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The Canadian Financial Advisor

If they’re so great, why doesn’t everyone invest in passive/index funds?

Benjamin Felix

First off, in the U.S., everyone is investing in passive funds. Massive inflows into passive funds and outflows from active funds have continued in 2015. The story is not the same in Canada.

It is easy to talk about the merits of a passive, evidenced based investment philosophy, and, when presented with the evidence, people tend to agree that a passive investment philosophy is the only responsible approach to financial markets. However, in Canada, the vast majority of retail money is not invested this way. Despite the clear evidence that it is a losing game, investors tend to direct their money into actively managed strategies that claim to outperform the indexes, and provide downside protection in turbulent markets. Canadians tend to be intelligent people, but we face some road blocks in embracing evidence-based investing.

Good advice is hard to find. The financial services industry is wrought with conflicts of interest, and Canadian financial advisors are not immune. In many cases, the people holding themselves out as financial advisors are in fact salespeople pushing financial products to earn a commission. What does this have to do with index funds? Index funds and similar low-cost products do not pay the big upfront commissions that traditional financial products do. Most financial advisors are not even taught to recommend passive investment products because they are not profitable for the firms that they work for.

We rely on our Big Banks. Our banks are trusted and expected to be fiduciaries. But the banks suffer from the same conflicts of interest that the rest of the financial services industry suffers from; the financial products that are profitable for them are detrimental to their clients. However, to remain profitable, they need to sell these products. People tend to assume that when they walk into the bank they are getting advice that is in their best interest, but that is not the case. Bank employees are trained to sell profitable products, extol the skill of their fund managers, and entice clients away from those boring index funds.

It looks like someone is always making money. Traditional high-fee investment products still attract assets because they can leverage performance outliers. In any given year, some investors and mutual funds will significantly outperform the average. For example, so far this year the AGF U.S. Small-Mid Cap Series Q has returned 42.40%, compared to 1.25% for the Russell 2000 U.S small cap index. Why bother with index funds when active fund managers can produce such stellar returns?

This is where the evidence is important; the vast majority of active money managers consistently underperform their benchmark index over the long-term, predicting which active managers are going to outperform in a future year cannot be done consistently, and strong past performance is in no way an indication of future performance. Embracing a passive investment philosophy is obvious when the data is considered, but the data is often hidden behind sales pitches. As a result, passive investing has not yet gone mainstream in Canada.

Original post at pwlcapital.com