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ETFs and Funds Investing Wealth

88% of Canadian Equity Funds Underperform

It’s a stock picker’s market, right? Investment manager earn their keep during down markets, right? Actively managed mutual funds can take advantage of market dispersion and volatility to pick outperforming stocks, right?

Wrong.

Yet again – through up markets, down markets, calm markets and volatile markets – Standard and Poors (S&P) proves that the myth of active investment management is pure bullshit.

S&P periodically releases the SPIVA Scorecard, which compares the performance of active mutual funds against their benchmarks. Whether looking at Canada, US or UK, this report has repeatedly shown that active managers underperform.

The SPIVA report is probably the most accurate of all mutual fund evaluations because of what it doesn’t leave out. The SPIVA Scorecard accounts for mutual fund survivorship bias. This adjustment is critical to understanding the true extent of manager underperformance over time.

Here’s how S&P explains this important adjustment:

Many funds might be liquidated or merged during a period of
study. However, for a market participant making a decision at the beginning of the period, these funds are part of the opportunity set. Unlike other commonly available comparison reports, SPIVA Canada Scorecards remove this survivorship bias.

Standard & Poors SPIVA Canada Scorecard

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Facts (from the SPIVA Canada Scorecard- ending June 30, 2020):

  • 88% of Canadian equity funds underperformed their benchmarks over the past year, in line with the 90% that did so over the past decade
  • On an asset-weighted basis, Canadian Equity funds returned a dismal 7.9% below the S&P/TSX Composite over the past year.
  • U.S. Equity funds posted the highest returns over the past year, with a 6.7% gain on an equal-weighted basis and 10.8% on an asset-weighted basis. Both of these metrics fell short of the 12.1% gain of the S&P 500 (CAD), with 84% of funds failing to clear this hurdle over the past year.
  • U.S. equities offered the best returns over the past decade, with the S&P 500 (CAD) gaining 16.9% per year, but active funds were unable to keep up: 95% fell short, by an average of 4.1% per year on an equal-weighted basis.
  • 53% of all funds in the eligible universe 10 years ago have since been liquidated or merged.

The performance tables below compare mutual fund categories (e.g. ‘Canadian Equity’) against their benchmarks (e.g. ‘S&P/TSX Composite’). The first table shows equal weighted returns (average fund return) and the second shows asset weighted returns (average fund returns weighted by size of assets in a fund). As you can see, there is significant underperformance across all time periods and categories.

This is not just an issue with the Canadian mutual funds industry. Here are some facts about the performance of mutual funds sold in the US:

Facts (from the SPIVA US Scorecard- ending June 30, 2020):

  • In 11 out of the 18 categories of domestic equity funds, the majority of funds continued to underperform their benchmarks.
  • 67% of domestic equity funds lagged the S&P Composite 1500® during the one-year period ending June 30, 2020.
  • In 13 out of the 14 fixed income categories, the majority of funds failed to keep up with their benchmarks.
  • Fund liquidation numbers across segments regularly reached into the 60% range over a 15-year horizon.

The equal and asset-weighted performance comparisons for US mutual funds are equally bad and just as significant as fund underperformance in Canada.

Why do most mutual funds underperform?

It’s simple.

1) Mutual funds charge a fee that can be as high as 3% in some cases (most are probably closer to 2%). Just to perform in line with the benchmark a fund manager has to outperform by the fee charged. They are starting from behind.

2) Mutual fund managers are trying to outperform against millions of other professional investors, all with the same public information. By the very nature of the market, there will be people who are wrong and people who are right. It is very difficult to be repeatedly right about something impacted by an infinite number of variables. Hence, the chance about being right about a particular portfolio (relative to a benchmark) at any point in time is about 50/50. Those odds are reduced over longer periods of time (the odds of flipping heads once is 50%, the odds of flipping heads twice in a row is 25%).

In that it provides no value added, investment fund management is therefore a commodity. An allocation to diversified portfolio of stocks has value, but the overlay of ‘active investment management’ provides no additional value (actually, it subtracts value as shown above). Investors should not pay for something that isn’t delivered. Therefore, investors should not pay active management fees, which are significantly higher than passive fees. This difference in fees could mean the difference between retiring well or retiring broke.

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Investing

Dividend Investing’s Psychological Edge

In theory, the companies that provide the best return are the ones with projects that produce the best ROIC (return on invested capital). Let’s say a retailer (Company X) has discovered a new format of store that generates an ROIC well above what investors could get elsewhere. For this company it would make sense to retain all earnings to reinvest in more stores. It wouldn’t make sense to distribute cash back to investors.

