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The Canadian Financial Advisor

Why Is It So Hard To Beat the Market?

Benjamin Felix

The data is in and, for fund managers who are still trying to “beat” the market, the numbers are still not on their side. As talented as active players often are at slicing and dicing the data, and as mightily as they may try, there’s considerable evidence that passive players continue to have the last laugh. Why is that? As usual, it has a lot to do with common sense.

It begins with simple math. Canada’s particularly high fund fees (on average) tend to add up fast. The challenge is further muddied by a tendency for investors to mistake lucky winning streaks as reliable results. Finding managers who have outperformed their highly competitive peers in the past – and will continue to do so moving forward – is far closer to a gamble than a guarantee.

Bottom line, after costs, it’s incredibly difficult to out-smart highly efficient capital markets that represent the collective wisdom of all market players, of all stripes. There are additional compelling reasons this is so. For example, have you ever heard the term “closet indexer”? To find out what that is, subscribe to Common Sense Investing and stay tuned for my next post.

Original post at pwlcapital.com

Why Aren’t More Canadians Switching to Index Funds?

Benjamin Felix

First, the good news: At the end of 2016, 11.3% of Canadians’ investment fund assets were held in index funds and similar passively managed products. That’s a start. But compared to our U.S. neighbors at 34% of the same, we’re slow on moving away from over-priced, underperforming actively managed funds and into index funds.

Why are we lagging behind? In large part, I believe it’s because your banker or commission-based advisor is often failing to recommend the solutions that are in your best interests. Their complex compensation models aren’t encouraging them to sit on the same side of the table as you. And regulators aren’t sufficiently requiring them to do so.

 For indexing to become the same movement here that it’s become in the U.S., we’ve got to talk about simple fees versus complex commissions. We need to differentiate fiduciary from merely suitable advice. We need to continue promoting clear versus confusing cost disclosures. 

Most of all, we need people like you and me to recognize there’s a better way, and insist that we get it. Common sense? You bet. To join our movement, check out today’s video, subscribe to Common Sense Investing, and send me your own questions to address.

Original post at pwlcapital.com

Introducing: Common-Sense Investing with Ben Felix, MBA, CFA

Benjamin Felix

The truth is easier to keep track of than a pack of lies. That’s just common sense. So is most of investing, even though many in the financial industry would have you believe otherwise. To help you separate financial facts from sales-oriented fiction – and then invest accordingly – I am pleased to host PWL Capital’s newest YouTube series: Common-Sense Investing.

As the name implies, you don’t need to chase fancy, complex strategies to invest safely and sensibly toward your financial goals. Nor should you let the forces found on Wall Street and Bay Street try to convince you otherwise.

Instead, by understanding a thing or two about the science of sound investing, you can build a bulwark of basic knowledge, and learn how to separate common sense from nonsense. In this series, I’ll focus on straightforward answers to your critical questions, such as:

  • Index funds seem so simple. Can they really outperform a more active approach to investing?
  • Is it really that hard to beat the market?
  • What are some of the biggest market myths out there?
  • How can you distinguish best-interest advice from veiled sales pitches?

While you don’t need a science degree to make good use of the science of investing, my own studies in mechanical engineering have helped me ground my financial career in logic and evidence. I’ve combined that with an MBA, being a CFA charterholder, and plenty of hands-on experience as an associate portfolio manager at PWL Capital. Plus, any advice I offer will be backed by peer-reviewed academic research, solid data, and clear logic.

Of the myriad ways people try, but often fall short of making money in today’s markets, there is one way that will never lose its luster: investing with common sense. Are you ready to learn more? Subscribe to “Common-Sense Investing” (and click on the bell). And if you’d ever like to see me take a common-sense approach to one of your questions, send it over.

Original post at pwlcapital.com

When Active Managers Win

Benjamin Felix

Fidelity has a massive billboard up in Toronto to promote one of their portfolio managers, Will Danoff. Danoff has managed the U.S. based Fidelity Contrafund since 1990; it is the largest actively managed fund in the world managed by a single person. The Contrafund has performed well – well enough to beat its benchmark, the S&P 500. Benchmark beating performance attracts assets. It also gives Fidelity the opportunity to advertise to the world how great their star manager is. The problem for investors is that an active manager posting strong performance numbers, even over long periods of time, does nothing to indicate for how long that performance will persist.

Less than half of the equity mutual funds that existed in Canada a decade ago continue to exist today. If a fund has several years of poor performance, its assets will decline as investors move their money elsewhere. Eventually, the fund will close. If an investor is looking at the universe of mutual funds that are available to them at a point in time, they will only be seeing the funds that have done well enough to survive. Survival may be an indication of a truly skilled manager, but it could also be dumb luck. A 1997 peer reviewed paper by Mark Carhart titled On Persistence in Mutual Fund Performance looked at 1,892 U.S. mutual funds between 1962 and 1993. The conclusion of the paper was that there was no evidence in the data of skilled or informed mutual fund portfolio managers. In other words, good performance is most likely explained by luck.

