These days, advisers who sell actively managed mutual funds are being peppered with questions from an investing public that is finally waking up to the fact that they’re often being poorly served. Here are the most common objections you’re likely to hear from advisers if you ask about index funds, and some suggestions for how to respond.

“Index funds offer no chance of beating the market.”

This is true. Index funds are designed to track their benchmarks closely, but they aren’t free, so they almost always lag slightly. The point is that actively managed funds usually underperform by even more. Well-run index funds routinely finish in the top quartile over any period longer than a few years, meaning they beat at least 75% of their peers.

Actively managed mutual funds do offer the possibility of outperformance. The question is, what is the probability? According to Standard & Poor’s, less than 20% of Canadian equity funds outperformed the S&P/TSX Composite Index in 2010. Over longer periods, that percentage drops even lower. During the last five years, just 2.5% beat the market. Over 25 years, the odds your portfolio will outperform resemble your nine-year-old’s chances of playing in the NHL.

“Average fund performance may be mediocre. But we select only the best managers.”

It’s amazing that there are billions of dollars invested in poorly performing mutual funds in Canada, but no adviser ever admits to recommending them. They all live in Garrison Keillor’s Lake Wobegon, “where all the children are above average.”

Advisers love to build portfolios with five-star funds and tell their clients they own the best in the business. The question is, did they start recommending those funds before they posted excellent results? If your adviser tells you that your fund has beat its benchmark over the last 10 years, ask him whether he was recommending it in 2002.

The best managers can only be identified in hindsight. Advisers can sell past performance, but unfortunately their clients can’t buy it.

Many investors would like to have exposure to US stocks in their portfolio even if they believe that the US dollar is in a secular decline against other major currencies. In theory, currency-neutral funds seem to offer the best of both worlds: exposure to one of the world’s most dynamic stock markets without the baggage of the risk of a depreciating currency. However, if you look at the (short) performance history of currency-neutral funds, a different reality emerges.

First, let’s compare the returns of the iShares CDN S&P 500 Hedged to Canadian Dollars Index Fund (TSX: XSP) with the iShares S&P 500 Index Fund (NYSE Arca: IVV) in US dollars. In the following table, the annual total returns of XSP are listed in Column 2 and the total returns of IVV in US dollars are listed in Column 3. The performance between the two funds is compared from 2006 because in 2005 and earlier years, XSP was a clone fund that used derivatives to skirt RRSP foreign content rules that were in place at that time. While XSP’s MER of 0.25% is just 16 basis points (0.16%) higher than IVV, the difference in performance (shown in Column 4) is much wider.

A Canadian investor who put $100 (Canadian) in XSP in 2006 would be left with just $99.27 at the end of 2011. A US investor who put $100 (US) in IVV, on the other hand, would be left with $114.03. In other words, the returns in XSP trailed that of IVV by an annualized rate of 2.33%. A Canadian investor betting that the C$ would appreciate against the USD and opting XSP over holding IVV directly would have been right on the first count but made no money on the bet. The C$ appreciated at an annualized 2.20% against the USD but the tracking error of XSP wiped out all the gains and then some.

This pattern of the currency-neutral fund exhibiting significant tracking error can also be observed in the TD e-Series index funds. As you can see in the following table, the TD e-Series US Index Currency Neutral fund underperforms the TD e-Series US Index (US$) fund by an annualized 1.82%.

It is often asked why currency-hedged funds have exhibited such horrendous tracking errors. It turns out that the bulk of the blame can be attributed to the tendency of stocks and currencies to move in opposite directions (See post Why Currency-Hedged Funds have Large Tracking Errors).

So, what should investors do? If past performance is any indication and if investment performance is the only consideration, it appears that investors will likely be better off obtaining direct exposure to foreign equities without hedging away currency exposure. Owning foreign stocks directly has provided better returns in the past and it has done so with lower risk.

