For Canadians with money parked in these funds, the likelihood of the investment proving worthwhile is vanishingly low.wutwhanfoto/iStockPhoto / Getty Images
Beating the market is hard. Not even the pros can do it with any kind of consistency, despite what the investment fund industry would have you believe.
Out of more than 650 Canadian actively managed equity mutual funds, how many of them were able to maintain superior returns over the last five years? Exactly zero.
An S&P Dow Jones Indices report looked at the best 25 per cent of performers from 2018, and found that not one of them is in that same bracket today.
The results are damning, if not surprising. A body of research stretching back decades shows that passive investing approaches using low-cost index funds tend to outperform actively managed strategies, on average.
And still, much of the pull of industry revolves around the idea of the visionary manager who can extract market-beating returns year after year.
“They’re trying to sell you on the fact that they can tell the future,” said Jason Pereira, president of the Financial Planning Association of Canada. “Is it surprising that people end up believing it?”
Undoubtedly, there are talented stock pickers out there capable of identifying and exploiting mispricings in the stock market in any given year. Repeating that feat is a much rarer thing.
In fact, merely staying above-average for more than a couple of years seems incredibly difficult. Consider the subset of Canadian mutual funds focusing on domestic stocks. The S&P report included 68 of them at the start of its analysis in July, 2017. How many of them stayed in the top half of performers for the next five years? Just one.
The results are similar across other equity fund categories, from dividend stocks to international stocks to U.S. stocks – one or two funds remained in the top half of their peers over five years, while none managed to rank in the top quartile the whole time.
For Canadians with money parked in these funds, the likelihood of your investment proving worthwhile is vanishingly low, undermining the whole premise of active investing.
This is not a shortcoming specific to Canada. S&P’s report for the U.S. market also found a zero rate of survivorship in the top quartile over five years. Many other studies consistently show that fund managers everywhere struggle to put up market-beating performance with any kind of regularity.
“The odds are stacked against them,” said Joseph Nelesen, senior director of index investment strategy at S&P Dow Jones Indices. “There are undeniable headwinds that active managers face, which are only getting stronger.”
Three inescapable challenges confront every active fund manager, Mr. Nelesen said. First, the professionalization of the fund management business means that every manager faces a deeper pool of competition, all trying to do the same thing. By definition, not all of them can beat the market.
Second, while the market tends to rise over time, returns are driven by a relatively low number of individual stocks. There are a lot more dogs than stars to choose from. This lowers the odds of a concentrated portfolio picking the right names.
And third, running a large active strategy is expensive. It requires a research team, well-paid portfolio managers, marketing costs, etc. As a starting point, all those expenses put an actively managed fund at a deficit against an index fund with miniscule fees.
The problem seems to compound the larger a fund gets. By the time the funds gain scale, the amount of excess return they’re extracting from the market “is basically being swallowed up by their fees,” Mr. Pereira said.
Looking at the last five years specifically, there’s another reason why so few Canadian stock pickers have consistently outperformed most of their peers. What worked well in 2017, when interest rates and inflation were low, may not work so well today.
Many managers find their style is best suited to certain market conditions, less so to others. This puts the burden on the investor to find the best fund managers for the moment. You might luck out, but the odds are not in your favour.
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