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The Tragic Perils of Passive Investing.
10/30/2014 9:41:55 AM
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The Screaming Capitalist
Calgary-based Financial Advisor, Kevin Cork, provides basic financial planning information for Canadians combined with optimism and scepticism that he calls "scoptimism."



By Kevin Cork  | Wednesday, March 24, 2004


 
When you look at the ten other largest Canadian equity funds that have at least a three year return you see that the iUnits fund has underperformed seven of them over the last three years.

I am disheartened to see how many investors and reporters are falling for the so-called benefits of passive investing. As I understand it, the myth works like this:

“Few mutual funds can beat the stock market index so you may as well just buy the index.”

Further to that, passive investing promoters will also squeal:

“The COST, or MER of the mutual fund is the most important aspect of choosing a mutual fund.”

Now let me back up a minute and acknowledge two things:

  1. I am completely biased because I love managed mutual funds and I make the bulk of my living selling mutual funds… though I can also make money offering index funds to people.
  2. Few mutual funds can beat the stock market index.

Now this second point seems to agree with the “myth” I just proposed above… in fact I just copied and pasted it. The reason I need to acknowledge it AND can still decry it as a myth is that when I say “few funds” that includes ALL index funds, ETFs etc.

The index is a theoretical representation. For all practical purposes it is impossible to invest in, as I’ll explain further below. Thus, “passive” investors are forced to buy an index fund or ETF (exchange traded fund) to participate as directly as possible in the index. Here has been the results as of :

(I am using iUnits S&P/TSX 60 Index because it is one of the largest index types of investments available AND the TD Canadian Index fund for longer time periods, as it is one of my personal favorite index funds I will use with the poor misled clients who insist on indexing.)

 

1yr

3yr

5yr

10yr

iUnits S&P/TSX 60 Index

35.65%

4.07%

n/a

n/a

TD Canadian Index

35.49%

4.13%

8.16%

8.29%

S&P/TSX Total Return

36.51%

4.69%

9.04%

8.37%

Av Canadian Equity Fund (Pure)

35.87%

4.58%

8.56%

9.05%

So we see that both the passive investments underperformed their index (obviously, as I’ll explain below) through all the listed performance periods. MORE significantly though is the fact that they under-performed the AVERAGE fund amongst their peers even though the median MER (fund cost) was 2.58% vs the 0.17% for the iUnits fund and 0.85% for the TD fund. And this is during a hugely BULL Market!!

Further, comparing relative performance in the calendar years 2002, 2001 and 2000 we see that the iUnits ETF made less than index in 2000 and then lost MORE than the index in 2001 and 2002! AND it’s not its fault!

Of COURSE the passive investment is going to provide sub-index returns. This is almost guaranteed for two reasons:

  1. Any passive investment is going to have some administrative fees.
  2. More significantly, unlike the index itself the passive investment constantly has to buy stocks with new money or sell stocks for redemption requests. Unlike a managed fund (which usually has a cash portion to use as a “float”) the passive investment has to buy and sell stocks. The structure of the investment guarantees the administrators for the investment are often being forced to buy high. As the index rises because of some single hot stock and the stock itself becomes a larger and larger part of the index, the passive investment continues to buy into that stock because it is required to do so. How many millions of dollars of investors’ money went into buying Nortel at $120 a share?

Then of course, the opposite is true. When a stock is falling in value, the investment administrators have no choice to but to sell it. (Also known as “selling low”)

Worst of all, given the herd-like attitude of too many investors, money flows INTO these investments when the markets are hot (or of course, just AFTER the markets were hot) and flows out of them when the markets are scared (and just about to be hot again.) In February of last year, $120 Million (net) of money flowed OUT of Canadian equity funds. This year of course, because everything was UP, over $550 Million (net) of new money flowed INTO mutual funds. This type of attitude, though perfectly understandable, further intensifies (up and down) the performance of passive investments.

Now, it seems to be the attitude of the media that regardless of the performance numbers, most Canadians are going to be better off in the iUnits fund than in the “high cost, low performance” funds their advisor is going to put them in. However, when you look at the ten other largest Canadian equity funds that have at least a three year return you see that the iUnits fund has underperformed seven of them over the last three years. Further, eight out of ten of those large funds were load funds offered by advisors.

Am I saying that the passive indexing approach is going to drive you to bankruptcy? Yes! Am I exaggerating? Yes. As with any investment strategy, anyone who actually sticks to the strategy will certainly have an OK return. For example those who bought into passive investments in August 2001 when it had a negative 12-month returns of minus 36% and KEPT INVESTING for the next two years are probably going to do very well. It is just not appropriate as a mainstream investing strategy, no matter what the newspapers say.

 

 

 

 
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