The following question was edited for brevity and clarity
Question:
I met with my financial advisor the other day. He is from Vancouver but was doing his ’rounds’ and I met him in Singapore. Our money is doing quite well with him (average 12% growth the past few years), and he charges 1% per annum. He, of course, showed all kinds of charts, just as your book suggested he would. And he was convincing. I’m wondering if he could be one of the ‘good guys.’
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Answer:
- If the advisor is purchasing ETFs (index funds) for your account and charging you 1%, this is a very good thing.
- If, however, he is selling you actively managed mutual funds AND charging you a 1% annual fee, this is not good.
The Bad Possibility
If your advisor is selling you actively managed mutual funds, you will likely be paying about 1.75% for your funds, if they are F class Canadian mutual funds. Add your advisor’s 1% annual fee, and your total costs would be at least 2.75% per year. Nobody should ever pay this much. It simply isn’t fair.
The Good Possibility
If, on the other hand, he is purchasing ETFs for your account, you will be paying about 0.10% per year for the ETFs. Add his 1% annual fee, and your account would cost a total of 1.10% per year. This second scenario would be a good one (despite the fact that you could build your own portfolio of ETFs for 0.10%)
As for your 12% annualized return over the past few years, your results should be measured against an appropriate benchmark, risk tolerance level and time frame.
For example, measured in Canadian dollars, the S&P 500 has averaged 16.6% during the past 3 years; Vanguard’s Developed International market index has averaged 17.2%; and Vanguard Canada’s stock market index has averaged 11.19%. You can see their respective performances here.
Is a 12% annual return good?
It depends. Let’s assume you have a high risk portfolio without any bonds. Assume that your portfolio is split evenly between the Canadian market, the EAFE (international) market, and the S&P 500 (U.S.) market. In such a case, your average compounding return would have been 15% per year.
If, on the other hand, your portfolio had 25% allocated to Canadian bonds, and the rest split between the U.S., International and Canadian stock indexes, your 3 year average annual return would have been 12.22% per year.
So when comparing your returns, you have to compare apples to apples, in terms of three things:
- The exact starting and ending points (I measured from March 31, 2012 to March 31, 2015)
- The exact asset allocation
- An exact dollar weighted comparison
In other words, when comparing your returns, you can’t just look at your fund returns. You must look at when you bought each specific fund, and how much you put into them. Then you would measure, on a dollar weighted level, exactly what you would have earned if you had bought index funds instead.
The Smokescreen Some Advisors Use
Be careful about your advisor trying to sell you on the past returns of specific actively managed funds.
In 2007, John Bogle wrote The Little Book of Common Sense Investing. In it, he said that some funds do beat the market. Most of them, however, lose their market-beating mojo. So Bogle says most investors should buy index funds instead.
William Bernstein is the author of five investment books. He says, “Three things account for the relative performance of investment managers: skill, exposure to easily identifiable portfolio characteristics like median company size and valuation, and dumb luck. The last two factors, which are random, are far more important than the first, and in such a world, manager outperformance shouldn’t persist.”
Keith Loggie, senior director of global research and design at S&P Dow Jones Indices says, “It is very difficult for active fund managers to consistently outperform their peers…There is no evidence that a fund that outperforms in one period, or even over several consecutive periods, has any greater likelihood than other funds of outperforming in the future.”
Each year, S&P Dow Jones Indices publishes The Persistance Scorecard. They show that funds with strong track records rarely keep winning. Their 2014 Scorecard evaluated 687 U.S. mutual funds that were in the top quartile of performers as of March 2012. By the end of March 2014, just 3.78% of the funds managed to remain in the top 25%.
Just 1.90 per cent of the large-cap funds, 3.16% of the mid-cap funds and 4.11% of the small-cap funds remained among the top quartile.
The Persistence Scorecard data also shows that fortunes can reverse. Of 426 funds that were in the bottom quartile in 2009, 28.64% moved to the top quartile over a five-year horizon, while 28.57% of those top-quartile funds moved into the bottom quartile during the same period. But why don’t winning funds continue to win?
Jason Zweig says investors flock to winning funds, increasing their asset sizes. The larger a fund gets, the tougher it is to beat the market. It’s less nimble. Fund managers then have a tougher time moving in and out of positions. When the manager discovers a great, underpriced stock, its growth also has less of an impact on a larger fund than it would have had when the fund was small.
Morningstar says that a fund’s expense ratio is the best predictor of future performance: the lower, the better. Because index funds offer the lowest costs, they’re the funds you ought to buy. Forget about actively managed performance charts. Such cherry picking of past performance (if indeed, that’s what your advisor is doing) means nothing.
Andrew Hallam is the author of The Global Expatriate’s Guide To Investing (Wiley 2015) and Millionaire Teacher (Wiley 2011)
