Wednesday, August 24, 2011

Investment Manifesto Appendix II: The Index Advantage

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.

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.

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