Digging Deeper for Index Beaters

02/07/2011 1:55 pm EST

Focus: MARKETS

Rob Carrick

Columnist, The Globe and Mail

On average, you’ll be disappointed if you buy mutual funds for index-beating returns, says Rob Carrick, columnist for The Globe and Mail.

Note the key word: average. When you look at average fund returns in a particular category, smart fund managers get lumped together with their inferiors into a mass of mediocrity. For periods of three years or longer, there’s hardly a time frame measured by Globeinvestor.com in which average Canadian, US, and international equity funds beat their respective benchmark indexes.

If you can’t be confident about beating the index, isn’t it better to buy the index through an exchange traded fund or index mutual fund? That’s a sensible approach, and one I use myself. But let’s not be hasty in dismissing mutual funds until we see how the performance of the industry’s A-Team matches up against indexing.

We’ll use the Analyst Picks list from the independent fund analysts at Morningstar Canada to build our A-Team roster. There are 42 Analyst Picks mutual funds that combine attributes such as low or reasonable fees, a consistent investing strategy, strong long-term performance, and protection in down markets.

In making this list shorter and more manageable, we can also address one of the main objections to mutual funds that index investing purists have. They concede that in any given year or any given time frame, some mutual funds will outperform the index. The problem is in repeating this feat. Past returns are no guarantee of future success and, all too frequently, today’s hot performers tend to lag the pack in the future.

One way to work around the concern about past success being repeated is to look for mutual funds that are run by firms with a proven, consistent, team-oriented approach that transcends any one individual. Morningstar fund research chief David O’Leary went through the Analyst Picks list looking for funds such as these and came up with the 21 names that will be known as the A-Team for this exercise.
A basic test of a mutual fund manager’s ability is to compare his or her returns to the appropriate stock or bond index. But that’s an overly simplistic approach because it doesn’t reflect the cost of owning an index-tracking exchange traded fund or index mutual fund.

So let’s compare the A-Team funds against returns for their benchmarks minus a small amount to represent the fee charged by comparable ETFs. That way, we get to look at real-world costs for indexing.

Now let’s tally up how the mutual fund A-Team did overall. Long-term returns are what matter most, so let’s use the ten-year numbers to decide whether each fund on the team has won out over indexing (we’ll use five years for funds that haven’t been around for a decade). The final tally is a solid win for funds—16 cases of index-beating returns to five where returns lagged the index. Click here for the full breakdown of the results.

The dominance of funds wasn’t overwhelming. A few funds on the list—examples include CI Signature Select Canadian, Ethical Special Equity, Mawer Canadian Equity and Trimark Fund SC, were index beaters strictly on the basis of  ten-year returns. For all other time frames measured here, they lagged the index.

Still, the overall performance of the A-Team is a striking contrast to the average return data that is typically used to compare mutual funds to index investing. Take the Canadian equity category, for example. The average mutual fund in this category has lagged the S&P/TSX composite total return index (includes dividends) over the one-, two-, three-, four-, five-, 10-, 15- and 20-year periods to Dec. 31. Over the past 10 years, the average fund made 5.2% and the index made 6.6%.

If you discount the index return by 0.25% to reflect the cost of owing an ETF, you still end up with an annualized return that beats the average fund by 1.15 percentage points. That’s worth an extra $1,907 on a $10,000 investment over 10 years.

Now check out Beutel Goodman Canadian Equity D, one of the A-Team’s Canadian equity funds. It doesn’t win every time frame measured here, but it’s highly competitive on the whole and delivers much less volatility than both the average peer fund and the S&P/TSX composite index.

Global equity funds happen to be a category where average returns have been quite competitive with the index over both the short and long term. The average tne-year loss in the category was 1%, compared to 1.3% for the index. Add the cost of buying into a global ETF and you have a loss that gets close to 2%.

It follows, then, that the mutual fund A-Team has several members in good standing in the global category. Take Mackenzie Ivy Foreign Equity, which lagged the index in 2010 and has trounced it otherwise.

The idea behind indexing is to hedge the risk that you’ll end up in the hands of some deadhead mutual fund manager who’d be better off running a community bingo hall. You give up the chance of beating the index in order to cover off the substantial risk that you will underperform the index.

The mutual fund A-Team shows there’s a viable alternative to indexing for investors. You have to dig for it, though, because the average mutual fund too often bows to the index.

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