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The (Passive) Barbarians at the Gate

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Image courtesy Outcome/CC BY 2.0

By Noah Solomon

Special to Financial Independence Hub

Well, I won’t back down
No I won’t back down
You could stand me up at the gates of Hell
But I won’t back down

No I’ll stand my ground
Won’t be turned around
And I’ll keep this world from draggin’ me down
Gonna stand my ground
And I won’t back down

– Tom Petty ©Emi Music Publishing

The (Passive) Barbarians at the Gate

Since 2008, there has been a major shift from actively managed funds into passive, index-tracking investments. During this time, more than $1 trillion has flowed from actively managed U.S. equity funds into their passive counterparts, which have increased their share of the U.S. investment pie from under 20% to over 40%.

The Efficient Market Theory and Active Management: Why Bother?

The theory underlying passive investing is the efficient-market hypothesis (EMH), which was developed in the 1960s at the Chicago Graduate School of Business. The EMH states that asset prices reflect all available information, causing securities to always be priced correctly, thereby making markets efficient. By extension, it asserts that you cannot achieve higher returns without assuming a commensurate amount of incremental risk, nor can you reduce risk without sacrificing a commensurate amount of return. In essence, the EMH contends that it is impossible to consistently “beat the market” on a risk-adjusted basis. When applied to the decision to hire an active manager rather than a passive index fund, the EMH can be neatly summarized as “why bother?”

It might seem that, as an active manager, I am shooting myself in the foot by pointing out the success of passive investing at the expense of its active counterpart … but bear with me for the punchline.

Bogle’s Folly & Not Backing Down

The first index funds were launched in the early 1970s by American National Bank, Batterymarch Financial Management, and Wells Fargo, and were available only to large pension plans. A few years later, the Vanguard First Index Investment Fund (now the Vanguard S&P 500 Index Fund), was launched as the first index fund available to individual investors. The fund was the brainchild of Vanguard founder Jack Bogle, who believed that it would be difficult for actively managed mutual funds to outperform an index fund once their costs and fees were subtracted from returns. His goal was to offer investors a diversified fund at minimal cost that would give them what he called their “fair share” of the stock market’s return.

In its initial public offering, the fund brought in only $11.3 million. Vanguard’s competitors referred to the fund as “Bogle’s Folly,” stating that investors wanted nothing to do with a fund that, by its very nature, could never outperform the market. To the benefit of the investing public, Bogle did not back down. Vanguard currently manages over $9 trillion in assets, the bulk of which is in index funds and exchange-traded funds. Importantly, approximately half of all assets managed by investment companies in the U.S. are invested in Bogle’s Folly and its descendants.

Bogle permanently changed the investment industry. Any investors can purchase shares of low-cost index funds in almost every global asset class. At Berkshire Hathaway Inc.’s 2017 annual meeting, Buffett estimated that by making low-cost index funds so popular for investors, Bogle “put tens and tens and tens of billions of dollars into their pockets.” According to Buffett, “Jack did more for American investors as a whole than any individual I’ve known.”

The Numbers Don’t Lie: Hype vs. Reality

In most cases, the long-term evidence makes it hard to strongly disagree with the EMH, and by extension to advocate for active over passive management. Specifically, active management has by and large failed to deliver.

  • According to S&P Global, 78.7% of U.S. active large-cap managers have underperformed the S&P 500 Index over the past five years ending December 31, 2023.
  • A $10 million investment in the index made at the end of 2018 would be worth $20,724,263 five years later, as compared to an average value for active managers of $18,481,489, representing a shortfall of $2,242,774 vs. the index.
  • Extrapolating the different rates of return of the index and active managers for another five years, the average shortfall of active managers increases from $2,242,774 to $8,792,966. After 20 years, the difference grows by an additional $59,006,123 to $67,799,089.

