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Beware, the Investing industry is conflicted!

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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 

Upton Sinclair, American writer & social reformer, 1935; Goodreads

If you want to know how to invest and which stocks or funds to invest in, who do you look to for help? The obvious answer, you might assume, is to ask an expert professional. After all, you would probably consult a doctor if you were worried about your health, or a lawyer if you faced a pressing legal issue.

But it’s not that simple with investing. The problem is that, although there’s no shortage of professionals only too happy to advise you, identifying someone who’s a genuine expert and, crucially, has your interests at heart is far more tricky than you might imagine.

The bottom line is that, no matter how professional we like to think we are, almost all of us have conflicts of interest, and it’s a particularly serious issue in the financial sector.

Can you trust an advisor?

Let’s start with financial advisors. As with every profession, there are good advisors and not-so-good ones. In my experience, even advisors who don’t dispense the best advice generally mean well. But advisors are only human, and if they’re incentivized to recommend a certain course of action, that’s what most will recommend — even if it’s not the best advice for the client.

Take actively managed funds, for example. The evidence is overwhelming that only a very small proportion of active funds beat the market in the long run. Therefore most investors are better off avoiding them, using low-cost passive funds instead, and resisting the temptation to buy and sell. And yet it is still extremely common for advisors in Canada to recommend active investing.

So why is that? Well, the simple answer is that advisors are often paid more money if their clients use active funds. Many advisors, for example, are paid through commissions from mutual fund companies, typically in the form of a trailing commission, or recurring payment, for as long as the client holds the fund. Actively managed mutual funds tend to have significantly higher expense ratios than passive funds, and these include a portion dedicated to advisor compensation.

Other advisors are employed by banks or other large financial institutions which offer their own actively managed funds. These advisors are usually incentivized through sales targets, bonuses or company performance metrics to sell in-house products.

Research links conflicts to poorer outcomes

There have been several studies over the last ten years into the effects of financial incentives on the types of investment Canadian advisors recommend.

One study, entitled The Misguided Beliefs of Financial Advisors, showed how Canadian advisors often steer clients into high-fee active funds, and encourage them to trade too often — both of which usually lead to lower long-term returns. (Surprisingly, the study showed that advisors often made the same mistake with their own money, but that’s another story!)

A 2016 study by the Ontario Securities Commission called Missing the Mark: Behavioural Insights and Investor Decision-Making, found that clients tend to trust their advisors’ recommendations without questioning the potential conflicts of interest arising from commission-based compensation.

The Canadian Securities Administrators (CSA), which regulates securities markets in Canada, has produced and commissioned a number of studies on this subject. The findings have been broadly consistent, namely that advisors are more likely to recommend funds that paid higher commissions, and that such commissions often lead to inferior investment outcomes, compared to cheaper products with similar risk-return profiles.

In response to such findings, the CSA and other regulators have introduced measures to improve fee transparency and address conflicts of interest in financial advice. However, concerns remain about whether these changes are sufficient to protect investors from biased recommendations.

What about DIY investment options?

Of course, you don’t need to go through a financial advisor. Some investors choose to use self-directed investing platforms, such as RBC Direct Investing, TD Direct Investing, BMO InvestorLine or CIBC Investor’s Edge. But these platforms may also have incentives to promote active funds over low-cost index funds or ETFs. 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…