Mutual Funds Institute Ham-Handed Research Hurts Own Cause

Mutual funds in Canada have been under fire for their high fees and under-performance (hat tip to Canadian Capitalist). The industry body, the Investment Funds Institute of Canada has been attempting to shoot back at mutual funds' main competitor, ETFs. But its latest sloppy and slapdash salvo in the form of the July 2011 report Active and Passive Investing does more to discredit the IFIC and its cause than to help it. How so?

1) Consider the publication of the report itself. Is it secret or not?

• Not Secret - Though I received a copy from Ken Kivenko of CanadianFundWatch.com (thanks, Ken) who forwarded the email attaching it sent out under the signature of IFIC CEO Joanne De Laurentiis.
  
• Secret - The IFIC original email has the warning at the bottom "This e-mail (including attachments) is confidential and is intended solely for the addressee..." Oh really?
  
• Not Secret - Why then does the text from De Laurentiis' say "It is the objective of the Report to clarify and counter misperceptions associated with active and passive investing so that research organizations and public policy makers can be better informed...". That sure looks as though it is intended to be publicly disseminated.
  
• Secret - The IFIC website itself, however, seems not to show the report in any public area, only in a reserved members area (through this search link).
  
• Not Secret - This secret public report meant to be used per De Laurentiis "... as a reference authority in materials developed by you (e.g., articles, reports, etc.)" can actually be accessed through (marvels of the Google and the Internet!) a link at the bottom of this post on Arbetov.ca.

On the whole the image one is left with is that IFIC is trying to feed ammunition to its membership of fund distributors and sellers to have numbers to quote to clients but that it does not want to release the report to wider public scrutiny, including skeptical bloggers!

2) The suspicion of devious intent gets stronger once one looks at the flawed report itself. Its basic approach is to show that passive investing can be expensive, done by trying to show that ETF costs are higher than many people think. However,

• ETF does not equal passive investing (and the flipside is that Mutual fund does not equal active investing). The report throughout treats all ETFs as if they are the same as passive index investments. That might have been a fair generalization ten years ago but today ETFs have become very diverse. Many high cost, poor-quality, narrowly focussed ETFs have come on the scene, some even with explicit active strategies.
  
• Mixing all ETFs together and calculating average costs raises the apparent cost of a passive index (i.e. a broadly based market-cap) strategy. Transaction costs, bid/ask spread and tracking error, which the report says add up to 1.2% ETF under-performance relative to index, is at most 0.1% for a fund like Vanguard's Total (US) Stock Market ETF (VTI) or the grand-daddy biggest-of-them-all SPDR S&P 500 (SPY). The true lesson is not that passive indexing is expensive, it is that today investors need to be just as careful picking ETFs as mutual funds. ETFs that are too small, too narrow and only sample stocks instead of replicating an index are prone to index under-performance from large tracking error.
• The 1% that IFIC says goes to providing advice to mutual fund investors, which ETF investors do not get, and therefore causes ETF under-performance by that amount, rests on the dubious conclusion that investors get 1% worth of advice. The previous IFIC report The Value of Advice (which also seems to be hidden away in IFIC's website) it cites as evidence received a thrashing on its release in 2010 - e.g. see Canadian Capitalist's Readers Rip IFIC Report to Shreds.
  
• Risk, as expressed in volatility, is not or should not be an end in itself, so for IFIC to state that actively managed funds offer investors the risk exposure they wish is beside the point. As books like Richard Ferri's The Power of Passive Investing, David Swensen's Unconventional Success and many others have repeatedly documented in great detail, actively managed mutual funds have performed poorly on a risk vs return adjusted basis. It doesn't help to take on risk if you lose in doing so.
  
• As I said in my review of Ferri's book, the issue is not active investing vs passive investing in principle or in general, it is with the funds actually available to small individual investors and how they perform in reality. That's why I am currently testing the RAFI fundamental strategy, which I think is better in principle and has been shown to be so using (non-investable) index data, against cap-weight using actual ETFs available to investors. A key question is whether the higher fees on the RAFI funds overcome their theoretical advantage and give off lower net returns.
  

