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The Wise Investor

Resources Getting Started The Wise Investor Online Investing Glossary Book Centre globefund.com Alert Table of Contents Put your financial adviser on a leash February 11, 2000 100% Foreign content for your RSP December 22, 1999 Tax Loss Selling or Dealing With Your Mistakes November 26, 1999 Life Stages of your RRSPs November 12, 1999 Just give me boring (but great) rates of return November 3, 1999 De-mystifying Demutualization - part Two October 25, 1999 De-mystifying Demutualization - part One October 19, 1999 Seg funds for the simple minded September 14, 1999 The interest rate game Part 2 August 12, 1999 The interest rate game Part 1 July 30, 1999 Choosing funds: Five for the long run July 14, 1999 New Funds: To buy or not to buy July 2, 1999 Making sense of momentum investing June 18, 1999 Rating the fund managers June 4, 1999 Resource recovery hinges on supply and demand April 30, 1999 Tech funds draw strength from favourable trends March 24, 1999 Withdrawing from your RRSP March 9, 1999 The economic implications of the euro - An interview with Ranga Chand February 12, 1999 Underperforming small-cap funds have strong upside potential January 29, 1999 How to pick a winning equity fund portfolio January 15, 1999 View the Weekly Insight archive

Index funds play catch-up in falling markets STEVE KANGAS, CA, CFA, and DOM RANDO Canada Trust's Investment Management Group. Tuesday, October 6, 1998 All the talk in recent years about management fees and money managers’ (in)abilities to outperform their respective benchmarks has created quite the controversy. Several fund managers in Canada and the United States have been embarrassed with the media questioning what value managers add based on mutual fund performance. Money managers are quick to argue that, in a rising market, index funds may appear to be gems at little cost; however, it is performance in bear or stagnant markets that will dictate the true measure of a fund manager. Why index funds? The indexing strategy attempts to match the performance of market indices such as the TSE 300 Composite Index by proportionally investing in identical securities. During the bull run over the last five or more years, index funds appeared to kick salt in the wounds of several equity fund managers. Maintaining excellent cost efficiency while posting superior numbers against some active money managers, index funds have won over significant mutual fund assets. MERs and cost effectiveness To match the performance of an index, an investor should seek a correlated index fund that charges the lowest MER (Management Expense Ratio). The difference in returns of two index funds investing in the same benchmark will likely equate to the difference in their MERs. Index fund performance during a market correction Using August 31, 1998, performance figures, the indices being tracked proved critical in evaluating the decision to consider an index fund. Time in the market was also a crucial factor. The average Canadian equity index fund did not outperform active money management consistently when looking over the short term (one-year or less). When looking at longer time horizons, Canadian index funds did indeed supply superior performance. Global equity Index funds, however, behaved rather differently. By holding these funds through the volatility we have seen over the last 12 months, the index investor would have, on average, outperformed the average global equity fund. In contrast, equity index funds in the United States during the first eight months of the year have underperformed actively managed funds. This would mostly be attributable to actively managed funds holding some cash as a cushion. Looking at periods of one year or greater, however, U.S. equity index funds have been by far the superior choice. This comes as no surprise due to the length of the last bull run and the fact that these funds are virtually 100% invested in the market. Even with the short-term underperformance we have seen in the Canadian and U.S. index funds, the index investor should be optimistic. Given the magnitude of the drop in the financial markets, index fund investors should expect to capture all of the upside when the market turns, while some money managers will be left behind with far too much cash in their portfolios. RRSP eligible foreign index funds RRSP eligible index funds don't actually buy foreign stocks. Instead, they buy futures contracts on the foreign market index while using Canadian T-Bills as collateral. This allows the investor to legally get around the 20% foreign content limitations, and do so without any leverage risk. The cost of this is a slightly higher MER. This modest premium is worthwhile in an RRSP due to the global diversification it allows. Some examples of these funds include the top performing CIBC US Index RRSP fund, and Canada Trust's Growth Series of funds, which are 100% RRSP eligible. Limiting foreign exposure could have serious long-term effects on investment portfolios. Despite the pleas of investors around the country, Revenue Canada has yet to show any inclination of an easing of the 20% RRSP foreign content rule. The dramatic implication occurs when comparing returns of the TSE 300 to those of the S&P 500 and the MSCI World Index: In dollar terms, investing $10,000 over 10 years would have returned about $22,000 if invested in the TSE 300, $35,000 in the MSCI World Index, and $62,000 if invested in the S&P 500. We do not recommend holding 'RRSP eligible' foreign index funds in a taxable account. Revenue Canada treats gains as income, taxed at the maximum rate. Holding 'normal' foreign index funds in a taxable account, on the other hand, would be tax efficient since trading of securities is limited and distributions are accordingly small. Drawbacks of index funds The informed investor buying managed funds will not invest with an 'average' money manager. Over the history of the mutual fund industry, several superior managers have emerged and have provided excellent value to their investors. These select managers have proven to be able to meet their respective benchmarks through their own disciplined approaches to stock selection. Are investors willing to forfeit the possibility of outperforming the index and accept the overall market returns? And, do investors have the information and the time to analyze the funds to determine who the best managers are? We expect many investors will find the simplicity of index mutual funds to be very compelling over the next few years.

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