Related Reading:

• Currency Neutral Funds Performed Poorly (Again) in 2008
• The Costs of Currency Hedging
• Performance of the Currency-Neutral MSCI EAFE Index Fund
• Comparing Currency-Hedged and Unhedged Holdings
• Currency-Hedged Funds Underperformed in 2010

Performance of Currency-Neutral S&P 500 Index Funds is brought to you by Canadian Capitalist — Helping you to invest & prosper.

Here’s another excerpt from my recent interview with Atul Tiwari, Dennis Duffy and Joel Dickson of Vanguard. These questions focus on the types of products we might see from Vanguard in the future. You can read also read Part 1 of the interview here.

Your first family of ETFs have all been plain vanilla funds that track major third-party indexes. What new products are on the horizon?

AT: We’re in the development and design stage for the next suite of ETF products that we’ll launch next year. Before we make any decisions about what those will be, we want to be in the market, talking to clients, talking to advisors, and then we will try to reach a conclusion about the next tranche.

The interesting thing that we have come across in terms of how to bring passive investing to Canada is that the index mutual fund market in Canada is pretty small. It’s concentrated in a few issuers and products that really don’t get much prominence. So we have seen indexing growing in Canada, but clearly the vehicle of choice is ETFs. The growth in the ETF market has been 30% or 35% per year, and predictions are $105 billion by 2016.

The main reason index mutual funds are not popular in Canada is that they’re way too expensive. So it seems to me there is a huge opportunity for someone to come in and grab that space.

AT: We have to start somewhere. You alluded to this idea when you asked about what we are bringing other than passive ETFs that already exist elsewhere, and we obviously think that it is not just low-cost. Our ETFs are the low-cost leaders in the market now, and we all know that low costs are important. But we also are bringing the thought leadership and the education.

The other big difference is our ownership structure: we are a client-owned organization, and we really do put clients first. We are all about continuously finding ways to lower our own costs so we can lower the costs of our investments for clients, and that’s unique. It’s not just unique in Canada, it is unique globally.

Can you explain how Vanguard’s ownership structure works, because there is a lot of confusion around that. I have heard Vanguard described as a nonprofit company, for example, which is clearly not accurate.

AT: The way it works is that in the US, the clients of Vanguard own the funds and ETFs,  and in turn the funds and ETFs own the management company. So we are not a public company, but we’re not a private company either in the classic sense of being owned by a family of shareholders. It’s more like a mutual. We are a for-profit company, but we give all the earnings back to clients in the form of lower expenses.

JD: The management company derives profits from its activities, and those profits are paid to the owners, who happen to be the investors in the US funds. Instead of being paid as a dividend, it is paid in the form of lower expense ratios.

Many investors have asked whether Vanguard will offer US and international equity ETFs without currency hedging.

DD: We have thought about it and I can tell you it is definitely something we are considering when we look at what we will be rolling out in the second tranche. We have done that in other jurisdictions, where we have offered both hedged and unhedged versions. So that’s definitely something we have looked at and will give it some consideration.

Vanguard offers a family of target retirement funds in the US. There seems to be few of these available in Canada, and I have a theory about why. If an advisor says to a client, “I’m going to put you in this target date and we won’t need to switch for 25 years,” the first thing the client is going to say is, “Then why the heck am I hiring you?”

JD: Even among advisors who buy into our philosophy, target date funds are not a huge seller, because advisors do view their job as asset allocation. Even if it is long-term strategic allocation, they want to build that for you rather than having it pre-packaged like a candy bar you buy in the store. So that is a hurdle. We get a lot of questions about how we might create target date funds out of our ETFs, but it’s just not clear what the distribution would be for a product like that.

DD: Much of the appeal of our target date funds has been in the retirement segment, for defined contribution investors. We just launched a series of target date funds in the UK, and that is also something we are looking at as we consider future opportunities in the Canadian market, where there is a huge number group RRSPs and defined contribution plans.

One of the alarming trends in Europe is the move towards synthetic ETFs. Is there any plan to move away from the physically backed ETF model that Vanguard has made its bread and butter?

