Tag Archives: indexing

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 Investors should know about ADRs and CDRs, and their Fees

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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…

My Own Advisor’s Top 5 Stocks

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By Mark Seed, myownadvisor

Special to Financial Independence Hub

Over the years of running this site, I have received numerous requests to share everything in my portfolio. For today’s post, I will reveal a bit more to help other DIY investors out since they are curious: what are my top-5 stocks?

Read on for this update including what has changed over the last year in this pillar post!

My Top-5 Stocks

As I approach 15 years as a DIY investor, a hybrid investor no less, we inch closer to our semi-retirement dream. Long-time subscribers will know we’ve always had two major financial goals to achieve as part of that journey:

1. Own our home.

Well, that goal is done!

You can read about our journey to mortgage-freedom / debt-freedom here below.

2. Beyond two workplace pensions, beyond our future CPP or OAS benefits, beyond any future part-time work – another big goal was for us to own a $1 million dollar investment portfolio for retirement.

Well, we accomplished that as well a few years ago.

We’ve actually been investing beyond that goal for some time only until recently – which I outlined in this Financial Independence Budget update.

Our investing goals have been accomplished using a hybrid investing approach – something that might appeal to you as well:

  • Approach #1 – we own a number of Canadian dividend-paying stocks for income and growth. We have essentially unbundled a Canadian dividend ETF for income and growth – and built our own ETF – without any ongoing money management fees.
  • Approach #2 – we own a few low-cost ETFs that focus on growth. We believe it is wise to invest beyond Canada for growth/diversification and so we do via a few low-cost ETFs like XAW and QQQ in particular. Our U.S. stocks are down to a handful now and potentially less over time in favour of those ETFs above.

A bias to getting paid – my top-5 stocks

With a bias to getting paid and getting more raises over time as a shareholder, we own a few stocks in particular. Before sharing my top-5 stocks, some highlights why DIY investing works for me.

1. Fees are forever.

With investing you usually get what you don’t pay for.

Based on all the information available today, to buy an index fund in particular, I don’t believe you need a money manager to perform indexing work on your behalf. That decision is up to you of course.

2. I/we control the portfolio.

Ultimately nobody cares more about your money than you do.

I run my site to help pay forward my successes but also share what’s not working. I have no problems admitting I am not perfect. I make investing mistakes. Most people do. Via my site, I share those lessons learned so you don’t have to make them. While there is no perfect portfolio you can design a portfolio that should meet many of your needs over time. Many DIY investors, readers here, have learned that sustainable dividend and distribution income is one such path to financial independence. In some cases, these DIY investors have been investing long enough that their portfolio income now exceeds their expenses – some of them earning over $100,000 per year from their portfolio after decades of investing. They’ve learned that the power of compounding is an incredible force if left uninterrupted. These DIY investors manage their investments based on their income objectives.

I simply hope to follow the same formula. 🙂

Given I control our portfolio, I feel I can manage our investments aligned to our objectives. A reminder about my free e-book below:

  • Chapter 1: Spend less than you make and invest the difference. Invest in mostly low-cost products. Strongly consider diversifying your investments including stocks from different sectors and countries that pay dividends and offer growth.
  • Chapter 2: Avoid active trading. Celebrate falling stock prices – buy more when they fall in price.
  • Chapter 3: Disaster-proof your life with insurance, where needed, to cover a catastrophic loss. Otherwise, keep investing and just keep buying.
  • Book conclusion: Read Chapters #1-3 and rinse and repeat for the next 30 years. Retire wealthy.

That’s the basics within 80,000+ personal finance books in just four bullets. 🙂

As a DIY investor I believe you have some powerful decisions most money managers will never possess:

  1. A money manager has to demonstrate value by trading. Otherwise, why use them when you can buy your own quality stocks or indexed funds instead?
  2. Money managers usually need approval for their transactions. Instead, you can decide when to celebrate lower prices to get your stocks on sale without another manager, director or VP-scrutiny involved.

To paraphrase the index investing community, with no way to consistently identifying manager performance ahead of time, there is very little chance of finding any money manager who after fees charged to clients can consistently best a basic index fund performance over the long-haul.

There are simply too many low-cost, diversified, easy-to-own ETF choices to build wealth with. As a DIY investor, you don’t ever have to pay someone else to do your work for you.

