Active vs. passive: Why fees make a difference

It’s unwise to compare an index without fees to a fund on an after-fee basis

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The debate between active and passive investors can lead to confusion at times. It’s common to hear passive do-it-yourself (DIY) investors highlight the fact that most mutual funds lag the market. But it’s an argument that usually neglects a few salient points.

First, investing in an index costs money. Practically speaking, most passive investors buy index mutual funds or exchange traded funds (ETFs) and their performance will be diminished by the fees levied by these funds. When deciding between taking an active or passive approach it seems unwise to compare the performance of an index without fees to that of a fund on an after-fee basis.

I hasten to add that good index ETFs charge very little these days and it’s a big reason why they’re rightly prized by passive DIY investors.

The second issue is also fee-related. While it is true that the average active fund in Canada charges more than the average index fund, the active funds usually come with individualized advice whereas the index funds do not.

When comparing the active apples to passive pears it is better to think about four different possibilities. DIY investors can buy either active or passive portfolios while advisor-guided investors can also take either path.

Most Canadian investment advisors charge about 1% per year (based on assets under management) for their services. That’s independent of whether the advisors recommend active or passive portfolios.

While DIY investors can avoid advisor-related costs, they also give up the potential benefits. For instance, advisors can help with portfolio construction, tax and financial planning, and hand-holding during downturns. For many people—and new investors in particular—these benefits may well outweigh the costs.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of May 16. The list is a good starting point for those who want to put some money to work this week. Just keep in mind, the idea is to hold the stocks for at least a year after purchase – barring some calamity.


Name Price P/B P/E Earnings Yield Dividend Yield
National Bank (NA) $42.03 1.51 10.33 9.68% 5.14%
Shaw (SJR.B) $24.66 2.22 14.17 7.06% 4.81%
CIBC (CM) $101.26 1.93 11.2 8.93% 4.66%
Power (POW) $28.84 1.02 9.05 11.05% 4.65%
Bank of Nova Scotia (BNS) $62.93 1.49 10.87 9.20% 4.58%
BCE (BCE) $59.99 4.17 18.92 5.28% 4.55%
TELUS (T) $40.76 3.16 18.12 5.52% 4.51%
Royal Bank (RY) $77.01 1.81 11.55 8.66% 4.21%
Manulife (MFC) $18.08 0.95 14.94 6.69% 4.09%
Bank of Montreal (BMO) $82.35 1.38 12.25 8.16% 4.08%

Source: Bloomberg, May 16, 2016

Notes

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)

Required Reading

The high price of low vol

As investors stampede into low volatility stocks, it’s time to ponder the future of the strategy.

 

3 comments on “Active vs. passive: Why fees make a difference

  1. Good article.

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  2. You have neglected to compare DIY passive investors that hold individual stocks. I know you are going to reply that with a fund you get instant diversification. But a portfolio that is as diversified as a fund can be constructed simply by looking at the fund holdings and buying the top weighted 20 to 30 stocks. You will capture the bulk of the fund’s returns. My costs come in at less than 0.03% (trading commissions) which is a one time expense. I would also like to point out that commissions are paid to buy and sell ETFs.

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  3. But it would make sense to compare an active fund to an ETF that tracks the appropriate risk adjusted index. As the active fund would have higher fees, it must, on average, under perform the passive approach. This is just the logic of the arithmetic of active management. Some of the pool of active funds will outperform, but there is no evidence that it’s possible to tell, in advance, which ones they will be. Therefore it’s a loser’s game to try.

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