DD: If we look at what we have launched in the US, the UK, Australia and Canada, having full-replication, asset-backed securities, as opposed to swaps, makes a lot more sense. I would never say never, but it is definitely not the direction that we are planning to go in.

JD: We have 35 years of experience managing physical, full-replication index funds, and that works great in large, liquid, diversified markets. There could be a role for synthetics in hard-to-access markets, where there might be some liquidity issues—where there might be restrictions on your ability to access those markets. Synthetic by itself is not the issue: it is how you negotiate the swap contracts.

When Vanguard announced its arrival in Canada this summer, investors welcomed the company with open arms: perhaps no country would benefit more from Vanguard’s devotion to low-cost investing. The company’s first Canadian ETFs started trading on the TSX on December 6.

On the day of the launch, I had the pleasure of sitting down with Atul Tiwari, managing director at Vanguard Investments Canada; Dennis Duffy, Vanguard’s director of business development for non-US markets; and Joel Dickson, a principal in Vanguard’s Investment Strategy Group.

Here are some highlights from the interview dealing with Vanguard’s overall strategy in Canada. Later this week I’ll run another excerpt that focuses specifically on the new ETFs and Vanguard Canada’s plans for the future.

Why did you decide to enter the Canadian market with ETFs rather than mutual funds? And why did you target advisors rather than retail investors?

AT: Having looked at the Canadian market for at least 14 or 15 years, Vanguard considered a number of different entry strategies. The reason we executed now is that the Canadian marketplace is changing. We are seeing a lot more advisors moving from a commission-based approach to a fee-based approach, and that fits in squarely with the Vanguard model. We don’t pay for distribution anywhere in the world, so to enter the Canadian market with mutual funds would be kind of tough, because it is a very commission-oriented business.

About 20% of advisors’ overall business in Canada uses a fee-based model, whereas in the US it is about 65%. Canada is probably where the US was about eight years ago. The other thing is, there are a lot of regulatory changes going on globally. By the end of next year, commissions will essentially be banned in the UK. Same thing in Australia. In the US, they are discussing the fiduciary standard for brokers, and even the OSC [Ontario Securities Commission] has said recently that they are going to consider a fiduciary standard. So with a little help from the regulatory changes, we think we will be well-positioned.

What were some of the uniquely Canadian challenges that you faced? For example, low-cost, direct-sold mutual funds are extremely popular in the US, but investors in Canada haven’t really embraced them.

AT: You’re absolutely right: a number of companies have tried, but direct-sold funds just haven’t caught on in Canada. And a lot of that is because mutual funds are sold and not bought. We haven’t got any plans to launch mutual funds at this stage, but that is not to say that in the future we won’t. We entered the market with the product that we thought would be the best entry point for Canada, and that is ETFs.

One of our other challenges—and certainly one of the key components of our Canadian strategy—is investor education. We will be doing a lot of thought leadership, a lot of seminars—we will do whatever we can to get the message across to investors and advisors about the effects that costs have on your returns over the long run.                                  

Index investors are well aware of the benefits of low costs. But how do you make that case to advisors?

DD: This has been a challenge for us in every market. Even before ETFs, we had a pretty significant advisor business in the US, but the fee-based business was a relatively small percentage of the overall market back in the early 2000s. We went into the UK prior to the legislation banning commissions: we felt there was enough fee-based business there, and we were willing to make the commitment. We are very patient company: look at how long it took us to get into Canada! But there is a lot of education that is going to be needed.

JD: It’s important to recognize that the advisor’s compensation doesn’t need to change at all [if they start using Vanguard ETFs]. Even if they are getting 1% or 1.5% or whatever for their services, we would hope that there is an opportunity to lower fund costs: if you can show 24 basis points with your ETF holdings as opposed to another 1.5% on underlying mutual funds, that’s a huge benefit.

Yet many advisors—and their clients, for that matter—continue to insist that active management is part of their value-added, despite overwhelming evidence to the contrary.

