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There is hardly a worse product in the investing universe than a mutual fund sold with no advice or financial planning.

Fees grind down your returns in these funds, with no offsetting benefit of advice that guides you toward financial success. Index-tracking exchange-traded funds are a better choice because their tiny fees are likely to result in superior returns. But what about mutual funds sold by advisers who provide advice and planning? Put into proper perspective, investment returns from advisers such as this are more competitive than you might think.

A lot of investors had the scare of their lives when stocks crashed early in the pandemic. Good advice and planning might have saved them some grief, and it still could help with the next crisis ahead. But too often, investors get caught up in fee comparisons that shame mutual funds and raise ETFs to investing sainthood. The advice factor tends to get ignored in these debates.

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It’s an ideal time to revisit the ETFs versus mutual funds debate because the latest Standard & Poor’s Indices Versus Active (SPIVA) analysis was released recently. It’s a definitive comparison of average mutual fund returns to the stock indexes tracked by the lowest-cost ETFs. The SPIVA report for 2019 was typical – 92 per cent of Canadian equity funds underperformed their benchmark in 2019 and 86 per cent underperformed over the previous 10 years.

Active vs. passive:  A real world comparison

The case for passive investing is based on the idea that mutual funds and other actively managed portfolios typically underperform index-tracking investments. But actively managed portfolio returns are weighed down by various fees, whereas index returns are presented without any fees. Let's look at what happens to index returns when you apply the same range of fees built into mutual funds. Note: The average mutual funds returns used here are asset-weighted, which means larger funds have more influence.

One-year
average annual
total return to
Dec. 31, 2019 (%)
Three-year
average annual
total return to
Dec. 31, 2019 (%)
Five-year
average annual
total return to
Dec. 31, 2019 (%)
10-year
average annual
total return to
Dec. 31, 2019 (%)
CANADIAN EQUITY FUNDS
S&P/TSX Composite Index22.96.96.36.9
 minus advice fees + other costs*1.061.061.061.06
Net index return21.85.85.25.8
Canadian equity funds16.44.54.66.2
CANADIAN DIVIDEND & INCOME FUNDS
S&P/TSX Cdn. Dividend Aristocrats26.275.99.2
 minus advice fees + other costs*1.251.251.251.25
Net index return25.05.84.78
Canadian dividend & income funds20.26.567.4
U.S. STOCK MARKET
S&P 500 (C$)24.81414.316
 minus advice fees + other costs*1.11.11.11.1
Net index returns23.712.913.214.9
U.S. equity funds21.711.911.412.6

Source: Standard & Poor's

*Fees comprise a 1 per cent advice fee plus typical costs for ETFs in various categories

The mutual fund industry has for years been bludgeoned with these SPIVA numbers, often deservedly. The standard takeaway is that investors holding mutual funds are better off “buying the index” through cheap, index-tracking ETFs.

Left out of this analysis is the value provided by planning and other guidance. A more nuanced comparison would address the advice factor and allow fund investors to better see what they give up in returns if they switched to DIY index investing. In fact, they may not have to give up much at all.

You can’t actually buy a stock index, which means using index returns as a point of comparison for mutual funds isn’t ideal. You can, however, buy a very cheap ETF that tracks an index. The management expense ratio on these ETFs could be 0.25 per cent or less.

A fair comparison of mutual funds and indexing would start by deducting these ETF fees from index returns. Next, the cost of advice would be factored in.

DIY investors may scoff at this advice, which is understandable. The ETF franchise was built in part by offering a cheap alternative to pricey mutual funds sold by do-nothing salespeople calling themselves advisers. But the best advisers actually advise. If one of their clients switches to DIY index investing using ETFs, he or she gives up something to get lower fees.

Mutual fund fees – they’re taken off the top before returns are published for investors to see – cover the operation of the fund plus compensation to be shared by the adviser who sold the fund and his or her firm. This trailing commission, as it’s known in the investment biz, amounts to one percentage point of the typical equity or balanced fund’s management expense ratio and 0.5 points for bond funds (total MERs may be in the 1.5-per-cent to 2.5-per-cent range).

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Given how popular balanced funds are, we’ll use 1 per cent as a standard cost of advice for this comparison. So deduct another one percentage point from those index returns that have already been reduced by the cost of owning index-tracking ETFs.

Doing this shifts the usual narrative that mutual funds are a failure because they lag the index. The latest SPIVA report shows that in the Canadian equity category, the S&P/TSX Composite Index beat the average Canadian equity fund return over the one-, three-, five- and 10-year periods to Dec. 31, 2019. A 10-year view: The index made 6.9 per cent on an average annual total return basis (share price changes plus dividends), while the equity fund average return was 6.2 per cent.

Asset-weighted returns are used here – that means popular, widely held funds have more influence on the numbers than smaller ones. If returns were equally weighted, the index outperformance is more pronounced over all time frames. For example, the average 10-year Canadian equity fund return falls to 5.6 per cent.

When we adjust index returns by deducting ETF costs plus advice, some of the magic of index investing disappears. Mutual funds still lagged in many cases, but they held their own or better in others.

Consider the Canadian equity fund, the core of the average investor’s portfolio. The measuring stick is the S&P/TSX Composite Index – as previously noted, it produced an annualized total return of 6.9 per cent for the past 10 years. To compare that with the average Canadian equity fund, we’ll reduce that index return by 1.06 percentage points (one point for advice and 0.06 per cent to represent the fees charged by a cheap Canadian equity ETF).

That leaves us with a 10-year return of 5.8 per cent. As mentioned, the average Canadian equity return over that period was 6.2 per cent on an asset-weighted basis.

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Shorter-term comparisons aren’t as favourable for mutual funds in the Canadian equity category. But the past 10 years should help reassure investors that a long-term relationship with an adviser selling mutual funds can result in competitive returns.

The U.S. market is the toughest nut to crack for mutual funds. Even after reducing Canadian-dollar returns for the S&P 500 by 1.1 per cent (one percentage point for advice, 0.1 point for ETF fees), you get a better return over all measured time frames than the average U.S. equity fund. The gap isn’t huge, but it’s there.

Canadian dividend funds did well in the past three- and five-year periods, but lagged somewhat over the 10-year period. The S&P/TSX Canadian Dividend Aristocrats Index average 9.2 per cent annually over the 10 years to Dec. 31, or 8 per cent after applying an advice fee of one point and ETF fees of 0.25 per cent. The average fund in the Canadian dividend and income category averaged 7.4 per cent over that same time frame on an asset-weighted basis.

For the do-it-yourself investor who forgoes financial planning or buys it separately on a fee-for-service basis, ETFs are leaner and meaner than mutual funds. But for the investor who wants advice, mutual funds are not the big comedown they’re sometimes made out to be.

Finally, it’s important to note that you can get advice and ETFs together from many advisers. You won’t get the same rock bottom costs as the DIY investor who uses ETFs, but you do get advice and planning if you have the right adviser.

Stay informed about your money. We have a newsletter from personal finance columnist Rob Carrick. Sign up today.

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