Current Benchmarks for Active Management Are Too High

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Mutual Fund Industry Lobbyists Resist Benchmarks

Many mutual fund companies (but not all) fight to keep benchmark index data from appearing anywhere they can on sales or regulatory documents. This is because most mutual funds don’t keep up to their benchmarks – a fact which drives a lot of investors into ETF and index mutual fund solutions.

Indexes Are Not An Appropriate Benchmark

You cannot invest in an index per se. You can invest in something that tracks an index, like an ETF or index mutual fund or an ETN, but they all have their own costs to run and administer. Index funds are expected to lag the benchmarks by the MER plus or minus other sources of tracking error (because it is actually quite difficult to track an index with perfect precision). In other words, if you buy an ETF that tracks the TSX Composite Index it will more than likely underperform it by a small amount over time.

But there is more to it than that. Most mutual fund assets in Canada include embedded advisor compensation which further drag down the returns. Blindly comparing an actively managed mutual fund sold through an advisor to a benchmark muddies the performance comparison. In one case you have the cost of the product and the cost of advice and in the other you have neither.

What Is A Better Benchmark?

Here’s my suggestion. Compare the mutual fund against the ETF that tracks the benchmark and further adjust the performance of that ETF by the cost of advice. The average cost of advice is 1.00% in Canada. So as an example, an actively managed Canadian equity fund would be measured against the XIU ishare ETF and further, XIU’s performance would be reduced by 1.00% per annum. (Technically, 1/12th of 1.00% would be deducted monthly just as some mutual funds choose to charge fees, but we don’t need to get into all the technicalities for the purpose of this post – I think you get where I’m going.)

For example, if in 2011 the TSX Composite Index has a performance of 3.45% and XIU has a return of 3.42%, then the benchmark for a Canadian fund would be more appropriate if it was (3.42% – 1.00% =) 2.42%, not 3.45%. Now we would have a more solid framework for comparing active management versus passive management. Right now we are comparing active management and advice versus passive management without any costs and tracking error.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 27 comments
  • Robert

    You make a good point that compare performance after embedded fees for advice against performance after only management fees (some ETFs don’t report the whole MER) is unhelpful. Another idea might be to compare gross performance.

    But either way, over what time period? Comparing performance over 3 months, 6 months or 9 months is almost meaningless, due to random fluctuations. Outperformance can only really be measured over periods of 3 to 5 years and longer. But by then, many people have (irrationally) switched investment strategies a couple times.

    I support disclosure that’s more meaningful. But at some point, I think we should acknowledge that most people either don’t read it or don’t understand it.

    • Preet

      Time Period: 1 year or less is absolutely meaningless. 3 to 5 is still give or take. The equity premium still needs about 30 years before one can statistically say it exists. One of the hurdles of active management is that as reliability of positive alpha due to skill increases (a function of time) the forward utility decreases (as the manager eventually retires, dies, or even just reverts to the mean). A career can only be so long.

      Practically 5 years, with lots of rolling time periods would be preferable.

      I agree, most people won’t read/understand it – that’s why we will always need advisors.

  • Michael James

    I’m not convinced that this is a reasonable approach. In my case, the “advice” I received from advisors years ago had negative value. For the most part they didn’t even pretend to offer advice. They just pitched different ways for me to borrow more money to invest. The fact that the average cost of advice is 1% of assets has no correlation to the actual value of that advice. I’m prepared to believe that the average value of advice is positive, but there is no way that it is worth 1% of assets in the typical case.

    • gene

      Yeah, I agree with Michael James. At the very least, I’m confused why an investor should accept a 1.00% under-performance bogey. Advice should add value, and I think in most cases advisor fees are hidden from the investor (or you could say “built into”) in the MER of a mutual fund. Am I missing your point, Preet?

      • Preet

        Yes, I think you are both looking at a different issue. What I’m trying to get at is the active versus passive discussion, stripping out advice from both. I’m trying to exclude looking at advice completely. For example, the SPIVA scorecards rank active funds versus benchmarks. Active funds include advice costs, benchmarks do not. Active proponents will point this out showing that the comparison is not fair to active managers, and that’s true. So if we make it apples to apples, then we will probably see the same conclusion, somewhat less robust, but same conclusion – and no defence.

        I agree with 1% being too much for the average quality of advice received in Canada – but this is a separate discussion from what I’m getting at here…

  • Sean

    Hi Preet. Good post.

    I agree with Michael James.
    Sure you can compare to XIU but why reduce by 1%?
    That would be like artificially adding 1% to the “active” mutual fund – a return it did not earn

    In the same vein, a few days ago, you had a blog removing “closet” indexers from the pool of “actively” managed funds to improve their returns. My response? – Did you know I had a perfect GPA in my last year at Uni if only they didn’t include the “C” I got in economics?!

    • Preet

      Hi Sean, the 1% reduction is to factor out the cost of financial “advice” costs from the investment manager performance. I’m looking at investment manager performance, not investment advisor performance. I’m going to try and explain in more detail in the next post.