There is nothing wrong with mutual funds per se. I don't think that as a technical legal structure they are any better or worse than ETFs. The problem is simply that the current mass of available mutual funds suffer from too high fees that negate their value. They don't add enough value to earn their fees. This lackadaisical offering from IFIC doesn't inspire much respect or do much to help their cause.

New Innovative ETFs that Investors Really Really Need

Sure, there are lots of ETFs and more weird and wonderful concoctions seem to come out every day. Think the financial industry is running out of ideas for ETFs to appeal to every possible interest? Just in case, here are my suggestions for innovative ETFs that could hit the sweet spot for investors.

1. Darwin's Centenarians - "Survival of the Fittest" is the theme of this ETF. Darwin told us that merely surviving is the definition of being fitter. If a company has survived 100 years or more, it has to be fit, right? Twelve Ultimate Buy and Hold Canadian Stocks lists the Canadian stocks to include. Wikipedia's List of oldest companies tells us that no less than 21,666 companies worldwide are centenarians or better exist. That choice is good because diversification through holding a basket of many companies is still required. Age does not guarantee survival - witness the demise in 2006 of Kongo Gumi the oldest continually operating independent company that had been operating for 1400 years. It was a victim of, you guessed it, too much debt.
2. Random Dartboard - We've all read that randomly throwing darts at a dartboard to select stocks works just as well as the average active mutual fund manager. So let's have that fund, please. In order to remove any human bias, and to give the fund a marketing handle, the fund management will consist of chimp Sammy Stockpicker (photo below) along with a human handler. Another advantage - the MER will be peanuts. . This will also help restore a bit of balance in markets, as apparently mathematicians like the one below are taking over trading in markets according to BBC's Quant Trading: How mathematicians rule the markets.
3. High-Yield Sovereign Debt ETF - Nicknamed the "Merkel Put Fund" in honour of the German leader who will be backed into "bailing out" Greece (i.e. having German taxpayers paying for Greek non-taxpayers), this fund will hold the debt of various countries with dubious ability to repay. There are already high yield corporate bond funds like Claymore's CHB so this new fund would only extend the concept. It might be a challenge to define what countries to include since the bond rating agencies' ratings of countries doesn't correspond systematically with countries that pay high yields e.g. Ireland pays quite hefty yields upwards of 8% despite its BBB+ Investment grade rating (see Wikipedia explanation) from Standard & Poors in this list of Credit Ratings by country in Wikipedia. I would propose the "if it looks like a duck and walks like a duck, then it is a duck" method of determining what is high-yield.
4. High Dividend Yield Country ETF - Nicknamed "the future will be like the past" fund, this one will invest in the market basket for the highest dividend yield countries. After all, if famous researchers Elroy Dimson, Mike Staunton and Paul Marsh tell us on page 21 in the Credit Suisse Global Investment Returns Yearbook 2011 (my review here) that an evenly balanced portfolio of the equity index for the highest dividend yield countries handily outperformed for 1900 to 2010 and multiple sub-periods within it, what could go wrong?
5. The Liquid ETF - The ETF Stock Encyclopedia lists a whole range of sector ETFs like retail, telecommunications, oil and gas, mining, utilities, pharmaceuticals, biotechnology, the list goes on and on. Why not set a new direction for themes with a fund that invests in the industries that produce liquids, i.e. a combination of water infrastructure, oil and gas, beer and wine producers. There must be excellent diversification potential as companies are likely to have little correlation with one another.
6. The Global Mega ETF - Finance theory tells us that an investor should hold the market portfolio, which consist of a holding in every available asset i.e. stocks and bonds in every country. Has anyone offered such a fund yet? The answer is No. Vanguard has something called the Total World Stock ETF (VT) but even that only includes 49 countries and no bonds at all. There isn't even a bond fund in its arsenal that tracks a total world bond index.
7. The Celebrity Dream ETF - We cannot all look like Angela Jolie (from Top Beautiful Women blog) or Brad Pitt (from Celebrific.com) but maybe we could invest like them. After all, celebs are wont to give us their opinion on politics, social justice, climate change, etc and with such beautiful faces and acting skills, everyone is convinced they are right. And so they will be regarding investments. Markets will follow them! Their stock picks and predictions will be self-fulfilling prophecies. Besides things always turn out fine in Hollywood. We should remember that though markets in the long term are weighing machines, in the short term they are popularity machines, as all technical traders know. Why bother with charts, statistics, patterns, moving averages and the like when we can go to the next step and actually lead the markets where we want to go? The only possible drawback is that celebs don't come cheap and fees may be high, though surely nowhere near as high as what the typical Canadian mutual fund now collects. So the ETF should still be competitive.

