PETER DOLEZAL: Active versus passive fund performance in 2014

Why do so many investors continue to hold mutual funds, despite long-term evidence of their consistent underperformance?

Why do so many investors continue to hold mutual funds, despite long-term evidence of their consistent underperformance?

Once again, Standard & Poor’s Indexes Versus Active Scorecard (SPIVA) has released its findings for Canadian funds for the year ended Dec. 31, 2014. While the entire report can be accessed online, the following is a brief summary:

 

• In 2014, only 26.47% of Canadian active equity fund managers outperformed the S&P/TSX Index. Over the past five years the rate of outperformance dropped to 20%.

 

• Among active managers in the Canadian Dividend & Income Equity sector only 6.67% beat the comparable Canadian Dividend Aristocrats Index in 2014. Zero percent of the active managers beat the Index over the past five years.

 

• In the U.S. Equity sector, only 11.1% of active funds beat the S&P 500 Index. Over five years the rate of outperformance declined to 2.90%.

 

• In the International Equity sector, 30% of active funds beat the Index in 2014;  only 13.16% did so over five years.

 

While the specific performance numbers vary each year, the historical trend-line remains unchanged. Every year, in every major market sector, the average mutual fund underperforms its comparable Index. The poor average performance in any single year deteriorates further when compared over five years.

Many investors remain unaware of both the significant fees they currently pay on their portfolios, and the high-likelihood of their mutual funds significantly underperforming their index benchmarks.

The mutual fund industry’s dismal track record continues to be accepted by millions of Canadians. The real beneficiaries of this strategy continue to be primarily the fund providers, and the investment advisers selling mutual funds to a generally under-informed public.

Yes, mutual funds are a convenient vehicle for achieving broad diversification. And yes, it is convenient to rely on an investment house to hold the investments and provide periodic reports to the investor. But, is this convenience worth the high annual fees and consistently poor performance?

Ten or 15 years ago, investors wishing to achieve broad diversification in their investments had little choice but to choose mutual funds and to accept their high fees.

Today however, several major options exist. Very low-cost Exchange Traded Funds (ETFs) and Index Funds are available, often at less than one fifth the cost of mutual funds. Neither of these options strive to beat the chosen Index — rather, they simply track it, usually with minimal tracking error.

The significance of a 2% reduction in annual holding costs is dramatic. It is equivalent to improving portfolio performance by 2%.

With the average annual total return of Canadian equity markets over the last ten years averaging approximately 8%, a comparable mutual fund would have needed to outperform the market by roughly 25% annually, in order for the investor to simply break even with the Index.

As the SPIVA reports have repeatedly demonstrated, beating the market by this margin, on a consistent basis, is almost impossible.

A partial solution to this problem will be welcome after July 1, 2016 when fee structures must become more transparent.

New regulations will require full and clear disclosure by mutual fund salespersons, of all fees embedded in each fund, and of his/her personal benefit from the fees charged. The disclosures will come as a shock to many investors, likely accelerating the already-emerging shift to less expensive options.

Saving for investment is a long and challenging exercise for most of us.

Before investing those savings for our long-term future, it makes sense to thoroughly understand the pros and cons of any investment, and to make a fully-informed decision.

Based on all available evidence to-date, mutual funds would be at the bottom of my personal investment choices.

 

A retired corporate executive, enjoying post-retirement as an independent Financial Consultant (www.dolezalconsultants.ca), Peter Dolezal is the author of three books, including his most recent, The SMART CANADIAN WEALTH-BUILDER.