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In an insightful ROB article, Ian McGugan recently pointed out that Canadians would enjoy higher investment returns if they were to invest in ultralow-fee index products (either funds or ETFs). Because of the lower portfolio turnover that comes with those products, they would also pay less tax.

The fact that some actively managed funds have beaten the relevant index, after fees, over the past 10 or more years, does not refute Mr. McGugan’s conclusion, which is based on several objective studies.

Ultralow-fee index funds and ETFs, which effectively own a fraction of the entire stock or bond market, consistently outperform most actively managed funds.

Why is that?

It’s not complicated. The return of the broader stock market is simply the weighted average return of all investors in the stock market. An index fund will match the market return. The average active manager will approximate the market return before fees. Their clients will receive that return less the fee charged.

Consequently, an index fund charging, say, ⅒ of 1 per cent can be expected to produce a higher net return than an actively managed fund charging 1 per cent.

“But,” a friend of mine said recently, “you are speaking of averages, and I assume some people are better at it than others.” If we were talking about a game like chess or singles tennis that is entirely skill-based, she would be correct. But investing is not such a game.

Many competitive activities combine skill with a large dollop of luck. These include most board games, and team sports.

Michael Mauboussin, the author of The Success Equation, has studied the results of NFL games to determine the role of luck. He concluded that the result of a single NFL game was 52 per cent skill and 48 per cent luck. When this analysis is applied to other professional team sports, it shows that the result of individual NBA games is about 88 per cent skill whereas individual NHL games are only about 47 per cent skill.

Where does investing fall on the skill-luck continuum?

That can be measured by studying the consistency of results over time. If skill dominates, results will be mostly (or entirely) the same. If randomness (luck) plays the dominate role, results will be all over the place.

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Mr. Mauboussin examined the results of more than 1,400 mutual funds, comparing their results relative to the average, between two successive three-year periods. In this study, he discovered a low correlation between the performance achieved by each fund in the two periods. He concluded that success in investing, measured over a three-year period, is an activity that is about 85 per cent randomness and only 15 per cent skill.

The importance of randomness in investing has been recognized since at least the 1970s. However, because of a phenomenon known as the paradox of skill, randomness has become increasingly dominant: As the overall skill level increases, the relative importance of skill declines.

Again, a sports analogy may be helpful. The winning time in the Olympic marathon race tends to fall over time, indicating the improving ability of the competitors. At the same time, there is less relative difference between the winner and the median time of the top 20 runners. As the overall skill level increases, the difference between the top performers shrinks.

The same is true in investing. As the education levels and the information available to investors has increased, the difference in levels of skill has contracted. Consequently, the relative importance of luck has increased.

Warren Buffett, long regarded as the epitome of a successful active investor, appears to have recognized this. He now recommends index products to his friends, and has instructed his executors to invest 90 per cent of his estate in a low-cost S&P 500 index fund.

A small minority of active managers will outperform an index product over the next 10 years. However, there is no way to identify these firms in advance.

Some financial advisers may be tempted to dispute the evidence that low-fee products will likely provide a higher net return. They would be smart to resist that temptation. Clients will prefer advisers who are completely honest about likely future investment returns, and focus their communication on other benefits that they are able to provide.

R.B. (Biff) Matthews is an investor and writer. He is the founder and chairman emeritus of Longview Asset Management, a Toronto-based investment management firm.

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