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Dan's Reports
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Has indexing lost its lustre?
Cherry picking misleads

There seem to be a number of articles surfacing lately that beat up on indexing - particularly in Canada - based on its performance during the most recent bear market. However, such articles focus on a single three-year period in making the case for active managers. But even proponents of active managers should be careful not to buy into such reasoning.

First, some numbers

The focus of these recent index-bashing articles is indexing's risk in down markets (in Canada) and the magnitude of bear market losses. At its peak, then high-flyer Nortel Networks accounted for nearly half of the large cap S&P/TSX 60 large cap index, and about 1/3rd of the Composite index.

So, it's no surprise that Nortel's subsequent loss of more than 95% weighed heavily on Canadian indices - and funds tracking the same. What today's index-bashers fail to acknowledge is that indexers benefited tremendously from the run up in Nortel and other heavily weighting stocks - leaving most active funds behind.

For the twenty-five months ending September 2002 (using Morningstar Canada month end data), the S&P/TSX Composite Index fell 43 percent, while the Morningstar Canadian Equity Pure Index lost 39 percent. This is hardly a significant margin of difference. And unlike standard comparisons to a median fund, the Morningstar index noted is an asset weighted return composite, which weighs the returns of funds according to assets size.

Further, if you isolate the period of September 2001 through September 2002, the Morningstar Canadian Equity Pure Index lost 10%, compared to the 8% loss of the S&P/TSX Composite Index.

Hence, even using short time periods does not offer any support for active managers' collective superiority in down markets.

Cherry picking

Canadian equity funds most often cited as index beaters are names like CI Harbour, Mackenzie Cundill Canadian Security, Mackenzie Ivy Canadian, and Trimark Select Canadian Growth. But these funds are hardly comparable to any - yes any - Canadian equity benchmark. The problem is that many of these funds simply don't hold all that much in Canadian stocks. (See Not-so-Canadian equity funds and Benchmarking Problems.) As a result, there are many improper comparisons being made - not to mention the resulting meaningless conclusions.

Don't get me wrong. I am of the opinion that quality money managers exist in the Canadian equity space - and that identifying those with a true value tilt and reasonable fees will add value over time. But the figures being tossed around in some recent articles go too far. They use a sample of outperforming funds - chosen in hindsight - and hold them out as proof of active management skill in down markets.

In short, investors can do a lot worse than indexing. However, those seeking advice will only benefit partially from its huge cost advantage since such investors will have to pay for advice in one form or another.

Bottom line

To be very frank, I wouldn't recommend the vast majority of mutual funds. Of the 414 mid-to-large cap Canadian equity mutual funds (i.e. excluding segregated and pooled funds) tracked by Morningstar Canada, I recommend just 22. Of those, a handful are not currently open to new purchases. Another handful are really "all-cap" funds so they're not strictly buying larger companies. And that leaves just a dozen - of which I'm reviewing a few due to huge inflows of cash.

Don't get too caught up in such comparisons. They can be useful if done properly but the focus should be on crafting suitable investment strategies and constructing well-diversified - and efficient - portfolios.

Correction

In my last article, I noted that, "Morningstar fund averages and medians are free from survivorship bias". A correction is in order. While Morningstar fund indices (i.e. Morningstar Cdn Equity - Mutual) are, in fact, free from survivorship bias, the 'median' (i.e. Median Canadian Equity - MF) and 'average' funds are not.

Note: It's time for a break. My weekly articles will return in August 2004.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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