Mutual Fund Investing, Ending the Passive Index Versus Actively Managed Fund Debate
Sometimes I am amazed that there is still a debate over investing in index mutual funds vs. actively managed mutual funds. Then I remember how much money the mutual fund companies and investment advisors make off actively managed funds and it all makes sense. Of course mutual fund companies and advisors do not want to admit actively managed funds may not be the best option for investors, because they will earn less money if everyone starts using index funds. All of the data clearly shows that very few actively managed funds beat the index. The longer the time frame you look at the more the data points to index investing being the superior option. In Feb 2010 Standard & Poor’s launched its most recent Canadian Indices Versus Active Funds Scorecard with data for the five year period ending December 31, 2009. Below are a couple quotes from the report.
“Over longer periods, we continue to observe indices outperforming the majority of domestic funds. In three-year and five-year periods, only 12.5% and 7.4%, respectively, of actively managed Canadian Equity funds have outperformed the S&P/TSX Composite Index.”
“Over the last five years, only 10% of active funds in the International Equity category, 13.9% in the Global Equity category, and 9.2% in the U.S. Equity category have outpaced S&P EPAC LargeMidCap, S&P Developed LargeMidCap and S&P 500 indices respectively.”
So over the last five years 93.6% of Canadian equity funds, 90.8% of US equity funds, 90% of International equity funds and 86.1% of Global equity funds have underperformed their respective indices. It is easy to figure out why actively managed investments consistently under-perform with the incredible high Management Expense Ratio (MER) that is charged on actively managed mutual funds in Canada. Having a 2%+ MER compared to an index funds MER of 0.75% or less is a lot to overcome. Overcoming these higher fees becomes an even more difficult task when you look at the holdings of a typical equity fund compared to its index. In most cases the holding are very similar. I took the most widely owned Canadian equity fund, the RBC Canadian Equity Fund and compared the holding to the RBC Canadian Index Fund. The data used is from the RBC 2009 semi annual report which had the holdings as of June 30, 2009. The majority of the investments held in the two funds, 77.36%, were the same, with 22.64% being different. It is only the returns of this 22.64% of unique assets of these two funds and total fees which will have an impact on the variance of their returns. The MER of the RBC Canadian Equity Fund was 1.97% and the RBC Canadian Index Fund was 0.68% a difference of 1.29%. In addition the Trading Expense Ratio (TER) for the Canadian Equity Fund was 0.22% compared to 0.02% for the Canadian Index Fund, a difference of 0.2%. So in total the RBC Canadian Equity Fund had expenses 1.49% higher then the RBC Canadian Index Fund. This means for the equity fund to just match the return of the index fund after fees the 22.64% in unique assets of the equity fund would have to outperform the 22.64% in unique assets of the index fund by 6.58%. Not an impossible task, but a difficult one.
If your goal when buying an actively managed investment is to just match the index then you might as well buy the index. People buy actively managed investments with a goal of beating the index. To beat the index fund by just 1% the unique assets would have to outperform by 11%. This is why most actively managed funds have underperformed the indices in the past and will most likely continue to do so in the future Since the holdings in these funds are so similar anyways just take the lower fee index option and be happy that you should do better then an actively managed fund about 90% of the time.