JD: That is a key issue: the value-added model has been disrupted. We talk about a concept we call advisor’s alpha, which is to say, how do you as an advisor position your value to clients in a world where it is not about picking the best funds, or the best managers? It’s about focusing on things you can control, like costs, and risk, and taxes and behaviour.

The problem is, these things are sometimes hard to measure. Some of the best “performance” an advisor could have provided came when the client called them up in the depths of the market in 2009 saying, “Get me out now!” and the advisor said, “Remember our overall asset allocation for the long run?” That doesn’t show up on your statement as the performance of your portfolio versus some benchmark. But if the investor would have sold out on their own, there is huge value added.

No new models yet

Many readers have emailed to ask me whether I will be updating my model portfolios with the new Vanguard ETFs. I’m not planning to do that just yet—for a couple of reasons.

First, the funds have been trading for only a couple of weeks, and while I have little doubt that Vanguard will do a good job keeping tracking errors and bid-ask spreads low, I would like to wait and see.

Second, Vanguard Canada’s US and international equity ETFs use currency hedging, which I have avoided in my model portfolios. It is possible that Vanguard will eventually launch unhedged versions of these ETFs, at which point I would be more likely to incorporate them.

I am resisting the urge to tinker with the model portfolios every time new ETFs are launched. However, this time next year I will re-evaluate the marketplace, and it’s likely that I’ll make some changes to the portfolios to reduce their cost.

Quicken winner

Thanks to everyone who entered the draw for the copy of Quicken Home & Business 2012 money management software. The lucky winner is Chris, who contributes some of the wisest comments on this blog. Congratulations!

Larry Swedroe is continuing his cross-country quest for alpha, making his next stop in Edmonton—and Canadian Couch Potato readers are invited to attend.

I was contacted last week by Marshall McAlister, a principal at Pavilion Investment House in Edmonton, who will be hosting the event this Friday morning, July 22, at 8 a.m. The firm would like to invite readers in Alberta’s capital to hear Swedroe discus the ideas in his latest book, The Quest for Alpha: The Holy Grail of Investing.

Swedroe delivered the same talk earlier this summer in Ottawa and Toronto. His presentation gives an overview of the main idea in his book: namely, that decades of evidence reveal that beating the market on a consistent, risk-adjusted basis is extraordinarily difficult for mutual funds, pension plans, hedge funds and individual investors.

The talk is free, although stock pickers will have to pass through a metal detector and submit to a thorough body cavity search. (Don’t worry, they’re just looking for alpha.) If you’re interested in attending, contact Lana Meyer at (780) 638-2491.

The Canadian connection

There is some interesting Canadian content in Chapter 9 of The Quest for Alpha, where Swedroe describes the financial industry’s unease with index investing.

I’ve always wondered why CIBC has the largest lineup of index funds among Canadian banks, but also charges the highest fees. This passage sheds some light on that question:

In the mid-1990s, [CIBC] made the decision to focus on growing its wealth management business. The problem was that the family of CIBC mutual funds had delivered poor results, leaving them with a marketing dilemma. The bank decided that the solution to their problem was to tout index funds as the winning strategy for investors. The bank created a family of index funds and placed Ted Cadsby in charge. His mission was to spread the gospel of the benefits of passive investing. He became a very public spokesman for the bank. Cadsby authored The Power of Index Funds, in which he railed against the evils of active management.

Cadsby was successful in his mission—assets under management doubled to $24 billion in just four years. CIBC had the second-fastest growing fund family among Canadian banks. Then Cadsby disappeared from public view. According to the Financial Post, Cadsby had been told to “quiet down.” Why? because the winning strategy for investors was the losing strategy for the bank.

Swedroe goes on to describe how CIBC Wood Gundy acquired Merrill Lynch Canada’s retail brokerage business in 2001, as well as TAL Global Asset Management, a firm that managed billions in active funds. Trying to convince investors to embrace low-cost index funds suddenly seemed like a bad business strategy. Early in 2002, a visibly nervous Cadsby was escorted from the CIBC offices by two burly men in black suits and sunglasses and has not been seen since.

OK, I made up that last detail.

