that, between 1996 and 2002 alone, "the underperformance of advisor-sold funds relative to funds purchased directly by investors cost investors approximately $9-billion per year."
2. Here's a real knockout punch from the same study listed in #1. "The study's conclusion: the weighted average return of equity funds held by investors who relied on advisers (EXCLUDING all charges paid up front or at the time of redemption [these are known as front-end or back-end loads, quite common in funds sold by advisors and would make the returns look even worse]) averaged just 2.9% per year compared with 6.6% earned by investors who took charge of their own affairs.
As an aside here, that percentage difference initially looks small. But let's assume for a minute that someone starts investing $10000 per year at age 25 and retires at 65. One individual trusts his advisor and invests in the funds they choose. They other goes it alone. Here is the difference in the value of their portfolios at age 65.
Advisor-assisted: $740 000
Self-directed: $1.8 million
So you essentially paid that advisor $1.06 million over 40 years to give you lousy returns. That's $26 000 a year. Not a shabby salary for him and the fund company but a real kick in the pants for you.
The last quote I leave you with is from the book discussing a unique study initiated by the New York Times in 1993.
"The editors asked five respected advisers how they would invest $50 000 in a tax-free retirement account holding mutual fund shares for an investor who had a time horizon of at least 20 years. The comparative standard would be the returns earned by Vanguard 500 Index Fund...By 2000, 7 years later, the Times reported their accomplishments. The hypothetical $50000 portfolios run by the advisers had turned in a profit, on average, of $88 500, ranging from $62000-$105000
...not one of these advisers was able to outpace the results of the Vanguard 500 Index Fund...$138 750. That is, the average adviser produced a paper profit on his portfolio of recommended funds that was about 40% less than the profit on the index fund...In mid-2000, the Times abruptly terminated the contest without notice."
Still not convinced? In my own experience, my simple portfolio of index funds purchased monthly and rebalanced annually that takes 5 minutes of effort every month has outpaced the recommendations of the adviser I fired 4 years ago by at least 5-10% in annual return. And when I went to setup an RESP for our newest addition I was confronted with the same old story by the in-house "adviser" (who has no more education than that offered by the bank and had less sophisticated knowledge about investments than myself). She was totally incredulous that I was using index funds and wanted me to switch to a Comfort portfolio, probably the worst form of mutual funds known as a Fund of Funds. That is, the fund itself holds various other funds sold by that company so you get hammered by the overarching fees of the fund itself and the hidden fees in the embedded funds. I politely declined and then she went on about its great past performance (which is pretty rich given that it was started at the nadir of the last stock market recession, so sure it looks damn good).
And finally, as a little thought experiment. What if I took the advice of MOST retail investment advisers to which most average individuals have access and purchased funds in my portfolio that have the best past performance? Starting in 2004, I'll identify the top 10 funds in each year for each of my portfolio asset classes, that is: Canadian Equity, US Equity, International Equity, Fixed Income. I'll then see where those funds rank in the subsequent year in terms of performance. My hypothesis is that they will show a stark and significant reversion to the mean. I will also run a hypothetical portfolio on Globeinvestor Gold to determine what would actually happen if I invested $10000, equally weighted into each asset class, each year and held the investments until present day. Stay tuned for the results.
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