How about it, all you ETF providers out there, innovation has to keep moving ahead, n'est-ce pas?

Passive Indexing Trend Leading to Increased Investment Risk

Too much of a good thing for individuals can be bad for everyone collectively when it comes to passive index investing. James Xiong and Rodney Sullivan explain how this has come about in How Passive Investing Increases Market Vulnerability, available for download here at Top100Funds.com and here at SSRN.

Through a series of statistical tests on US equity data back to 1979, they show how the take-off of passive index investing since 1997 is strongly associated with their disquieting stock effects:

• "... the rise in passive investing meaningfully corresponds to a decrease in the ability of investors to diversify risk in recent decades" and
• "... the diversification benefits of equity investing have decreased for all styles of stock portfolios (small, large, growth, or value). The decline in diversification benefits can couple with increased market volatility and firm-specific volatility."

Passive index investments in mutual funds and ETFs by late 2010 reached about a 1/3 share, or $1.2 trillion, of the total in such funds of $3.5 trillion - active investment funds makes up only 2/3 of the total. (The paper also tells us that institutional investors now hold 70% of US equity stock vs 44% in 2000 and only 24% in 1980.)

The chart below from the paper shows the vertiginous rise in correlations between pairs of stocks. Note how the more passively indexed segment, the SP500 large caps, has higher correlations than smaller caps, the non SP500 stocks in the chart.

They checked that the effects were not only manifest during the recent periods of extreme market crisis - the dot com crash in 2001/02 and the credit crisis crash in 2008/09 - when all asset class correlations rose significantly. The same pattern of rising correlations continued through the other more normal years of the study period.

There may still be value for individual investors to buy those passive index funds but the free lunch of passive diversification now appears to be merely selling at a discount. One thing for sure, as I tried to suggest in the thought experiment post What Would Happen if Everyone Did Passive Indexing? the success of passive indexing, when it becomes big enough, does have an effect on markets. In another post last year, Index Investing Becoming a Victim of Its Own Success, I noted research by Jeffrey Wurgler on the S&P 500 that reaches similar conclusions. No wonder the avant-garde of risk-aware, efficiency-aware institutional investors is moving away from cap-weight passive index investing, some to private equity direct investing, such as the big pension funds and others to alternative-weighting indices.

Cool Tool: Stock and ETF Market Visual Heat Maps

Like to get a quick impression of how various stocks, sectors and ETFs are doing today or in the past year? Check out these heat maps, which show through colours - red down, green up - how markets have been doing. On most, you can drill down by clicking on individual trading symbols to get a lot more detail.

FinViz.com - S&P500 grouped by sector, Foreign Stocks (including Canadian) Traded on US exchanges, US-traded ETFs. Data includes performance today to 1-year, P/E, P/B, P/S. Dividend Yield, Earnings

StockMapper.com - NYSE Euronext stocks (which includes 66 largest Canadian stocks), S&P 500, World Regions. Data includes today's percent change, latest news

SmartMoney.com - US stocks "over 500". Data includes daily percent price change organized by sector.

What Would Happen If Everyone Did Passive Indexing?