The Power of Index Funds is now widely available in used bookshops alongside Dow 36,000 and The Beardstown Ladies.

Earlier this week I described how several US and international equity index funds get their market exposure by using index futures rather than holding the stocks directly. This structure is partly a holdover from the days when Canadians could keep only a small portion of their RRSPs in foreign investments. But the question remains: now that foreign content rules are long gone, why don’t these funds just move to a traditional structure and buy all the stocks in the index?

I put that question to Paul Mayhew, RBC Global Asset Management’s VP of Research and Product Development. He explained that the non-hedged version of the US Index Fund actually does hold all the stocks in the S&P 500. However, RBC decided to continue with the old structure in the US and international index funds that use currency hedging, because futures contracts provide an easy way to manage the foreign exchange risk. More important, however, was the potential tax advantage of keeping the derivative structure intact.

Their loss is your gain

This is actually pretty counterintuitive. Funds that use index futures are not normally tax-efficient, because any gains are treated as interest income, which is fully taxable at your marginal rate. That didn’t make any difference when these funds were designed for RRSPs, of course, but if you hold these funds in a non-registered account today, the derivative structure could be a drawback.

However—in RBC’s case, anyway—it turns out to be a benefit. The reason is that over the years the funds have built up significant “non-capital losses” as they’ve renewed the futures contracts. The fund can carry these losses forward and use them to offset future gains.

A look at the funds’ financial statements (available on the SEDAR website) shows that the US Index Currency Neutral fund carried forward $64.9 million in non-capital losses last year, compared with $89.9 at the close of 2009. The RBC International Index Currency Neutral fund booked $101.9 million in losses at the end of 2010, down from  $117.2 million a year earlier.

No distributions doesn’t mean no returns

It’s important to understand why this is a good thing. Normally when you hold a mutual fund in a taxable account, dividends, interest and capital gains are automatically reinvested as soon as they are received. Then at the end of the year you get a T3 slip telling you how much you need to report on your tax return. In the case of these RBC index funds, however, you would not have received a T3, because all of the gains—which came via futures contracts, not actual dividends or stocks being sold at a profit—were offset by previous losses.

Sure enough, while RBC’s regular US Index Fund has always made annual distributions, the Currency Neutral version did not do so in the last three years, nor from 2001 through 2003. The RBC International Index Currency Neutral has paid taxable distributions in just three of the last 10 years. (See page 2 of the PDFs linked in this paragraph for the details.)

Mayhew says that about 90% of the assets in the two RBC currency neutral index funds are held in registered accounts, where this tax shield is irrelevant. And the benefit certainly isn’t guaranteed: the funds paid very substantial distributions from 2005 through 2007, when the S&P 500 and MSCI EAFE indexes saw large gains in Canadian dollar terms.

“They are still more appropriate for registered accounts,” Mayhew acknowledges. “But the losses provide a significant tax shield that should last for at least a few years.”

Disclaimer: I own RBC index funds in my own RESP accounts. The information in this post should not be considered tax advice. Always consult an accountant or tax advisor before making any investment decision for tax reasons.

In a series of posts last month, I looked at ETFs from Horizons and Claymore that use derivatives rather than simply holding the stocks or bonds in their underlying indexes. A number of readers responded by saying that they were wary of non-traditional index funds and preferred to use the plain-vanilla variety. What they may not realize is that several Canadian index mutual funds also use derivatives to get exposure to foreign stocks. You may even own one without even being aware of it.

Here’s a list of the funds that fall into this category:

RBC US Index Currency Neutral (RBF558)
RBC International Index Currency Neutral (RBF559)
Altamira US Index (NBC846)
Altamira US Index Currency Neutral (NBC856)
Altamira International Index (NBC839)
Altamira International Index Currency Neutral (NBC877)
Scotia CanAm Index (BNS351)
Scotia NASDAQ Index (BNS397)

The above funds hold well over 90% of their assets in T-Bills and cash equivalents, and they get their market exposure by holding index futures. These are  agreements to purchase the stocks in the index at a contracted price on a specific future date. (Index futures are traded on an exchange, so they are transparent, highly liquid, and carry no counterparty risk.) The funds never actually take delivery of the stocks, however: they close out each futures contract before it settles and then enter into a new one. This is similar to the way many commodity funds get exposure to oil, natural gas, and precious metals.

