The Globe and Mail

One of the top no-brainer investing moves is to put money in an exchange-traded fund or index fund if you want to clean up in a bull market.

But the advantage of ETFs isn't so clear over a longer period that includes a down market. The past seven years are a good example. If you bought ETFs at the peak of the last bull market on Sept. 1, 2000, and held until this past Oct. 31, your returns would look puny compared with many popular Canadian equity mutual funds.

If you've been paying attention to the Canadian market lately, this isn't mere trivia. The S&P/TSX composite is looking shaky right now after a five-year bull run and, despite some optimistic forecasts of solid returns in 2008, you have to be cautious. An extreme reaction to this outlook would be to cut your exposure to stocks. A more moderate approach would be to keep investing in the Canadian market, but through mutual funds rather than ETFs.

The reason why funds look like the better choice right now relates to their performance following the last stock market peak a little over seven years ago. It's surprising how much better Canadian equity funds have done over that period than ETFs.

The country's most popular ETF, the iShares Cdn LargeCap 60 Index Fund, made a cumulative 22.2 per cent from the last market peak to Oct. 31 just passed. CI Harbour, a conservative Canadian focused equity fund, made a total 99.1 per cent over the same period; Phillips Hager & North Dividend Income, one of the better values in all of fundland, made almost 83 per cent; RBC Canadian Equity, which you can buy over the counter at any Royal Bank of Canada branch, made 60.6 per cent.

Don't read these numbers as an endorsement of mutual funds over ETFs, because they're not. Rather, they're an illustration of how index investing sometimes gets a free ride in comparison to conventional mutual funds. Sure, ETFs are an express elevator to the top floor when the markets are going strong. But if the markets are already high, then the experience of the past seven years suggests that funds may offer a more comfortable ride going forward.

ETFs are called passive investments because they provide the returns of a particular stock index, minus a bit for fees (note: ETFs trade like stocks and are listed on stock exchanges). Mutual funds are actively managed, which means that market pros are using their training and experience to pick the best stocks.

In a rampant bull market, go with ETFs. Of course, there will always be some funds that outperform the index, but the majority will not. Your best, then, is put your money on the index.

You'll find data supporting this rule in the comparative returns of ETFs and mutual funds over the past five years, a period in which the markets have done little but go up. For the purpose of this column, I created a list of some of the most widely held funds in the Canadian equity and Canadian focused equity categories. In the five years to Oct. 31, only one of them delivered a better return than the LargeCap 60 ETF - TD Canadian Equity.

This fund averaged 22.2 per cent annually, while the LargeCap 60 ETF made 21.9 per cent. The next closest fund, RBC Canadian Equity, made 19.2 per cent and the rest of the bunch ranged as low as 6 per cent and as high as 19 per cent.

Mutual fund data providers typically show you long-term performance numbers for periods in multiples of five years. Today, a five-year slice of data shows you only bull market conditions, while a 10-year slice is of little use because many funds and ETFs haven't been around that long. This brings us to the seven-year comparison prepared especially for this Portfolio Strategy column. Let's call it a "peak-to-peak" analysis because it starts back at the height of the last bull market, continues through the ensuing bear market and then follows the market back to its current heights.

Several things stand out when you look at the past seven years, the first being that the S&P/TSX composite index hasn't been especially strong at all. From its closing level of 11,388.80 on Sept. 1, 2000, the index rose to 14,625 on Oct. 31. That's a cumulative gain of only 28.4 per cent.

And yet, the index is up about 21 per cent annually for the five years to Oct. 31. What gives?

The explanation is that the S&P/TSX composite index plunged from 11,388.80 to a low of about 5,695.33 in early October, 2002, a loss of about 50 per cent. Once it hit bottom, the index took off like a rocket and went on to clock the kind of gains we've seen in the past five years.

Some mutual funds took a different path over the past seven years. Take CI Harbour as an example. Its net asset value per share on Sept. 1, 2000, was $11.70 and on Oct. 9, 2002, it was $10.93. While the S&P/TSX composite was plunging, this fund barely flinched.

RBC Canadian Equity fell from a net asset value per share of $19.30 to $12.33 over the same period, a decline of 36 per cent. PH&N Dividend Income fell from $50.80 to $43.95, a drop of 13.4 per cent.

One explanation for this pattern is the Nortel effect. Nortel Networks accounted for close to one-third of the major Canadian stock indexes at its peak in 2000 and its utter collapse was devastating. Many fund managers had much less Nortel exposure, which gave them an automatic advantage over the index.

Fund managers can also hold cash to buffer the effect of a declining stock market, and they can allocate money to defensive sectors like consumer staples and health care. This flexibility is what makes funds, ideally, a better choice than index funds for putting money into a market that appears to be at a high point.

Naturally, some funds are a better choice for investing in an uncertain market that seems to offer a degree of both opportunity and risk. One way to identify them is to look for a low beta, which is a measurement of how volatile a fund is in comparison to its benchmark stock index. The index automatically gets a beta of 1, so only funds with lower scores are of interest.

On our list of 20 funds, only a single name has a three-year beta of more than one - it's TD Canadian Equity at 1.21. This is a highly successful fund, but its aggressive stance may not be ideal if you're worried about the market's downside. The lowest beta funds are Mackenzie Ivy Canadian, at 0.33, and CI Signature Dividend, at 0.37. Both funds have been weak performers in recent years, evidence of an especially conservative approach that hasn't clicked in the fast-moving markets of recent vintage.

In between the two beta extremes, you'll find several funds that have combined good returns since the last market peak with lower volatility than the index. Think of them as examples of the kind of fund that might do best in today's nervous market.

PEAK-TO-PEAK PERFORMANCE

Here's how some of the most popular Canadian equity and Canadian focused equity funds have done from the peak of the last bull market, through the depths of the bear market and then back up again to the heights of recent days. For comparison's sake, we've included the returns of a popular exchange-traded fund and the S&P/TSX composite index.

*a benchmark stock index has a beta of one -- funds or stocks with lower numbers are considered

to be less volatile, and vice versa a three-year beta has been used here

SOURCE: GLOBEFUND.COM, GLOBEINVESTOR.COM