Canadians are bananas for not embracing index funds (2024)

One of the great mysteries of the market is why so many investors sabotage themselves.

In theory, this isn’t supposed to happen. In practice, it happens all the time. Despite overwhelming evidence that index funds beat most actively managed funds over the long haul, investors still shy away from indexing. By doing so, they sacrifice returns.

There are signs investors are gradually waking up to what they’ve been missing, but, gosh, it’s taken a long time.

In the United States, index funds started pitching their wares to ordinary investors in the late 1970s, yet they finally achieved dominance only this past month. According to investment researcher Morningstar, the assets in index funds in the U.S. at the end of 2023 at long last surpassed the assets in funds that actively select their own investments.

This is a heroic accomplishment. Canadians, though, are nowhere close to accomplishing a similar feat.

Canadians are bananas for not embracing index funds (1)

The triumph of the indexers

Passive, or index, funds have at long last overtaken actively

managed funds to become the most popular investing strategy for

U.S. investors. (Trillions of U.S. dollars invested in U.S. mutual funds

and exchange-traded funds.)

$16

Active Assets

Passive Assets

12

8

4

1993

‘96

‘99

‘02

‘05

‘08

‘11

‘14

‘17

‘20

‘23

THE GLOBE AND MAIL, SOURCE: MORNINGSTAR

Canadians are bananas for not embracing index funds (2)

The triumph of the indexers

Passive, or index, funds have at long last overtaken actively

managed funds to become the most popular investing strategy for

U.S. investors. (Trillions of U.S. dollars invested in U.S. mutual funds

and exchange-traded funds.)

$16

Active Assets

Passive Assets

12

8

4

1993

‘96

‘99

‘02

‘05

‘08

‘11

‘14

‘17

‘20

‘23

THE GLOBE AND MAIL, SOURCE: MORNINGSTAR

Canadians are bananas for not embracing index funds (3)

The triumph of the indexers

Passive, or index, funds have at long last overtaken actively managed funds to become the most

popular investing strategy for U.S. investors. (Trillions of U.S. dollars invested in U.S. mutual funds

and exchange-traded funds.)

$16

Active Assets

Passive Assets

12

8

4

1993

‘96

‘99

‘02

‘05

‘08

‘11

‘14

‘17

‘20

‘23

THE GLOBE AND MAIL, SOURCE: MORNINGSTAR

According to the financial advisers at PWL Capital, index funds – or passive funds, as they’re known in the trade – accounted for a mere 15.5 per cent of the Canadian market at the end of 2022.

This is bananas. Researchers have known since the 1930s that even professional investors don’t usually beat the market. By the 1960s, academics had accumulated mountains of data in favour of the efficient market hypothesis: This is the notion that the market does a fine job of incorporating all (or at least, most) public information into share prices.

If the market is efficient, then most investors can’t expect to outperform it, no matter how much research they do or how actively they trade. The best bet for most investors is simply to buy a fund that passively tracks a broad market index at the lowest possible cost. In short: If the market is so hard to beat, why not just own the market?

This approach proves to be surprisingly powerful. The folks at S&P Dow Jones Indices regularly update a scorecard that shows how index funds are performing against active funds. The bottom line speaks volumes.

According to the most recent scorecard, from mid-year 2023, more than 70 per cent of actively managed Canadian equity funds failed to keep up with the index over one year. For longer periods, the results were even worse for the active crowd. More than nine out of 10 actively managed Canadian equity funds lagged behind their market benchmark over the preceding five and 10 years.

So why aren’t more people using index funds? The financial services industry is partly to blame. It makes more money from active funds than passive ones. It therefore pushes what is most profitable for its own bottom line, not the customer’s.

Banks and advisers can’t take the entire rap, though. Television ads now blare the case for index investing. So do books, newspaper articles and tired old pundits. Investors can’t claim to be misled any longer. No, they’re seeing the case for passive investing and choosing to ignore it.

I have three theories as to why.

The first says index investing runs counter to our notions of what is fair. Most of the time, paying more for a service means you receive a better level of service. With index investing, the opposite is true. You (usually) pay considerably less for an index fund than an active fund but you (nearly always) get more in terms of results over the course of five or 10 years. This strikes many people as just too weird.