A legacy from the past

To learn why these index funds don’t just hold the stocks directly, I spoke with Paul Mayhew, RBC Global Asset Management’s VP of Research and Product Development. He explained that the structure is a legacy from the past. “To understand the current versions, you have to go back to when the funds were launched in 1998,” Mayhew says. “Back then we had foreign content limits in RRSPs.”

For investors too young to remember the 1990s, in those days you could hold no more than 20% of your RRSP in non-Canadian assets. This foreign content limit was raised a few times in the early 2000s and then abolished altogether in 2005.

“There were a lot of ‘clone funds’ at that time,” Mayhew explains. “Because of the derivative structure, they could hold, say, 95% of the assets in Canadian money market instruments while the rest was set aside as margin for futures contracts. That allowed you to treat the fund as Canadian from a content perspective, but it got you exposure on a dollar-for-dollar basis to the foreign stocks in the S&P 500 or the MSCI EAFE.”

These old foreign content rules explain why the funds were originally set up using derivatives, but why do they still operate this way? Why not just switch to a traditional strategy and buy up all the stocks in the index? I’ll answer that question later this week.

Last month I put together the Global Couch Potato’s 10-year report card. I calculated the returns of this simple index portfolio using data from TD’s e-Series index funds, including annual rebalancing. The annualized return of the portfolio from 2001 through 2010 was 4.03%.

In a subsequent post I looked at how the Couch Potato stacked up against other globally balanced mutual funds. But at that time, the only 10-year performance data I could get was what I looked up myself in annual reports. So even though it appeared that the Couch Potato did well during a turbulent decade, it was hard to say much more than that.

While researching my column for the June issue of MoneySense, however, I collected much more complete data. I called Morningstar and asked them to provide me with the 10-year returns for all Canadian mutual funds in two categories: Global Equity Balanced and Global Neutral Equity. These categories most closely resemble the Global Couch Potato, with its 40% bond allocation and its equity holdings spread across Canada, the US and international markets.

How many of these outperformed a portfolio of humble index funds? And could you have identified these winners in advance?

This could get ugly

Warning: the following paragraphs include mutual fund data that may be disturbing to active managers. Reader discretion is advised.

Let’s begin in the Global Equity Balanced category, where Morningstar had 54 funds with a 10-year track record. The average return of the funds in this category was just 1.76%, and only five (9%) outperformed the portfolio of index funds over that period.

In the Global Neutral Equity category, the news was slightly less dreadful. Among the 53 funds in the category, the average return was 2.98%. In this case, a whopping 10 of the 53 funds (19%) beat the Global Couch Potato’s performance over the last decade.

Overall, then, 86% of 107 comparable mutual funds in Canada — about six out of every seven — were unable to outperform an index portfolio during one of history’s worst decades for equities. (Who was it that said that indexing only works in bull markets?) Remember, too, that we’re not talking about a hypothetical index benchmarks here: the Couch Potato’s returns were calculated using the real-world performance of actual funds.

It must also be noted that Morningstar’s mutual funds returns do not account for the front-end loads that are tacked on to many of these funds. Many investors in the outperforming funds would not have achieved these returns because of these additional costs.

The Couch Potato Challenge

Proponents of actively managed mutual funds like to argue that they can identify good mangers and outperforming funds in advance. To find out if this true, I’ll issue a challenge. If any advisor can produce a verifiable document from 2001 (such as client newsletter or a list of recommend funds) that contains one of the 15 outperforming funds, and they can demonstrate that at least one of their clients held that fund for 10 years, I will buy him or her a steak dinner. I’ll even throw in a potato.

Here’s the list of all 107 funds and their annualized returns from 2001 through 2010:

Source: Morningstar

Source: Morningstar