In the spirit of going it alone, doing it yourself and being accountable for your own results, I feel my hybrid approach offers the best of both worlds:

  • In Canada, we own many of the top-listed stocks in the TSX 60 index for income and growth.
  • Beyond Canada, beyond a few U.S. stocks, we use indexed ETFs for extra diversification.

We fired our money manager years ago and have never looked back … that approach might work for you too.

Without further delay, here are our top-5 stocks in our portfolio by portfolio weight current to the time of this post.

My Top-5 Stocks

1. Royal Bank (RY)

Since publishing the original post in fall of 2023, I can share that Royal Bank of Canada (RY) remains our largest single stock holding. About 4-5% of the total portfolio. We’ve owned RY for many years – profiled here.

Here are the returns compared to one of my favourite low-cost ETFs (XIU) for comparison:

Royal Bank September 2023

All images/sources with thanks to Portfolio Visualizer. 

 

2. TD Bank (TD)

While the management team at TD is certainly due for some changes, I will disclose that TD is our second largest stock position at the time of this post. Like RY, we’ve owned TD for many years – profiled here – as early as 2009.

Again, returns for comparison purposes:

TD Bank September 2023

Banking is just one important sector in our Canadian economy. Fortis owns and operates multiple transmission and distribution subsidiaries in Canada and the United States, serving a few million electricity and gas customers.

Last time I checked, just like people need to bank or borrow money (see the desire for us to own banks!) folks love electricity and power.

I own Fortis for steady dividend income and some capital gains. I started my ownership in Fortis also back in 2009. You can read about that here.

Again, historical returns for context:

Fortis September 2023

Our Canadian stock market operates in an oligopoly, meaning there are a few dominant players controlling the market. We see this in banking, utilities, and it continues with our telco industry. As a shareholder, Telus has been focused on expansion in recent years but in doing so has also taken on some debt in the process. The share price has lagged. With interest rates due to come down further over the coming 24 months, I believe Telus is a great buy to add more to my portfolio.

You can read about when I started buying Telus here.

Again, returns for comparison purposes:

Telus September 2023

5. Canadian Natural Resources (CNQ)

Following the stock split and rise in share price, CNQ continues to be a stock on the rise in my portfolio.

I’ve been a CNQ shareholder for many years – the evidence is here since 2013.

Again, some recent returns for comparison purposes current to 2024:

CNQ vs. XIU August 2024

My Top-5 Stocks Summary

You’ll notice a few things in this post. Continue Reading…

7 Leaders reveal their favorite Index Funds for Financial Independence

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Photo by Mikhail Nilov on Pexels

 

In the quest for Financial Independence through savvy investing, we’ve gathered insights from Presidents and CEOs to share their top index fund picks.

From choosing a high-dividend yield ETF to recommending a total stock market index fund, explore the seven expert recommendations that could pave your path to financial freedom.

 

 

  • Choose High-Dividend Yield ETF
  • Suggest Vanguard Total Stock ETF
  • Prefer Zero Fee Total Market Fund
  • Select Australian-Domiciled International ETF
  • Opt for Monthly Distribution Index
  • Pick Broad-Market S&P 500 ETF
  • Recommend Total Stock Market Index Fund

Choose High-Dividend Yield ETF

My go-to for building Financial Independence has got to be the Vanguard High-Dividend Yield ETF. A lot of folks who’ve made it to FIRE (Financial Independence, Retire Early) live off dividends, and if that’s your goal, this ETF is worth considering. It sports a yield of 3.65% and keeps costs low with an expense ratio of just 0.06%. The fund aims to mirror the performance of the FTSE High-Dividend Yield Index.

It’s packed with stocks known for higher-than-average yields. You won’t find many fast-growing tech stocks here because those companies usually reinvest their profits into growth rather than paying out dividends. Instead, the ETF focuses on older, established companies with a strong history of profitability. As of the last update, the top five holdings included big names like Johnson & Johnson, JPMorgan Chase, Procter & Gamble, Verizon Communications, and Comcast.

While it might not match the S&P 500 in terms of rapid growth or impressive returns, the stability and consistent income it offers can be a major advantage, especially if you’re looking for reliable dividend income. — Eric Croak, CFP, President, Croak Capital

Suggest Vanguard Total Stock ETF

As a CFO, I recommend index funds like the Vanguard Total Stock Market ETF (VTI) for building long-term wealth. It provides broad exposure to over 3,600 U.S. stocks with an ultra-low expense ratio of 0.03%. 

