Some people believe in the Loch Ness monster and Bigfoot, while others cling to the notion that they can beat the market if they find just the right system for buying stocks and bonds.
I’m not going to refute the existence of cryptids like Nessie or a giant walking carpet, but I would like to suggest that, over a lifetime, most do-it-yourself stock pickers will underperform their benchmark indexes.
My rationale? If most professional investors can’t beat a portfolio of indexes, then it’s safe to say that the average market moonlighter will also fall short.
Consider Canada’s actively managed mutual fund industry. It’s composed of trained, professional investors who spend every working hour researching and trading stocks and bonds.
Yes, the average fund charges embarrassingly high expense ratios. But even if professionally managed funds charged nothing at all, would most of them beat their benchmark indexes over a decade or more? I decided to find out.
I examined the performance of the myriad of Canadian balanced equity funds tracked at globefund.com. If professional investors could pick winning stocks and knew when to jump into stocks and when to take refuge in bonds, these actively managed balanced funds would have been beacons in a murky decade for investors.
Here’s the reality: The average annual return of Canadian equity balanced funds from Aug. 31, 2002 to Aug. 31, 2012 was 4.7 per cent.
These funds hold both stocks and bonds, so I compared their results with a simple two-fund portfolio made up of the TD e-Series Canadian equity index fund (60 per cent) and the TD e-Series Canadian bond fund (40 per cent). If you bought these two index funds in August 2002, without making a single adjustment, you would have turned a $10,000 investment into $20,419.39.
Instead, if the same $10,000 were invested in a representative collection of Canadian equity balanced funds, it would have grown to just $15,829.48.
This, of course, just proves that most active managers can’t overcome the costs of their management fees. But let’s take a closer look and assume that the average management expense ratio (MER) for the actively managed funds was 0 per cent instead of 2.64 per cent.
Add this 2.64 per cent management fee to the 4.7 per cent performance earned by the Canadian balanced funds over the past decade, and the average annual returns (if the MER didn’t exist) would have been 7.34 per cent.
It looks better now, doesn’t it? But 7.34 per cent is still slightly behind the 7.4 per cent you would have earned by putting 60 per cent of your money in TD’s Canadian e-Series stock index with 40 per cent in the bank’s e-Series bond index.
Canada’s active fund managers aren’t foolish rookies. If there were exploitable advantages to buying dividend stocks, growth stocks or value stocks, most of these professionals would be all over the winning strategies. Yet they still, as a group, underperformed the index investor who chose similar allocations of stocks and bonds.
What’s more, TD e-Series index funds aren’t particularly cheap. Their management fees amount to roughly 0.4 per cent per year. You could do even better with a collection of low cost exchange traded funds, much like those in my Strategy Lab indexed portfolio. Shaving a further 0.2 per cent in fees would add profits to your bottom line.
I can’t say that the Loch Ness Monster and Bigfoot don’t exist. Nor can I say that you won’t be able to dance in and out of stocks and bonds and manage to beat a portfolio of indexes over your lifetime. But one thing appears clear. To do so, you’ll need to exert more skill than the average professional investor – even if that professional were working for free.
Your investment portfolio isn’t a Strategy Lab contest. It’s real money that you’ll be investing over your lifetime. Are you sure you want to risk it?