The Canadian experience has been similarly damning:

  • According to S&P Global, 93.0% of Canadian equity managers have underperformed the TSX Composite Index over the past five years ending December 31, 2023.
  • A $10 million investment in the index made at the end of 2018 would be worth $17,079,526 five years later, as compared to an average value of $15,217,594 for active managers, representing a shortfall of $1,861,932 vs. the index.
  • Extrapolating the different rates of return of the index and active managers for another five years, the average shortfall of active managers increases from $1,861,932 to $6,013,505. After 20 years, the difference grows by an additional $25,454,288 to $31,467,793.

Given these dire statistics, it is no wonder that swaths of institutional and individual investors have migrated from active management to passive investing. Investors have been getting the message that the proclaimed advantages of active management are more hype than reality.

Acceptable Failure, Unacceptable Failure & Michael Jordan

Legendary basketball superstar Michael Jordan stated, “I can accept failure, everyone fails at something. But I can’t accept not trying.” Relatedly, within the sphere of active management it is imperative to discern between what I refer to as sincere and disingenuous underperformers.

Sincere underperformers try their level best to outperform (an “A” for effort scenario). These active efforts entail expenses that passive funds do not face, such as paying investment professionals to analyze companies with the goal of identifying stocks that will outperform. These extra costs must be passed on to investors, resulting in higher fees than passive vehicles. In contrast, disingenuous underperformers are not truly trying to outperform. Their portfolios more or less replicate their benchmark indexes. Such funds, which are pejoratively referred to as “closet indexers”, are charging active management fees for doing something that investors could do for a fraction of the cost by investing in an index fund or ETF – good work if you can find it!

An academic study titled, “The Mutual Fund Industry Worldwide: Explicit and Closet Indexing, Fees, and Performance,” determined the pervasiveness of closet indexers across a sample of developed countries. Out of the 20 countries included in the study, Canada ranked highest in terms of its percentage of purportedly active mutual fund assets that are actually invested in closet index portfolios. Every year, billions of dollars in fees are unjustifiably being charged to investors.

Don’t Throw the Baby Out with the Bathwater

Although the historical data clearly indicate that the vast majority of managers have underperformed their benchmarks, this is not universally the case. Although few and far between, there are managers who have outperformed, either in simple terms, in risk-adjusted terms, or both.

According to S&P Global, 93.9% of Canadian dividend-focused funds have underperformed over the past five years. In sharp contrast, the algorithmically driven Outcome Canadian Equity Income Fund has outperformed the iShares TSX Dividend Aristocrats Index ETF (symbol CDZ) by 13.1% since its inception nearly six years ago in October 2018. A $10 million investment in the OCEI fund made at its inception would have a value of $$17,731,791 as of the end of last month, as compared to a value of $16,426,492 for the iShares TSX Dividend Aristocrats Index ETF. Importantly, the fund has achieved these higher returns while exhibiting significantly less volatility and shallower losses in declining markets. In combination, the fund’s higher returns and lower volatility have enabled it to achieve a risk-adjusted return (Sharpe ratio) that is 49.9% higher than its benchmark.

Noah Solomon is Chief Investment Officer for Outcome Metric Asset Management Limited Partnership.  From 2008 to 2016, Noah was CEO and CIO of GenFund Management Inc. (formerly Genuity Fund Management), where he designed and managed data-driven, statistically-based equity funds.

Between 2002 and 2008, Noah was a proprietary trader in the equities division of Goldman Sachs, where he deployed the firm’s capital in several quantitatively-driven investment strategies. Prior to joining Goldman, Noah worked at Citibank and Lehman Brothers. Noah holds an MBA from the Wharton School of Business at the University of Pennsylvania, where he graduated as a Palmer Scholar (top 5% of graduating class). He also holds a BA from McGill University (magna cum laude).

Noah is frequently featured in the media including a regular column in the Financial Post and appearances on BNN. This blog originally appeared in the August 2024 issue of the Outcome newsletter and is republished here with permission. 

What is Quality Investing?

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As consumers we prefer higher quality things, and with stocks it may be no different. Learn why Quality may be important to investors.