Between survivorship bias and the lack of evidence of manager skill, it should be no surprise that many great fund managers have had dramatic falls from grace. The following examples are borrowed from Larry Swedroe’s The Incredible Shrinking Alpha.

In the 1970s, David Baker managed the 44 Wall Street fund to market beating performance for ten straight years. The following decade, it was the single worst performing fund, dropping significantly while the S&P 500 gained. Even more impressive was the Lindner Large Cap Fund, which beat the S&P 500 for the 11 years ending in 1984. While this market beating performance no doubt attracted attention, the fund spent the following 18 years being decimated by the S&P 500. If 11 years wasn’t enough to weed out the lucky managers, Bill Miller’s Legg Mason Value Trust Fund beat the S&P 500 for the 15 years ending in 2005. It suffered miserably against the index for the next seven years before being taken over by a new manager in 2012. Possibly most impressive of all is the Tiger Fund – a hedge fund formed in 1980. It spent 18 years averaging returns over 30% per year, and its assets had grown to a hefty $22 billion by 1998. Over the next two years the fund lost $10 billion, and closed its doors in 2000.

The odds of outperformance are slim, but some active managers do beat the market. The challenge for investors is identifying winning managers before they win. Unfortunately, finding a manager that has done well in the past is not helpful in finding a future winner.

Original post at pwlcapital.com

91.11% of Canadian Equity Funds Underperform Over 10-Years

Benjamin Felix

A staggering majority of Canadian mutual funds have underperformed the index over the past decade. This data comes at a time when U.S. investors are pulling billions of dollars out of active funds managed by stock pickers, instead favouring low-cost passive index funds. Canadians are not following this trend, adding roughly equal amounts to both active and passive funds in 2016.

In the ten years ending December 2016, 91.11% of Canadian Equity mutual funds trailed their benchmark index according to the SPIVA Canada 2016 Year-End report. For the first time since it has been produced, the report shows ten years of Canadian data. Similar U.S. data for U.S. Equity funds shows that only 82.87% were outperformed by their benchmarks. As of 2015, Canadian mutual funds had the highest fees in the world, while the U.S. had some of the lowest. Fees are known to be one of the best predictors of future performance.

The idea that active managers are not able to consistently beat the market after fees is not new – it has been demonstrated in academic research papers consistently over the last 40 years. Recently, many investors and advisors have arrived at the same view.

The SPIVA Canada report showed ten year data for four fund categories, none of which posted impressive results. Against their benchmarks, 91.11% of Canadian Equity funds underperformed, 75.44% of Canadian Small/Mid Cap Equity funds underperformed, 100% of Canadian Dividend & Income funds underperformed, and 98.28% of U.S. Equity funds underperformed.

Despite the poor performance, Canadian investors continue giving their money to active managers. In 2016, U.S. investors pulled $326 billion from active funds and added $490 billion to passive funds while Canadian investors added $10 billion to active funds and 10.9 billion to passive funds.

A Bit of History

Benjamin Felix

There has been a lot of talk about automation and how it might affect the global economy. Some people are worried about how these potential changes could affect their portfolio, especially if they passively own the whole market. The thinking is usually that if an industry disappears due to automation or some other factor, and you own that industry, then you might take a loss. While it may seem like this is a disadvantage of passive total market investing, it's actually an advantage. There is no way to tell which industries will fail, or which industries will appear to replace them. Without knowing the future, the most sensible thing to do is participate in global capitalism by owning the whole market.

Just as we expect the world to change going forward, it has changed a lot since 1900, when nobody could imagine that email would replace the telegraph, or that air travel would connect the globe. Technology has transformed the way that we work and live, and globalization has moved many industries out of the developed world and into emerging markets.

As you might expect, those changes are largely reflected in financial markets. In 1900, 80% of the U.S. market's value was concentrated in industries that barely exist today. Below are two charts showing the industry weightings of the U.S. financial market at the end of 1900 and at the end of 2015. Despite all of the changes in how the world works, a dollar invested in the U.S. market in 1900 had grown by an average of 6.4% per year net of inflation by the end of 2015. Of course, there is some survivorship bias here. The U.S. market has been exceptional. In 1900, it was only 15% of the global market capitalization, and at the end of 2015 it was 52.4%. The UK was 25% of the global market in 1900, and 7.1% in 2015. In 1989, Japan was 45% of the global market while the U.S. was 29%. The U.S. has continued to outpace the world. 

Data source: Dimson, Marsh, Staunton (2002, 2015); FTSE Russell 2015. Chart adapted from Financial Market History - Reflections on the Past for Investors Today, CFAI Research Foundation.

Data source: Dimson, Marsh, Staunton (2002, 2015); FTSE Russell 2015. Chart adapted from Financial Market History - Reflections on the Past for Investors Today, CFAI Research Foundation.

