Three Year Anniversary Giveaway Reminder
Don’t forget, I’m giving away an iPad, a gold coin, a titanium spork and more to celebrate the blog turning three years old! Click here to enter the contest. Also don’t forget to thank our contest sponsor, RedFlagDeals.com, by visiting the following link: Credit Card Comparison Tool – who knows you might find a better credit card to be using…
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.