Company X can generate better returns for investors by reinvesting in its own growth prospects. Therefore, Company X stock price should outperform other companies with less favourable growth prospects.

I get the theory and it makes sense. A stock with high growth prospects will tend to have a higher total return than a stock with lower growth prospects. (Of course, not all growth prospects become real so many growth companies eventually fall behind expectations. In fact, there is some research that suggests dividend growers outperform non-dividend stocks over the long run. But for this article, let’s use the simplistic assumption that growth stocks outperform dividend growth stocks.)

The assumption that growth stocks outperform dividend-paying stocks fails to consider investor behaviour and what actually happens at the account level. At the account level, a big segment of investors will perform better by investing in slower growing companies that pay regular and growing dividends.

Stock prices frequently experience corrections and bear markets. Investors have a tendency to ‘buy high, sell low’ – the opposite of what they’re supposed to do – because when stock prices are falling it often feels like the world is crumbling. The news is bad and investors have no idea how much the decline will be. So they see that their holdings are down 10, 20% and they sell. These emotional buy/sell decisions made at the wrong time have a huge negative impact to long-term returns. Indeed, investors tend to drastically underperform the S&P 500.

One of the critical components to becoming a decent investor is to control emotions. We need to fight millions of years of evolution telling us to run when things start to look bad.

My view is that dividend streams help to do that. An investor that holds a portfolio of dividend paying stocks will still receive a stream of cashflow into their account, regardless of stock price performance. I believe these payments are a form of positive reinforcement that rewards good investor behaviour – namely, doing nothing or investing more when stocks are down.

Taking this a step further, many dividend investors view their capital as the price of entry to receive a perpetual and growing dividend stream. You’re trading a lump sum for a stream of income. Investors who look at their portfolios this way will be even less inclined to sell when markets correct, for that would cut their stream of income.

In summary, dividend growth stocks might not produce higher total returns than growth stocks. However, dividend growth investing might because of the positive effects on investor behaviour.

Categories
Investing

Does Gold Outperform Stocks Over the Long Run?

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There’s a financial meme out there that suggests gold and silver have outperformed stocks over the past 20 years. The chart looks something like this:

Gold line = gold
Silver line = silver
Blue line = Dow Jones Industrial Average (DJIA)
Red = S&P 500

Looking at this chart, one might come to the conclusion that gold and sliver outperform stocks over the long run. However this conclusion is incorrect.

First of all, the relative performance shown in the chart is very sensitive to start and end dates. For example, if the chart goes back an additional 10 years the outcome completely reverses with stocks outperforming gold and silver:

Alternatively, if I shift the 20 year period to 1959-1979 gold and silver’s out-performance is dramatically amplified.

The point I’m trying to make is that the relative performance of gold and silver is highly dependent on the time period in question. In other words, the performance of precious metals changes with the economic environment. One cannot judge long-run expected returns for gold and silver based on any single period alone.

The next point I want to make is that these memes often make the mistake of comparing gold and silver against the price returns of various stock indices. The charts above use the price returns for the DJIA and S&P 500. Price returns don’t include dividends and therefore provide an incomplete picture of the actual returns from holding stocks.

Below, I’ve re-created the charts and added a black line that represents the total returns provided by large cap stocks (using the Wilshire Large Cap Index back to 1978 and S&P 500 Total Returns Index prior to 1978). While the price return for S&P 500 (red line) was 129% over the 20 year period, the Total Return (black line) was 240%. Gold and silver still dramatically outperformed during this 20 year period.

Like in the previous example, extending the history to 30 years flips the script. While the price indices outperform (as they did in the earlier example) the new total returns line dominates. The added compounding effects of dividends becomes increasingly noticeable as time goes on.

The farther back you go, the more impactful the compounding effects of dividends become. The following chart compares 100 years of returns, with the total returns index being the clear winner, while gold, silver and price return stock indices barely register.

Today, we could be in a period in which gold and silver outperforms stocks. This out-performance is highly dependent on the prevailing economics, such as negative real yields and currency depreciation. There are so many factors that nobody really knows for sure.

I personally believe a strategic allocation to gold can help improve portfolio risk-return characteristics. I also believe that we might be in an economic environment in which gold outperforms stocks. However, to extrapolate the out-performance of the last 20 years to argue that precious metals should provide higher expected returns over the long-run is misleading.

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