Over the past 25 years, the total U.S. stock market has returned over 9% annually. While volatile, for long-term investors, index funds are a simple, low-cost way to earn solid returns. I have leveraged index funds in my own portfolio and for clients to build wealth over time. 

Vanguard’s scale and expertise allow for minimal costs and maximum tax efficiency. For small or large portfolios, VTI should be a core holding. For clients aiming to retire early or build wealth, low-cost broad market exposure is the most effective strategy. Total U.S. stock market funds provide the broadest, most diversified exposure available. — Russell Rosario, Owner, RussellRosario.com

Prefer Zero-Fee Total Market Fund

The Fidelity Zero Total Market Index Fund is my top pick for building Financial Independence. It covers the full spectrum of the U.S. market without charging any management fees, which means your investment grows faster without extra costs. This fund’s wide exposure to both established and emerging companies helps balance risk and reward. For anyone serious about long-term growth, it’s a great tool to steadily build wealth over time. — Jonathan Gerber, President, RVW Wealth Continue Reading…

Active or Passive Investing: Which is Best?

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Image courtesy Justwealth

By Robin Powell, The Evidence-Based Investor*  

Special to Financial Independence Hub

* Republished from the Just Word Blog from Robin Powell, the U.K.-based editor of The Evidence-Based investor and consultant to investors, planners & advisors  

There are broadly two types of investing: active and passive investing. Active investors try to beat the market by trading the right securities at the right times. Passive investors simply try to capture the market return, cheaply and efficiently. So which approach is better?

Instinctively, most people who haven’t looked into the issue in any detail tend to assume that active investing is superior. After all, the thinking goes, it’s surely preferable to be doing something to improve your investment performance, instead of just accepting whatever return the market offers. Active investing has certainly been much more popular than passive in the past.

But if you look at the evidence, you’ll see that over the long run, most mutual fund managers have underperformed passively managed funds.

S&P Dow Jones Indices keeps a running scorecard of active fund performance in different countries, including Canada, called SPIVA. It consistently shows that, regardless of whether they invest in equities or bonds, most active managers underperform for most of the time.

The latest SPIVA data for Canada were released a few weeks ago, and they chart the performance of active funds up to the end of December 2023. What the figures show is that the great majority of funds have lagged the relative index once fees and charges are factored in, especially over longer periods of time.

Underperformance over ten years is even more pronounced. For example, 98.04% of Canadian Focused Equity funds, 97.56% of U.S. Equity funds and 97.60% of Global Equity funds underperformed the benchmark. Remarkably, on a properly risk-adjusted basis, not a single U.S. Equity fund domiciled in Canada beat the S&P 500 index over the ten-year period.

In fact, fund managers have found it so hard to outperform that, of the funds that were trading at the start of January 2014, just 61.33% of them were still doing so at the end of December 2023. That’s right, almost four out of ten funds failed to survive the full ten years.

Of course, it might still be worth investing in an active fund if you knew in advance that it’s likely to be one of the very few long-term outperformers. The problem is that predicting a “star” fund ahead of time is very hard to do, and past performance tells us very little, if anything, of value about future performance.

To illustrate this point, the SPIVA team examined the persistence of funds available to Canadian investors. Among Canadian-based equity funds that ranked in the top half of peer rankings over the five-year period to the end of December 2017, only 45% remained in the top half, while 55% fell to the bottom half or ceased to exist, at least in their own right, in the following five-year period.

To be clear, I’m not saying that active managers in Canada are any less competent than their counterparts in other countries. What the SPIVA analysis shows is that managers all over the world struggle to add any value whatsoever after costs. Distinguishing luck from skill in active management is notoriously difficult, but the proportion of funds that beat the markets in the long run is consistent with random chance.

Why do so few active managers outperform?

So why is active fund performance generally so poor? The most important reason is that beating the market is extremely difficult. Why? Because the financial markets are highly competitive and very efficient. Never before have investors had so much information at their disposal. New information is made available to all market participants at the same time, and prices adjust accordingly within minutes, or even seconds.

In the short term, then, prices move up and down in a random fashion. So, identifying a security that is either underpriced at any one time is a huge challenge.

Another reason why active fund performance tends to be so disappointing is that active managers incur significant costs. Salaries, research, marketing, the cost of trading and so on: all of these things need paying for, and it’s the investor who picks up the tab. Once all these costs are added together, they present a very high hurdle for fund managers. Simply put, any outperformance they succeed in delivering is usually wiped out by fees and charges. Continue Reading…