There's one research report in my reading pile I've been avoiding, although it eventually worked its way to the top.
Vanguard, the giant U.S. mutual-fund company ($1.8-trillion U.S. under management) produces some great research, particularly in the area of investor behaviour. In conjunction with the launch of its exchange traded funds in Canada, Vanguard published a paper entitled A Case for Indexing – Canada.
In it, the authors pointed out that Canadian equity mutual funds have failed to keep up with the indexes, a conclusion that echoes other comparisons of this type, including the often-quoted SPIVA Scorecard (Standard and Poor's Indices Versus Active Funds).
Now even though I run a firm that offers actively managed funds (hence my procrastination), I take no issue with the conclusion of these studies. That's because the state of active equity management in the Canadian mutual-fund industry is abysmal.
Fees are high, too many funds own too many stocks (hundreds in some cases) and too many managers hug the index rather than try to beat it. In addition, fund stewardship is sorely lacking – fund holders are often subject to manager and mandate changes, which result in inconsistent investment philosophy. There are plenty of well-managed, efficiently designed funds in Canada, but the overall fund complex is a picture of mediocrity.
Having said that, I do take issue with these studies because they overstate the case for indexing. They compare apples to oranges – "after-fee" mutual-fund returns to "pre-fee" benchmarks returns.
The cost of owning a mutual fund is captured in the management expense ratio. An MER is the full-meal deal – it includes the manager's fee, all legal and regulatory expenses, any sales commissions paid and in most cases, a charge for ongoing advice, known as a trailer fee. While the cost of owning mutual funds in Canada is generally too high, and there's little transparency around who is getting paid for what, investors can be assured that the returns reported by the funds are after all costs.
In the studies, however, mutual funds aren't measured against actual index portfolios, but rather market indexes that have no costs attached. Unfortunately, investors can't replicate these benchmark returns. ETFs have MERs too, and when they're bought or sold, trading commissions are charged and a small premium/discount to net asset value is absorbed. My indexing friends tell me it costs about 0.5 per cent (all in) to run a balanced ETF portfolio at a discount broker. Investors wanting advice would expect to pay an additional 0.75 to 1.25 per cent at a full-service firm.
Like mutual funds, ETFs can also miss their performance targets. A report published in May by Morgan Stanley showed that of more than 700 ETFs in the U.S., 47 per cent lagged their benchmark by more than just the fee. These shortfalls (they're rarely additive) vary depending on the type and size of fund and market conditions.
Levelling the field
So the question is, would these studies arrive at a different conclusion if mutual funds were compared to ETFs instead of uninvestable indexes? It's hard to say definitely without getting into the data, but a rough assessment based on the Vanguard numbers would suggest that Canadian equity ETFs would still be leading an albeit closer race. If a charge for investment advice was factored in, it would be a dead heat, with some categories going to ETFs and others to mutual funds.
But regardless of any adjustments to the numbers, investors shouldn't expect to hear that the average mutual fund has beaten the indexes because, as noted above, too many funds in the sample aren't trying hard enough. For reasons of size, risk management and marketing strategy, many managers can't or won't stray far from their assigned benchmark. A Canadian equity fund holding 15 to 20 of the top 25 stocks on the S&P/TSX 60 Index (four or five banks, one insurer, Barrick, Suncor, Encana, either Potash Corp or Agrium, CN or CP Rail and two of Bell, Rogers or Telus) shouldn't be expected to generate a return that's different enough to offset its fee disadvantage.
In the long run, everyone would be better served if more rigour was brought to the active-versus-passive comparisons. ETFs have a good story to tell without tilting the playing field. And fairly priced funds that are consistently managed and distinct from the index shouldn't be dismissed simply because they're categorized as mutual funds.