      As for the closet indexers comment: I did not have a post that discussed removing closet index funds from actively managed funds to improve their returns. I had a post about closet index funds: http://wheredoesallmymoneygo.com/almost-250-billion-invested-in-closet-index-funds-in-canada/ Is that to what you are referring?

  • Dan Hallett

    Preet, I think your approach is a valid one. The responses so far indicate that investors should do one of two things. For DIY investors, just compare to your default DIY option – i.e. the straight ETF with no additional fees – since you won’t seek/pay for advice anyway. For the others (which by the way is most Canadian investors), deduct the 1% from ETF returns because if you want advice you have to pay for it, whether you’re investing in ETFs or something else. I have written about this in recent months in our own blog.

    http://thewealthsteward.com/2010/04/no-free-lunch-with-etfs-unless-youre-a-disciplined-diy-investor/

    There are some links in that short post worth following. In short, there is a delicate balancing act required to successfully invest in ETFs, whether you’re a DIY or advice-seeking investor.

    • Preet

      Dan – I read your article in G&M. I think the nuances, which you point out, get forgotten by many who just read the headlines of low-cost indexing on a DIY basis. To borrow from Jonathan Chevreau, many Do It Yourself investors become Did It To Themselves investors. Thanks for the link too – good post as always.

  • Michael James

    I agree that most investors need advice. Unfortunately, few investors with advisors seem to get anything that could usefully be called advice. No doubt there are some investors who get good value from the 1% they pay for advice, but they seem to be in the minority.

  • Patrick

    I too am looking forward to the justification for subtracting that 1%.

  • TIm

    You gotta love the language of the financial industry. “embedded advisor compensation” == sales commission. When doing comparison shopping for anything else do you subtract the commission the salesman makes from the price? Of course not. The industry has basically balked at rebating trailers for self-directed investors which deflates the claim this is the cost of “advice” and not a sales commission.

    The vast majority of FA are straight up salesmen, and the compensation model is busted. Investors want change, the industry doesn’t. Even still, you have to consider that if wasn’t for the FAs advising their clients to invest in a particular fund, the fund would have less AUM and enjoy less economy of scale, which would increase the average cost per unit. Trailers should be treated no differently than marketing costs because they are both methods of generating inflow.

    And since trailers are a cost to the fund then it should be taken it into consideration when comparing it to indexes. I mean, you’re not going to argue (at least I hope not) that we shouldn’t consider the other costs of a fund (trading costs, research dept., back office, etc) because indexes don’t have those either..

    • Preet

      I think you have missed my point also (which is subtle, but is clarified here: http://wheredoesallmymoneygo.com/active-management-and-financial-advice/ )

    • Preet

      “When doing comparison shopping for anything else do you subtract the commission the salesman makes from the price? Of course not.”

      -What else do you buy that keeps charging the commission your whole life?

      “Even still, you have to consider that if wasn’t for the FAs advising their clients to invest in a particular fund, the fund would have less AUM and enjoy less economy of scale, which would increase the average cost per unit.”

      In the US, costs have come down minimally as fund assets have increased exponentially. The savings due to economies of scale is not passed down to the investor.

      “And since trailers are a cost to the fund then it should be taken it into consideration when comparing it to indexes.”

      Unless indexing means bypassing the advisor – which it doesn’t necessarily. If an investor was choosing between an advisor who used active funds and an advisor using passive funds and the investor’s only criteria for ajudication was performance, then the trailers cancel out and you can then compare “active investment management” against “passive investment management”.

  • Thicken My Wallet

    Isn’t the logical conclusion of your post that it is unreasonable to compare active vs. passive investing approaches? I understand what you are trying to do to get to an apples to apples comparison but when the rubber hits the road, a mutual fund isn’t an a la carte product where you can strip out parts of the cost structure.

    I would look at it the other way. Time equals money- the hours a DIYer spends researching strategy and product is not free but is thought of as free erroneously. There is an opportunity cost or this time has to be valued in some manner. Now, it may be very difficult, if not impossible, to determine opportunity cost/cost of time on an aggregate basis but I would add in this costs to the MER of an ETF. One may find a true comparison of cost in this manner (and highlight the problem with trailers).

    Great post as usual.

    • Preet

      Well, I think it is fine to compare active management to passive management, I just don’t think it is fair to compare active management including cost of advice (i.e. most mutual funds) to passive management benchmarks with no cost of advice because it assumes: 1) All indexers are DIY and 2) Active management is only available through mutual funds.

      There are two variables we are looking at: 1) Active management versus passive management and 2)Advisor or No Advisor.

      So far everyone is looking only at two of the four quadrants and ignoring the other two. In the end the “practical” conclusion is apparent, but it is drawn from sloppy analysis.

  • larry macdonald

    There are studies showing financial planners and advisors don’t add value to the selection of mutual funds. But they may add value through tax planning, estate planning and other personal finance issues — and more so for bigger accounts than smaller accounts. So I wonder if the comparison Preet suggests may be valid at least for high net worth persons.

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