Image courtesy BMO ETFs/Getty Images

By Erin Allen, Vice President, Direct Distribution, BMO ETFs

(Sponsor Blog)

Quality is a very familiar concept in society. As we know, an item can’t be judged on price alone. If one shirt costs $10, versus another that costs $30, does this mean the cheaper shirt is better based on price alone?  Most likely not, as what matters is the quality of the shirts, and how it will perform in the future!

In investing, Quality is no different. It starts with a base assumption that all stocks aren’t created equal, some are going to be higher quality than others, and as a result may enjoy better risk-adjusted returns. As consumers we prefer higher-quality things, and with stocks it is no different. Indeed, higher-quality stocks have historically shown benefits to investors, outperforming over time.[1]

What makes a company a quality company?

There are different approaches to identifying Quality, with associated pros and cons. Warren Buffett prefers to look for companies with “competitive moats” and companies that exhibit earnings power in excess of its peers. If a business model is easily replicated, one would expect copycats to soon enter, and drive down profitability.  Companies with competitive moats have advantages that competitors find difficult to touch, and would be considered higher quality. Many fundamental investors have a Quality screen in place and will also often look for high-quality management teams, which are assessed by in-person meetings, and other heuristics.

Quality can also be defined by assessing financial metrics in a consistent and disciplined approach. This is an approach BMO GAM has taken for the ETFs listed below, using the MSCI index which BMO’s Quality ETFs are based. Three metrics are assessed: ROE (Return on Equity), Leverage (Debt to Equity), and Earnings stability (the consistency of earnings through time). Having discipline, and a regular rebalancing schedule to assess and make changes, is of tremendous benefit in investing, to mitigate the role of emotion and behavioural biases, and to ensure the portfolio remains on plan, and true to its intended exposure.

ROE – This is a measure of profitability. Companies with higher profitability are winners in their respective industries. In investing, while things do evolve over time, winners tend to remain winners*1. Higher profitability is a good signal a company has a high-Quality business model.

Low Leverage – High Quality companies tend to be cash rich, from driving solid and consistent business results. Apple is a great example, as it is currently sitting on over US$60 billion of cash and short-term investments2. In short, Quality companies often have less need for debt, so BMO GAM screens for companies with less debt overall.

Earnings Stability – Companies with strong competitive advantages tend to have more consistent earnings streams, as competitors find it difficult to take a “bite out of their lunch.” Quality companies tend to show their merits in earnings consistency through time.

When does Quality tend to perform well, and when may it lag?

Quality companies tend to have a risk level at or slightly below broad markets, and can participate in growth, while maintaining a measure of defensiveness should volatility in markets increase.  Investing in higher-profitability stocks tends to give the quality exposure a growth flavour, while in negative equity markets quality stocks will often be preferred due to their strong overall balance sheet strength, with less debt and more consistent earnings. As well, higher interest rate environments tend not to be as much a concern for quality companies, as their debt levels are lower and they are less exposed to higher interest rate impacts.3

Performance wise, like all factors, Quality is best evaluated versus broad market performance through the entire market cycle, or market cycles. However, as a generalization, Quality stocks tend to do well in growth markets. In very strong bull markets Quality stocks tend to participate well, but higher risk/lower quality stocks may outperform when investors are the most exuberant and take on more risk.  In backdrops with higher market volatility, Quality tends to outperform, as company fundamentals and balance sheet strength matter. These are general historical performance trends, and performance in specific market scenarios may vary.

The chart below illustrates factor performance over the past 10 years which shows quality outperforming in many years.

Other considerations

Implementing a quality exposure in your portfolio leads to sector differences and security differences versus the broad index. For example, in the U.S., Quality tends to overweight Technology companies, as many of these companies fit the bill of high profitability/low debt/consistent earnings, and underweight other sectors such as Consumer Discretionary, where the metrics are not as strong. Continue Reading…

Retired Money: Taking RetireMint for a test spin

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My latest MoneySense Retired Money column has just been published: you can find the full column by clicking on the highlighted headline here: What is RetireMint? The Canadian online platform shows retirement planning isn’t just about finances.

