The case for low cost passive investing
I’ve been in the financial industry for 20 years and I’ve done a lot of investment research over the years. What I have found is the whole financial industry is biased to selling high cost actively managed investments with the goal of being above average. Experts are constantly flaunting their great stories or sexy ideas to make lots of money or their strategies to beat the market. But does it really work?
It’s a ‘relative’ world
Relative performance is simply looking at the performance of a fund and comparing it to the performance of other funds. Two of the most common relative benchmarks are the index comparisons and peer group (average) comparisons.
Comparing to the peer group
When looking at the average, it is very important to compare apples to apples and oranges to oranges. For example, when you are comparing the performance of a Small Cap Canadian Equity Fund to that of an international equity fund or a foreign bond fund, you are comparing completely different investments.
Instead, you should take a look at the fund you own and then compare it to other funds of the same type. Theoretically, if you take a group of funds like the Canadian Equity funds, half will be above average and half will be below average.
The other approach is to look at a fund category and compare it to the appropriate index.
Last year, the TSX lost 8.7%. If you had a Canadian Equity investment that lost less than -8.7%, then those in the financial industry would say, it did well on a relative basis. The data suggest that not many Canadian Equity Funds did well comparing against the index. In fact, only 27% of funds were able to beat the index:
Out of 580 Canadian Equity Funds with a 1-year track record (as of Dec 31, 2011),
- Only 156 Canadian Equity Funds beat the index (-8.7%)
- 177 Canadian Equity Funds beat the iShares TSX Index
We can do the same analysis looking at 3, 5 and 10 year periods (Snapshot performance to Dec 31, 2011):
177 Canadian Equity Funds with a 10-year track record
- Only 6 beat the index (7%)
- Only 12 beat the iShares TSX Index
- Only 55 beat 5%
- 6 of the top 20 funds were low cost passive index funds
305 Canadian Equity Funds with a 5-year track record
- Only 8 funds beat the TSX index (1.3%)
- Only 11 funds beat the iShares TSX Index
- Only 44 funds had positive 5 year returns
448 Canadian Equity Funds with a 3-year track record
- Only 40 funds that beat the index (13.2%)
- Only 54 funds that beat the iShares TSX Index
The longer the time frame, the fewer investments beat the index.
My two cents
This data may be overly simplistic but I have done this simple comparison many times over my 20 years in the investment industry. The figures may be slightly different at different times but the conclusion is always the same.
Most funds have a tough time beating the benchmark index over any period of time in any market environment. The data suggests that a winning strategy is a low cost passive approach to investing. In fact, Academic research has proven over and over again that it is really difficult to time the markets and essentially ‘predict’ the future with any degree of accuracy which is why there has been a proliferation of low cost, passive investment strategies that don’t try to beat the market but rather replicate the market.
What do you think? Do you have any evidence that active managers can beat the index more often than not?