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Comparing the apples and oranges of fund world

Quarterly S&P reports offer good - but not perfect - comparison on how managed funds perform against indexes

Let's hope your kids bring home better reports cards than the mutual fund industry gets every three months from the analysts at Standard & Poor's.

Talk about a weak student. Typically, you'll see a majority or near-majority of funds in a particular category delivering returns that fall short of the stock index used to gauge their performance. The obvious conclusion from this data: If many funds can't beat the index, why not just buy the index through a much cheaper exchange-traded fund or index mutual fund?

But there's another, more subtle lesson to be drawn from the quarterly Standard & Poor's Indices Versus Active Funds (SPIVA) reports. Where investment products generating billions of dollars in revenues are concerned, the truth is always more complicated than it appears at first.

The most recent SPIVA report came out two weeks ago and found that more than two-thirds of Canadian equity funds trailed the S&P/TSX composite index in 2009. Funds in other categories fared well against their respective indexes last year, but over longer periods they were laggards.

The mutual fund industry calls this and other SPIVA reports unfair and simplistic. "I think we have to be very careful about the conclusions that are being drawn here," said Dennis Yanchus, manager of statistics and research for the Investment Funds Institute of Canada, the trade organization for fund companies.

One of the fund industry's top complaints about SPIVA is that it compares the net, after-fee returns of funds (fund returns are always net of fees) against the gross returns of an index.

"The index is a theoretical thing - it's not something you're actually investing in," Mr. Yanchus said.

A more fair approach would be to compare funds against index returns minus the comparatively small fees that ETFs charge. But which fees? There are four different ETF families in Canada and their fees differ widely.

"We don't think there's a clean way to put fees in, but we don't want to hide them, either," said Jasmit Bhandal, a director at S&P in Canada. "There are notes through the [SPIVA] document that there hasn't been a deduction of fund expenses."

It's questionable how much a difference adding fees would make to the SPIVA findings. Take the Canadian equity category, for example. The latest SPIVA report says the average mutual fund in the category made 5.6 per cent annually for the past five years on an asset-weighted basis (larger funds have more influence than small ones), while the S&P/TSX composite total return index made 7.7 per cent. Even if you chop 0.5 of a point off the index return to account for fees, it still outperforms.

It's a similar story in the dividend and income equity, international equity, global equity and U.S. equity categories over the past five years. One exception is the popular Canadian-focused equity category (which mainly has Canadian content, but also some U.S. or global stocks), where including the cost of a typical ETF fee widens the small advantage of actively managed funds.

Another fund industry objection to SPIVA relates to the fact that fees for most mutual funds include a regular payment to investment advisers and their firms. It's called the trailing commission and it accounts for up to 0.5 to 1 percentage point of the management expense ratio (MER) for the typical equity fund.

Exchange-traded funds have no advice fees built in for the most part, which puts them at an advantage in a comparison with mutual funds. In essence, you're comparing a cheap do-it-yourself product, ETFs, with mutual funds, a product that bundles advice into the package and costs more.

"I know there are do-it-yourself investors, but the reality is that the majority of people are always going to use advice," Mr. Yanchus said.

ETFs are used by many advisers, and the usual practice is to charge an extra fee of at least 1 per cent on top of the MER for the individual funds in a portfolio. If you're a client of an adviser who uses ETFs, add a percentage point or more to your ETF fees to get a truer picture of what you're paying.

As with fees, Ms. Bhandal said it's difficult to come up with a standard charge for advice to put into the ETF side of the SPIVA analysis. She also noted that ETFs are a natural tool for investors who choose to run their own portfolios rather than seeking help.

S&P claims several benefits to its SPIVA data, the most notable for investors being the fact that it eliminates the benefit the fund industry gets when it closes its lame products and removes them from the historical mutual fund database.

This is called survivorship bias and it can artificially make average fund industry returns better than they actually are. S&P addresses this by examining all the funds that were in place at the beginning of an analysis period and following them along, rather than taking the funds in place at the end and looking back at how they did.

As always in investing debates like the one over SPIVA's credibility, there's big money at stake.

Index-tracking ETFs account for only about 5 per cent of the $585-billion held in mutual funds in Canada, but they're growing at a much faster rate. If it's going to retain its dominance, the fund industry needs to suppress the ETF insurgency. One way to do that is to advance the argument that actively managed funds are a superior way to invest.

S&P has a financial interest in the debate as well because it's in the business of building and maintaining stock indexes that ETF companies license for their products. Examples: the S&P 500 index and our very own S&P/TSX composite and 60 indexes are used for ETFs.

Ms. Bhandal said S&P has many lines of business, including one that provides stock research to the active fund managers - those who disavow the strategy of passively mirroring indexes.

"We don't try to spin the results in favour of passive versus active," she said. "This [SPIVA] is as unbiased as we can make it to provide a tool for investors to make educated investment decisions."

In another couple of months, there will be a new SPIVA report and it's going to show that there are lots of mediocre to awful mutual funds out there, and that index investing really makes sense. Dig deeper and you'll find another message. There are some good mutual funds out there, and index investing isn't always the answer.

Follow me on Facebook. I'm at Rob Carrick - Personal Finance.


The world according to SPIVA

Here are some results contained in the most recent Standard & Poor's Indices Versus Active Funds Canada report, which compares the performance of mutual funds against their benchmark stock indexes. Here, we see the percentage of funds that have outperformed the index over various periods ending Dec. 31, 2009.

Percentage of Funds
Beating the Index
Fund Category Comparison Index 1-year 5-Year
Canadian EquityS&P/TSX composite total return30.47.5
Cdn small-mid cap equityS&P/TSX completion total return52n/a
Cdn div. & income equityS&P/TSX Cdn dividends aristocrats total return00
U.S. equityS&P 500 total return C$39.79.2
International equityS&P EPAC large-midcap total return C$51.210
Global equityS&P developed large-midcap total return C$58.213.9
Cdn focused equity50% S&P/TSX composite TR, 25% S&P 500, 25% S&P EPAC6139.7
Notes to help you understand these numbers:
these are index returns; if you buy an ETF that tracks these indexes, your return will be lowered by fees and other factors.
mutual fund fees include a significant portion that compensates advisers; ETF fees are much lower, in part because they do not include an advice component
the S&P EPAC large-midcap index is very similar to the MSCI EAFE Index, and the S&P developed large-midcap index is similar to the MSCI world index


The third way

Every quarter, the Standard & Poor's Indices Versus Active Funds Canada report stokes the ongoing debate about whether it's better to own index-hugging exchange-traded funds or mutual funds. Analyst Pat Chiefalo of National Bank Financial suggests a third way - use both when building a diversified portfolio.

"We set about thinking what the best product was for each situation," Mr. Chiefalo said.

"What we found was that you have to be selective in choosing. There's no one product that will serve all needs."

Mr. Chiefalo evaluated funds and ETFs in six areas based on costs, user-friendliness and performance. In the end, funds and ETFs were each was found to be the best choice in four categories.

Here's the breakdown:

Category Funds ETFs
Cdn Equity
Div. and Income
Natural Resources
Precious Metals
Financial Services
Real Estate
Cdn Sm/Mid-caps
U.S. Equities
Source: National Bank Financial

© 2007 The Globe and Mail. All rights reserved.

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