We provided a sneak preview of RetireMint late in August, which you can read here: Retirement needs a new definition. That was provided by RetireMint founder Ryan Donovan.

The MoneySense column goes into more depth, passing on my initial experiences using the program, as well as highlighting a few social media comments on the product and some user experiences provided by RetireMint.

RetireMint (with a capital M, followed by a small-case letter I rather than an e) is a Canadian retirement tool that just might affect how you plan for Retirement. There’s not a lot of risk as you can try it for free. One thing I liked once I gave it a spin is that it isn’t just another retirement app that tells you how much money you need to retire. It spends as much or more time on the softer aspects of Retirement in Canada: what you’re going to do with all that leisure time, travelling, part-time work, keeping your social networks intact and so on.

In that respect, the ‘beyond financial’ aspects of RetireMint remind me of a book I once co-authored with ex corporate banker Mike Drak: Victory Lap Retirement, or indeed my own financial novel Findependence Day. As I often used to explain, once you have enough money and reach your Financial Independence Day (Findependence), everything that happens thereafter can be characterized as your Victory Lap.

As Donovan puts it, this wider definition must “break free from the tethered association of solely financial planning.”

Donovan says roughly 8,000 Canadians will reach retirement every single week over the next 15 years. And yet more than 60% of them do not know their retirement date one year in advance, and more than a third will delay their retirement because they don’t have a plan in place.

Retirement not calendar date or amount in your bank account

Donovan says  “Retirement has become so synonymous with financial planning, and so associated with ‘old age,’ that they’re practically inseparable. Yet, in reality, retirement is a stage of life, not a date on the calendar, an amount in your bank account, and is certainly not a death sentence.” He doesn’t argue that financial planning is the keystone of retirement preparation, as “you won’t even be able to flirt with the idea of retiring without it.” But it’s much broader in scope than that. As he puts it, this wider definition must “break free from the tethered association of solely financial planning.” Continue Reading…

Real Estate Investments for Findependence

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Commercial Real Estate: Image via Pexels: Brett Sayles

By Devin Partida

Special to Financial Independence Hub

Real estate is a powerful investment tool for anyone looking to build wealth and achieve Findependence [Financial Independence], especially in the U.S. and Canada. It offers the potential for passive income, long-term growth and significant tax advantages, making it an attractive option for many investors.

It is crucial to understand the different types of real estate investments — such as residential, commercial and short-term rentals — and how they align with market trends in North America to make the most of this opportunity. Each type comes with risks and rewards, but real estate can be fundamental to a diversified and profitable investment portfolio when approached strategically.

The Role of Real Estate in Diversified Portfolios

Real estate provides a sense of stability that many investors find appealing, especially when compared to the volatility of the stock market and the impact of inflation in the U.S. and Canadian markets. One-third of Americans view real estate as the best long-term investment, even above stocks, gold, savings accounts or bonds.

Balancing properties with traditional investments like stocks and bonds can enhance financial stability and create a more resilient portfolio. However, understanding regional market trends is essential — particularly in high-demand areas like New York, Los Angeles or Toronto — where property values increase steadily. Being informed about these markets allows investors to make practical decisions that support their long-term goals.

Types of Real Estate Investments

Several investment options are available when building wealth through real estate. Here are different types to help investors choose the right path:

Residential Properties

Residential spaces — including single-family homes, duplexes and condos — are popular investment options for those aiming to generate rental income. Investors can also take advantage of property appreciation through this method, especially in fast-growing areas like the suburbs of Toronto, Vancouver or Austin. While the potential for returns is strong, they must consider risks like fluctuating home prices, tenant turnover and maintenance expenses.

One factor to consider is reviewing any restrictive contracts — particularly in spaces with homeowners’ or condominium associations — because these can limit how the space is used. For example, some groups have strict rules about short-term rentals, which can affect an investor’s ability to maximize returns.

