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 enthusiast deeply entrenched in the world of finance and investing, I can attest to the compelling evidence that supports the shift towards index funds as a superior investment strategy. My understanding goes beyond mere awareness, extending into the realm of practical application and analysis.

The article discusses a longstanding mystery in the market—why investors frequently sabotage their own returns despite overwhelming evidence favoring index funds over actively managed ones. This phenomenon is not just theoretical; it is a practical reality that has persisted for decades. The evidence in favor of index funds is robust, with data suggesting that they consistently outperform actively managed funds over the long term.

A key point highlighted in the article is the recent dominance of index funds in the United States. After starting their appeal to ordinary investors in the late 1970s, index funds finally overtook actively managed funds in terms of assets at the end of 2023. This shift is depicted through a graphical representation of active and passive assets over the years.

The article points out a stark contrast in Canada, where index funds accounted for only 15.5% of the market at the end of 2022. This discrepancy is deemed perplexing, considering that researchers have known since the 1930s that even professional investors often struggle to beat the market.

The efficient market hypothesis is introduced as a foundational concept. Dating back to the 1960s, this hypothesis posits that the market efficiently incorporates all relevant public information into share prices, making it challenging for investors to consistently outperform it. The logical conclusion is that passive investing, specifically through index funds, is a prudent strategy for most investors.

To support this assertion, the article cites S&P Dow Jones Indices' scorecard, which reveals that a significant majority of actively managed Canadian equity funds fail to keep up with the index over various timeframes. This data underscores the consistent underperformance of actively managed funds compared to their passive counterparts.

The article then delves into possible reasons why more investors are not embracing index funds. It points a finger at the financial services industry, which often prioritizes more profitable actively managed funds over passive ones. Additionally, behavioral factors such as a preference for perceived fairness, the allure of lotteries, and the entertainment aspect of active investing are discussed as potential explanations.

To counter these behavioral biases, the article suggests considering notable success stories in index investing. Examples include Warren Buffett's endorsement of low-cost index funds and his successful bet against a group of hedge funds using a simple S&P 500 index fund. The article emphasizes that index investing may seem less exciting but is a more reliable path to wealth accumulation.

In conclusion, the article urges investors to closely examine index investing, citing specific products like Vanguard Canada’s balanced index portfolio (VBAL) or iShares' equivalent (XBAL) as excellent starting points. The message is clear: investors should consider the evidence and understand what they might be missing by not incorporating index funds into their investment strategy.

Canadians are bananas for not embracing index funds (2024)
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