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 avid investor with a proven track record in financial markets, I find the persistent reluctance of many investors to embrace index funds both perplexing and intriguing. My extensive experience in analyzing market trends and performance metrics allows me to shed light on the underlying reasons and present a comprehensive understanding of the concepts discussed in the article.

The author rightly points out the paradoxical behavior of investors who, despite overwhelming evidence favoring index funds, continue to sabotage their own returns by opting for actively managed funds. This phenomenon is not only observed anecdotally but is substantiated by robust data presented by investment researcher Morningstar.

The historical trajectory of index funds in the U.S., culminating in their recent dominance, is a testament to their triumph over actively managed funds. The graph depicting the shift in assets clearly indicates that investors are gradually waking up to the benefits of passive investing.

However, the scenario is vastly different in Canada, where index funds only accounted for a mere 15.5% of the market at the end of 2022, according to financial advisers at PWL Capital. This stark contrast raises questions about the factors influencing investor behavior in different regions.

The article delves into the efficient market hypothesis, a concept dating back to the 1960s, which posits that the market efficiently incorporates public information into stock prices. This theory forms the foundation of the argument favoring passive investing, as beating the market consistently becomes a challenging task for most investors.

The power of index investing is underscored by S&P Dow Jones Indices, which regularly updates a scorecard comparing the performance of index funds against actively managed funds. The data, as of mid-year 2023, reveals that over 70% of actively managed Canadian equity funds failed to keep up with the index over one year.

The article addresses a critical question: Why aren't more people using index funds? It points fingers at the financial services industry, highlighting the profit motive that incentivizes the promotion of actively managed funds over passive ones. This industry bias, coupled with the allure of lotteries and the perception of investing as entertainment, contributes to the persistence of active management.

To counter these biases, the author introduces three theories explaining why index investing faces resistance. The theories touch upon the notions of fairness, the love for lotteries, and the entertainment value associated with active investing. These psychological factors provide insights into the mindset of investors and the challenges faced by proponents of passive investing.

Drawing upon the authority of renowned investor Warren Buffett, the article emphasizes the endorsement of index investing as a sensible approach. Buffett's famous bet, where a simple S&P 500 index fund outperformed a group of hand-picked hedge funds, serves as a powerful testament to the efficacy of index strategies.

In conclusion, the article advocates for a closer examination of index investing, citing specific products like Vanguard Canada's balanced index portfolio (VBAL) and iShares' equivalent (XBAL). These low-cost, globally diversified blends of stock and bond indexes offer a compelling alternative for investors, and the article encourages a thoughtful consideration of the benefits before choosing an investment strategy.

Canadians are bananas for not embracing index funds (2024)

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