Commercial Properties

Commercial properties generally provide investors with the opportunity for longer-term leases and higher rental income than their residential counterparts. Additionally, they can take advantage of tax breaks and deductions — such as depreciating the property over 39 years — which can reduce taxable income. These factors make buying and improving commercial spaces attractive for investors looking to maximize their returns.

However, these investments come with risks, including economic downturns that may affect tenants and the added complexities of managing larger spaces. For those willing to navigate these challenges, commercial real estate can be rewarding to a diversified investment strategy.

Real Estate Investment Trusts (REITs)

REITs provide an accessible way to invest in large-scale commercial properties without needing direct ownership. They’re great options for those seeking regular dividends and diversified exposure.

While REITs offer attractive returns, investors have very little control over individual properties. A recent example of market impact is the decline in the market cap of Canadian REITs, which fell from nearly $59 billion in 2021 to just $38.2 billion in 2023. Despite these risks, they remain popular for those looking to enter commercial real estate quickly.

Expert Tips for Maximizing Returns

Managing a property investment requires careful planning and strategy to maximize returns. Here are tips to help investors stay ahead and ensure long-term success: Continue Reading…

What Investors should know about ADRs and CDRs, and their Fees

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Deposit Photos

Recently one of our Inner Circle members asked, “You mentioned recently that TSI recommends a handful of ADRs (American Depositary Receipts) providing exposure to European and Japanese stocks. One question: What are the ADR fees charged to investors by U.S.-listed ADRs?”

An American Depositary Receipt, or ADR, is a proxy for a foreign stock that trades in the U.S. and represents a specified number of shares in the foreign corporation. ADRs are bought and sold on U.S. stock markets, just like regular stocks, and are issued or sponsored in the U.S. by a bank or brokerage firm. If you own an ADR, you have the right to obtain the foreign stock it represents. However, investors usually find it more convenient to continue to hold the ADR.

One ADR certificate may represent one or more shares of the foreign stock. Or, if the stock is expensive, the ADR may represent a fraction of a share; that way the ADR will start out trading at a moderate price or be in the range of similar securities on the exchange where it trades.

The price of an ADR is usually close to the price of the foreign stock in its home market. There are no redemption dates on ADRs.

When an investor owns an ADR, a custodian — Citi, Bank of New York Mellon, and J.P. Morgan Chase are among the largest — is in charge of holding it. The custodian also maintains the records and collects the dividends paid out by the foreign issuer. It then converts those payments into U.S. dollars and deposits them into stockholders’ accounts. For all these services, the custodian charges an ADR fee.

The custodian may deduct that ADR fee from the dividends, or it may charge the ADR holder separately. If the ADR doesn’t pay a dividend, the custodian will charge the ADR fee directly to the brokerage, which in turn will charge it to a client’s account.

We feel you can find all the foreign investment variety and exposure you need by confining your purchases to U.S. and Canadian stocks, plus low-fee ETFs (exchange traded funds). However, if you want to invest in a particular foreign stock, it’s generally more convenient and economic to hold ADRs of foreign stocks, rather than the foreign stocks themselves.

Bonus: What are CDRs?

CIBC

While I’m on the topic, some investors confuse ADRs, with CDRs. Canadian Imperial Bank of Commerce (CIBC)’s Canadian Depository Receipts (CDRs) give investors the opportunity to buy shares and/or fractions of shares in any of a number of U.S. or other foreign companies, in bundles that start out trading at a price of about $20 Cdn. each. CDRs come with a built-in hedging feature that reduces exchange-rate fluctuations. This feature costs you 0.60% of your investment yearly.

CDRs let you invest small sums in U.S. or other foreign stocks, some of which have exceptionally high per-share prices. (For instance, Nvidia currently trades for $610 a share.) Note, though, that with highly liquid stocks like Nvidia, or the other shares underlying CIBC’s CDRs, investors can easily buy, say, just one or two shares if they want. Continue Reading…