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Report On Business Canadians have been surprisingly slow to adopt low-cost index investing

The shift to low-cost indexing in Canada has proven to be less of a great shakeup than a mild quiver.

While U.S. investors continue to sink enormous sums into passive alternatives, in Canada, the stock pickers still rule the market.

"I think the penetration of indexing in Canada has been really, really disappointing," said Tom Bradley, president of Steadyhand Investment Funds. "We need to get to a better balance."

The pace of change could soon pick up, however. A shifting regulatory backdrop and rising fee awareness could quicken the adoption of index funds, according to a Morningstar report.

"The threat that Canadian active managers have faced from passive rivals has been modest thus far, but the warning signs of a coming storm are there," wrote Christopher Davis, director of research at Morningstar Canada.

The storm has already engulfed Wall Street.

Money is gushing out of active U.S. funds amid a growing body of evidence supporting passive strategies with minimal fees.

The low-rate environment that has persisted since the financial crisis has increasingly brought scrutiny upon fees, making every basis point count.

Meanwhile, the rise of the exchange-traded fund has facilitated the transition to passive investing, giving average investors options they never had before.

In the U.S. market, $1.3-trillion (U.S.) has flowed into passive funds in the three years up to last September, while active funds have lost $84-billion over that time.

While the same trend is evident in Canada, indexing has not proven to be even close to the same disruptive force.

Active Canadian funds continue to considerably outdraw passive investments, which account for fewer than 10 per cent of the industry's assets.

Not since 1998 have U.S. stock pickers enjoyed that level of control, Morningstar said in its November report.

"Despite the clear virtues of passive management, traditional active managers in Canada have been able to resist the tide thanks to market and regulatory factors that have historically favoured their interests," Mr. Davis wrote.

The same catalysts driving change in the United States are certainly evident in Canada – namely, the high relative cost of active investing, combined with low rates of outperformance by stock pickers in recent years.

Over the 10 years up to last September, more than 80 per cent of Canadian equity funds either didn't survive or failed to beat the S&P/TSX composite index, Morningstar said.

The reason so many Canadian active funds fell short of the index was not for lack of expertise, but rather high fees eroding returns, said Dan Hallett, vice-president of HighView Financial Group.

"The fees charged at the retail level dilute the skill that does exist among professional investment managers," he said.

One reason Canadian investors may be sticking with higher-cost funds is that they are more willing to pay for advice, Mr. Hallett said. The cost of that advice is typically embedded as trailing commissions on mutual funds, usually adding a full percentage point to mutual-fund management fees.

Those fees, however, provide little incentive for financial advisers to push indexing as a cheaper alternative.

"Historically, fund companies paid advisers to sell more costly funds, and they've gotten their wish," Mr. Davis said.

The Big Six banks together control nearly half of long-term mutual-fund assets, which are overwhelmingly of the active variety.

"Even BMO, the country's second-largest ETF provider, wraps its moderately priced ETFs in high-priced mutual funds before selling them at bank branches," Mr. Davis said.

Trailing commissions are on the decline, however, as more and more advisers shift to a fee-based model. And Canada's securities regulators seem to be creeping toward banning embedded commissions outright.

The new fee and performance disclosure rules known as CRM2, meanwhile, could push more investors into the passive fold.

Even as an active fund manager, Mr. Bradley would like to see a quicker shift toward indexing and away from the highest cost funds, particularly those qualifying as "closet indexers" – funds masquerading as active but which actually closely track the market benchmark.

"The sooner they're gone, the better," he said. "I would hope some of that would go to full-on active, but I concede that a lot of it will go to indexing, which is just fine."

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