There is much advice out there telling us investors to buy passive market-cap weighted index funds (e.g. iShares' TSX Composite XIC for Canada and Vanguard's Total Market VTI for the USA) instead of actively-managed funds which try to beat the market, and instead of trying to pick winning stocks ourselves. Suppose everyone woke up one morning and "went 100% passive" so that no one held anything other than one of these ETFs or something equivalent? What would happen?

From then on, there would be no change in price of any stock as everyone, through the fund, simply accepted the last going price. There would not even be any reason to have different bid-ask prices. There would be no change in price in a day, a year, or ten years ... no matter what happened to any of the companies whose stock was in the portfolio. Now that would be interesting, we/ the fund could happily be paying big bucks for the stock of shrunken companies, or tiny amounts relatively speaking for vastly expanded others. The investor would receive no capital gains, only dividends, increasing from some successful companies and declining or disappearing from the unsuccessful ones. Things would get very out of whack.

The only change within index funds would come as a result of Standard & Poors or other index providers adding or dropping stocks from indices. It would be rather difficult for the index providers to decide which to include or exclude since the basic method relies on the market capitalization of stocks, a number which would never (or almost never, excepting new stock issuance) change in a totally passive world.

That situation wouldn't be at all stable given the reality that a) stock prices should reflect the value of the profits being generated by the components of the index, b) cagey investors would notice the too-high or too-low craziness of prices and start taking advantage by buying up strong companies with extremely high dividends. Prices would change. Active investors are thus the very mechanism that keeps prices more or less fair. Without the active investors constantly making judgements and moving prices up or down, the passive index investor wouldn't be buying a good product. Nobel Laureate Professor William Sharpe notes this ironic relationship between active and passive investing at the end of his easy-to-read article recommending Index Investing.

Why Stewardship is Proving Elusive for Institutional Investors from the Harvard Law School Forum on Corporate Governance and Financial Regulation notes a further likely effect:

• passive index funds exhibit poor ownership behaviour, effectively letting company management and boards run amok, as the focus on fund cost minimization leaves little money for company oversight and active involvement as a shareholder; in fact, many funds do not even have the shares to be able to vote as they lend them out to generate extra revenue and thus do not have them in hand to vote.
• passive index funds, which own the whole market of perhaps thousands of stocks, cannot practically exercise any corporate owner stewardship even if they attempt it.

In these circumstances, it is a sure thing that abuse, rip-offs and exploitation by insiders at companies at the expense of passive shareholders, would increase considerably.

Scott Vincent in the April 2011 paper published on SSRN called Is Portfolio Theory Harming Your Portfolio? argues that the rising trend to passive index investing is increasing the opportunities for informed investors to take advantage of market inefficiencies. First, he notes that such informed skilled active investors are not new: " ... In reality, there is an abundance of evidence that markets are less than perfectly efficient, yet most practitioners and academics find that exploiting these inefficiencies is, at minimum, very difficult. It is not easy to consistently outperform the market, but talented managers can and empirical data supports this fact... " He also maintains that most studies of actively managed funds get their measurements wrong because a majority of these supposedly active funds are essentially passive. Instead of holding a few stocks, they are quite diversified in fact and therefore mostly track the index, whether consciously or unconsciously.

Furthermore, he says, "Multiple studies indicate that funds which are more actively managed, or more concentrated, outperform indexes and do so with persistence (Kacperczyk, Sialm and Zheng (2005), Cohen, Polk, Silli (2010), Bakks, Busse, and Greene (2006), Wermers (2003), and Brands, Brown, Gallagher (2003), Cremers and Petajisto (2007))".

According to Vincent, the end result of the contemporary trend to passivity is that: "... as more money flows from truly active managers to investment vehicles that deploy money “blindly,” inefficiencies become more prevalent creating opportunities for those whose eyes are open to them."

Vincent's recommendation is that individual investors can take advantage by a) searching out mis-priced securities themselves, or by b) searching out and investing their money with those truly active and truly successful fund managers - " ... look for concentrated, fundamentally-driven, relatively small funds with talented managers. Since persistence has been demonstrated in this subset, it turns out that a good manager may be identified from past performance".