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Don Macfarlane is a Senior Financial Advisor with Assante Financial Management Ltd.

The right numbers

I agree the average mutual fund does not perform as well as the benchmark index. But this simplistic view ignores the fact that the average value of assets among the top quartile of funds measured over a 10-year period is huge when compared with the bottom or even the third quartile in the same asset class.

Consider: among the Canadian Focused category at February 2010, there were 154 funds with a minimum of 10-year returns reported. In the bottom 77 funds, only four have assets over $1 billion; none are over $2 billion. In the top 77 funds, 12 have assets in excess of $1 billion. People aren’t taking into account the weighted value of the fund. The best-performing mutual funds are usually the ones with the most AUM, a fact glossed over by promoters of the passive option.

No fee advantage

Transaction costs on ETFs, though small, are never included in any discussion around the overall performance of an ETF. Only recently have we seen published returns from third parties such as Morningstar.

Previously, we were always asked to compare mutual fund returns with the index, and were expected to believe ETFs always mimicked the underlying index.

Investors can buy no-load funds. I have not sold DSC or low-load in my practice for more than two years. And we do not charge for switches. While this is not the practice of everyone who sells mutual funds, it means the MER is the only fee that applies. We can assume fee-based practices offer F-Class funds with lower management fees and add an advisory fee, which in many cases would produce a total similar to or less than the MER on a typical retail fund.

Passive investing presupposes that markets reflect all relevant knowledge. Yet that’s not true. Active managers dig deeper and find things out about companies through face-to-face interviews, for example. An indexed mutual fund manager doesn’t meet with executives of companies they hold shares in, because they’re going to hold shares due to the company’s market weight. Same with ETFs.

Alan Radlo (now at CI Investments) and Kim Shannon (who now markets Sionna funds through Brandes Investment Partners) both predicted the Nortel collapse when the price was north of $85. At its peak Nortel represented 31% of the index, so if you’re pinned to the index with a passive strategy you’ve just gone over the hump on a roller coaster — start screaming.

Trading or investing?

ETFs have to follow the herd when there is a long trend in one stock either up or down. As a stock rises in market cap and is adjusted, the index adjusts the weighting up or down, and the ETF follows — it’s forced to react after the active managers have made their money. This knee-jerk action pushes or pulls the market for that stock up or down after the party is over. When the fall is precipitous, the pain is greater.

Some will argue ETFs constitute such a small percentage of investment activity that they don’t accelerate market declines. But if you’re aggressively encouraging more people to buy them, market share will increase and ETFs will then accelerate market declines.

Many people are buying ETFs on speculation. They’re chasing performance by playing the market, and that’s a disaster waiting to happen. If you’re buying and selling intra-day, you’re trading, not investing.

Vanguard’s intention in developing ETFs was to give long-term investors who prefer a passive approach the ability to buy the market for a low fee. If they’re used this way, there isn’t much wrong.

The three largest Japanese ETFs sold in the U.S. underperformed the Nikkei by more than 5% after the recent disaster. This was likely a function of intra-day trading by some ETF holders. Forward pricing on mutual funds, a rule imposed in the 1970s to protect smaller and less nimble investors, is not perfect, but it does treat participants equally.

Passive investments have been around for 30 years, yet account for only 10% of the industry. Wouldn’t more people be invested in them if they were so effective?

Dean DiSpalatro is Senior Editor of Advisor Group. Contact a professional advisor to discuss your circumstances prior to acting on the information above.

Originally published in Advisor's Edge Report

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