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Stingy Investor Tip Sheet
The Standard & Poor's Indices Versus Active Funds (SPIVA) scorecard
for the most recent quarter (Q3 2008) is out. As usual, some fund
categories did well compared to the index, others not so much.
Over the years the good folks at Standard & Poor's have improved their
reporting but some significant flaws remain. Despite its problems,
the report is usually widely cited by indexing proponents who are
delighted when active funds fail to measure up.
Mind you, I expect the gloating to be diminished this quarter because
the headline figure for Canadian funds is positive. They say, "for
the third quarter of 2008 59.4% of Canadian Equity active managers
were able to outperform the S&P/TSX Composite Index."
But active funds shouldn't rejoice too much because they usually trail the index.
I don't have a big stake in the results. I like both index funds and
some low-fee active funds. But there are a few facets of the SPIVA
report that may be misleading to investors.
What about fees?
SPIVA compares the performance of active funds to that of the index.
Did you catch the problem? The active fund returns are reported after
expenses (including MERs, not including loads) whereas the index
returns are presented without costs included.
Most active fund investors avoid loads. Front-end loads are often
waived entirely and back-end loads aren't charged when investors hold
the fund for a long time.
If you buy an index fund, or an exchange-traded fund (ETF), then
you'll pay a fee. The fund's fee is called a management expense ratio
or MER. An ETF will also charge a MER and you have to pay a brokerage
commission to buy (or sell) it.
In the end, you can't buy index performance. You can buy an index
fund but the index fund will tend to lag the index's performance by
the fees charged.
Of course, index funds usually charge relatively low fees. Indeed,
smart indexers will gravitate towards those index funds that charge
very low fees.
With fees in mind, let's look at that headline number again. SPIVA
reports, "for the third quarter of 2008 59.4% of Canadian Equity active
managers were able to outperform the S&P/TSX Composite Index."
If you ladle in a fee for the index, the percentage of funds that
outperform may change dramatically.
To demonstrate, consider the following hypothetical case of 10 funds
where the funds' returns, after fees, are 1.0%, 3.8%, 4.2%, 4.6%,
4.9%, 5.1%, 5.3%, 5.9%, 6.0%, and 7%. Let's say the index gained 5%
and an index fund with a MER of 1% gained 4%. Some 50% of the active
funds beat the fee-free index. However, 80% of the active funds beat
the index fund. That's a big swing.
It's true that I've used a contrived example but it also demonstrates
why I'm suspicious of SPIVA's outperformance figures when they're
generalized to real world investors.
Here's another wrinkle. S&P only uses return figures from one share
class for each particular fund. But fees usually vary from share
class to share class. Do they select the class that charges the most
or the class that charges the least? The class that charges the most
will have the worst return record. SPIVA may be comparing the
highest-fee and worst-performing version of each fund to the index
without fees. I don't know if that's what they're doing because they
don't say how they do it.
What did you put in my index?
Unfortunately, a few years ago, S&P decided to pollute the S&P/TSX
Composite with trusts. (They were all the rage at the time.) But is
it really fair to benchmark equity funds that only hold common stocks
to the S&P/TSX Composite which tracks both stocks and trusts? Not
(I run into this problem all the time. For better or worse, the
S&P/TSX Composite is the big index for stocks in Canada. Data on it
is plentiful and an inexpensive alternate is not readily
available. So, I use the benchmark myself but it's not perfect.)
To see the problem, consider these recent 5-Year Annualized Average
S&P/TSX Composite Index Total Return: 12.04%
S&P/TSX Income Trust Index Total Return: 15.26%
Income trusts have performed well over the last 5 years. Indeed, I
suspect (but have no proof) that the S&P/TSX Composite's performance
would have been lower had trusts not been added to the index.
Should stock-only funds be penalized by being compared to a
stock-plus-trust index? I say no.
It's a shame
Despite the problems, I suspect that SPIVA's fundamental findings are
true. Namely, that the index tends to outperform the average active
fund over the long-term. The finding is likely to remain true if
index-fund fees are included. It's just a shame that SPIVA
overreaches because the case for indexing is already strong enough.
|11/14/2008 10:20 PM EST Permlink save & share||Indexing|