Reach the Top

[lead]This blog post is adapted from my French column with the Les Affaires blog.[/lead]

How would you like to be at the top of the class with your investments? As in many other areas, standing out with your investment results requires good documentation. To do this, a good starting point is the report published by the research firm Standard and Poor’s (also known as the “SPIVA^®” report or “Standard and Poor’s Index versus Active”) on the performance of actively managed mutual funds in Canada. This report analyzes their performance from three angles.

Highlights of the “SPIVA” report

First, the report documents the proportion of funds that fail to outperform their benchmark. Basically, over the past ten years, between 65% and 97% of actively managed funds (depending on asset class) have failed the test. Detailed results are shown in Table 1.

Table 1: Proportion of actively managed funds that have failed to outperform their benchmark (ten years ending December 31, 2020)

Source: Standard & Poor’s

Second, the report analyzes the proportion of funds that survived over time. Surprise! Depending on the category, only between 36% and 62% of the funds available ten years ago still exist today. In other words, when you invest with an actively managed fund, there is a good chance that the latter will be wound up or merged with another fund within ten years. Let’s just say that this is not the most stable scenario for a long-term investor.

Table 2: Survival rate of actively managed funds (ten years ending December 31, 2020)

Source: Standard & Poor’s

The final aspect covered by the report is the difference in the returns of actively managed funds vis-à-vis their benchmarks. In each of the seven categories, actively managed funds have, on average, a ten-year return below (and sometimes far below) their benchmark. Details are shown in Table 3.

Table 3: Return difference – actively managed funds minus benchmark index (ten years ending on December 31, 2020)

Source: Standard & Poor’s

Does it make sense to shun passively managed funds?

Let’s recap. Actively managed funds very rarely beat their benchmark. In addition, they are victims of a high death rate. Finally, their annualized returns over the past ten years is significantly lower than the benchmarks. It would, therefore, be logical for investors to opt mainly for funds with passive management. This is far from being the case. Our most recent study on competition in the investment fund universe reveals a market share of only 13% for passively managed funds in Canada, a staggering result. Why is this so? Here are some assumptions.

Hypothesis #1: Financial advisors are misinformed

Very possible. A study published this spring by the prestigious Journal of Finance analyzes the behaviour of 4,000 Canadian financial advisors between 1999 and 2013. Researchers conclude that advisors in general follow the same strategies for their own investments as for their clients. According to the authors: “Advisors trade frequently, chase returns, prefer expensive and actively managed funds, and underdiversify.” The study also claims that advisors persist in managing their own assets in this way after retirement, to the detriment of their own best interests.

Hypothesis #2: The Standard & Poor’s study is incorrect.

False. In fact, the SPIVA Report has been updated semi-annually for many years and the results remain the same. In addition, other studies –notably those of the research firm Morningstar as well as many academics – arrive at the same result.

Hypothesis #3: Behavioural biases favour actively managed funds.

Perhaps. The Standard and Poor’s study is nevertheless known to many investment advisors. But the majority of them persist in investing with actively managed funds for a variety of reasons. One of them is probably that actively managed funds offer a chance—however slim—to significantly outperform the market. Another potential reason could be the fear of their clients’ negative perception of passively managed funds. Indeed, if an advisor has been telling clients for several years that he is bringing them added value by selecting winning funds for them, it can be difficult to change course in favour of passive ETFs. Finally, the companies that employ the advisors may not allow them to recommend passive ETFs to their clients.

Reach the Top

To join the select club of investors who stand out with superior returns, simply set and maintain a target asset allocation and plant it using low-cost total market index ETFs. I have offered such a portfolio for several years in my columns. Each of the ETFs in this portfolio ranks in either the first or second quartile (see Table 4) of the Canadian investment fund universe, that is, they are consistently above the median. None of these ETFs use complicated strategies to achieve this. Their strategy is to replicate, as closely as possible, the target asset class at a very low cost. Not only have these ETFs performed well historically, but they are also likely to continue to outperform the vast majority of actively managed funds in the future.

Table 4: Morningstar Ranking of ETFs in my Model Portfolio

Source: Standard & Poor’s