The second theory holds that people love lotteries. They cherish the notion that they have a chance – even an infinitesimal chance – of becoming wealthy overnight thanks to their investment in bitcoin, tech stocks, gold miners or whatever. Index investing doesn’t play to that fantasy, even if it does boost your chance of getting rich slowly.

A third theory says many people regard investing as entertainment. They don’t like index investing because – let’s admit it – buying an index fund is duller than watching a parliamentary channel rerun. Active investing, in contrast, involves personalities, dramas and the clash of viewpoints. It’s inherently more interesting.

I have at times felt the tug of all these theories so I sympathize with people who are still wedded to active management. The best antidote may be to remind yourself of some notable index-investing triumphs.

You can start with Warren Buffett’s endorsement of index investing. “Both large and small investors should stick with low-cost index funds,” the billionaire investor wrote to shareholders in 2017.

You can also remind yourself of his famous bet that a simple S&P 500 index fund would beat the results of a hand-picked group of hedge funds over the course of a decade. (It did so, quite handily.)

If that’s not enough, you might also want to remind yourself that even state-of-the-art, professionally managed endowments at Ivy League universities often struggle to keep up with the results of a simple indexed portfolio of 60-per-cent stocks and 40-per-cent bonds.

The upshot of all this is simple: Investors should take a close look at index investing. Vanguard Canada’s balanced index portfolio (VBAL) or the equivalent from iShares (XBAL) are excellent places to begin your inspection of the index universe. Both products offer low-cost, globally diversified blends of stock and bond indexes.

No, you don’t have to go all-in on indexing with these products or others. You should, though, take a close look at them and know what you’re missing if you choose to go in another direction.

As an investment expert with a deep understanding of financial markets, I can shed light on the compelling evidence supporting the shift towards index investing and why many investors still struggle to embrace it. The article addresses a fundamental paradox in the market – despite overwhelming evidence favoring index funds over actively managed ones, a significant portion of investors continue to resist the transition.

The piece correctly emphasizes the historical dominance of index funds over actively managed ones, particularly in the United States. Morningstar's data, cited in the article, reveals that index funds finally surpassed actively managed funds in terms of assets in the U.S. at the end of 2023. This represents a culmination of a trend that began in the late 1970s when index funds were first introduced to ordinary investors.

Contrastingly, the situation in Canada lags behind, with index funds accounting for only 15.5% of the market at the end of 2022, as reported by PWL Capital. This discrepancy is puzzling, considering the long-standing evidence that even professional investors struggle to consistently outperform the market.

The article rightly touches upon the efficient market hypothesis (EMH), a cornerstone in financial theory since the 1960s. EMH suggests that markets efficiently incorporate all available public information into stock prices, making it challenging for investors to consistently beat the market through active management. This aligns with the core argument for index investing: if the market is difficult to beat, why not passively track a broad market index at a low cost?

To bolster this argument, the article refers to S&P Dow Jones Indices' scorecard, demonstrating that over 70% of actively managed Canadian equity funds failed to outperform the index over one year, and the results worsened over longer periods. Such empirical evidence underscores the challenges of active management.

The article also addresses the role of the financial services industry in perpetuating the preference for active funds, driven by higher profitability. Despite increasing awareness through advertisements, books, and media coverage, investors continue to overlook the merits of index investing. The three theories presented – the fairness principle, the allure of lotteries, and the entertainment factor in investing – provide psychological insights into why investors may resist the evidence.

As someone well-versed in the subject matter, I find these theories plausible and relatable. The article suggests that investors, even with the awareness of the benefits of index investing, may be drawn to the excitement and perceived higher returns associated with active management. The piece successfully counteracts these biases by highlighting endorsements from prominent figures like Warren Buffett, who advocates for low-cost index funds.

To conclude, the article serves as a persuasive call to action for investors to seriously consider index investing. It recommends specific low-cost, globally diversified index funds like Vanguard Canada’s VBAL and iShares' XBAL, emphasizing the importance of understanding what investors might miss by choosing alternative paths. Overall, the article provides a well-supported argument for the adoption of index investing backed by historical data, financial theories, and real-world examples.

Canadians are bananas for not embracing index funds (2024)
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