Despite the U.S. being a clear case of survivorship bias, global markets have done pretty well in aggregate too. Even when we include two markets, China and Russia, that at one point failed completely (meaning investors lost 100% of the money invested in those countries) a dollar invested in the global market in 1900 would have grown by an average of 5% per year net of inflation by the end of 2015. The world is always changing. Some countries dominate over some periods of time, and falter later. The same goes for industries. It is impossible to know what is going to do well, which is why it makes sense to own the market and stay disciplined.

In 1900 it was not possible to buy an all-world index. In 2017, that technology is available through low-cost ETFs to anyone with a brokerage account. Passively participating in global capitalism has never been easier.

The Bank May Not Be Your Best Bet For Investing

Benjamin Felix

The big Canadian banks have come under fire recently for their aggressive tactics and, in some cases, claims of unlawful behaviour by stressed employees chasing sales targets. Most of the media attention has focused on customers being pushed to increase credit limits and overdraft protection, or apply for a more expensive credit card. But there is another product that banks have been aggressively selling for years while only attracting a bit of attention: High-fee mutual funds.

‘Suitable’ investments

Walking into a bank branch and asking to speak with a financial advisor about investments will likely result in a recommendation to purchase the bank’s high-fee actively managed mutual funds. Asking for low-cost passive index funds might be answered by a slick rebuttal focused on how well the bank’s fund managers have done in the past.

The advisor will generally be licensed to sell mutual funds – a registration that requires them to make suitable recommendations to their clients. A suitable recommendation is permitted to be a better deal for the bank, as long as it matches your risk profile and circumstances. This is true despite the evidence that higher cost actively managed funds, while more profitable for the bank, are likely to underperform lower cost passive index funds over the long-term. You do not want suitable advice.

The friendly financial advisor at your bank is probably not malicious. They’ve been taught that the bank’s funds are excellent. It’s also unlikely that they’re familiar with the large body of academic research discrediting the claim that active fund management adds value over time.

There are other options

Canadians seem to be happy to take suitable investment advice for now – they added $10.9 billion to passive funds and $10 billion to active funds in 2016.  In contrast, Americans added $490 billion to passive funds and removed $326 billion from active funds over the same year. This may be driven by the growth of registered investment advisors in the U.S., who are legally required to act in the best interest of their clients.

There are financial advisors in Canada who are held to this higher standard. A Portfolio Manager is a regulated title in Canada with a legal duty to put the interest of their clients ahead of their own. Similarly, CFA charterholders are held to a code of ethics and standards of professional conduct which require clients’ interests to come first.

Of course, if you want to cut advice out of the equation entirely you can also try your hand at managing your own couch potato portfolio.

Investing in the banks’ mutual funds is more likely to help them post record profits than help you meet your long-term goals, but you will get a much rosier story from their financial advisors. Buyer beware.

Original post at pwlcapital.com

Smart investment decisions are simpler than you think

Benjamin Felix

Do you ever wonder what it’s like to be a smart investor? Chances are that you do; most Canadians own investments that underperform the market. If a financial advisor says that they know when to buy gold, they may be perceived as smart, and their clients will likely listen to them. The ability to predict is associated with investing intelligence. This approach to investing is known as active management – figuring out which stocks or assets will do well, or knowing when to get in and out of the market. As intelligent as it may seem, there is no evidence to support its efficacy.

Most Canadians own mutual funds, and pay over 2% per year to have their mutual fund assets actively managed. The idea behind that fee is that the fund manager will be able to outperform a benchmark index; it makes sense to pay a higher fee for better performance. This would be great if mutual fund managers delivered above-benchmark returns, but year after year the data on mutual fund performance is disappointing. Most funds underperform over any given time period. What about the good funds? Unfortunately, funds that have done well in the past are no more likely to do well in the future. Stock prices move randomly based on the development of new information. No amount of analysis or intelligence can predict randomness. If knowing when to buy gold doesn’t make you a smart investor, how does anyone do well with investing?

Luckily, there is an investment strategy that some of the smartest people in the world agree on. Four winners of the Nobel Prize in Economic Sciences, and Warren Buffett, one of the most successful and well-known investors in history, are proponents of investing in low-cost index funds. An index fund passively owns all of the stocks that represent a market, for a fraction of the typical 2% cost of a mutual fund. Being smart by avoiding prediction altogether, and eliminating the high fees and commissions associated with trying to make the right calls, has proven over time to deliver excellent results.

One of the greatest challenges for Canadians is that, in general, those providing financial advice do not have an incentive to recommend index funds. Unlike actively managed mutual funds, index funds do not pay commissions. When many financial advisors earn their income based on commission, asking them what they think about index funds is like asking the butcher if you should eat salad for dinner. Try as your financial advisor might, there is no way to refute the evidence. The simple investment strategy of owning low-cost index funds is the smartest thing that you can do with your money.