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Disturbing trend raises questions about the value of traditional mutual funds

by Wayne Cheveldayoff, 2006-08-31

Mutual fund managers are having a hard time beating the S&P/TSX Composite Index and this raises questions for Canadian investors about the value of traditional, actively managed equity mutual funds.

In the first half of 2006, only 18.8 per cent of actively managed Canadian equity mutual funds outperformed the index, according to Standard and Poor’s Indices Versus Active Funds Scorecard (SPIVA) for Canada (available at

Over the longer time periods that most mutual fund investors care about, the situation is no better. Over the past five years, only 13.9 per cent of Canadian equity mutual funds outperformed the index.

In the United States, 38.6 per cent of active managers outperformed the index in the first half and a lower ratio -- 25 per cent – outperformed over the past five years.

The numbers obviously suggest that if you want top investment performance, as every investor should, index funds may be the better way for at least a portion of your portfolio.

Investors are fortunate that an organization such as Standard and Poor’s is keeping tabs on mutual fund performance versus the index. The mutual fund companies are not providing such numbers.

Standard and Poor’s has put a lot of research effort into this project. A key attribute of the SPIVA methodology is its correction for survivorship bias, which can significantly skew results as funds liquidate or merge. Statistics produced by mutual fund companies usually don’t correct for this.

Standard and Poor’s says five-year survivorship ranges from 60 to 66 per cent for the Canadian equity, Canadian small-cap, and U.S. equity fund categories. This suggests that about one in three funds in these categories has merged or liquidated in the past five years.

One sector where underperformance is less severe is Canadian small-cap funds.

“It is commonly believed that in the small-cap space, active managers have a better chance of beating benchmarks because of the relative inefficiency of that market,” the research group states. Inefficiency means stocks haven’t been completely picked over and managers can capture higher returns through finding gems among ignored companies.

But even in small caps, active managers have been losing their edge. Over the past five years, 43.8 per cent of actively managed Canadian small-cap funds have outperformed the S&P/TSX SmallCap Index, and 61.9 per cent outperformed over three years, but in the second quarter of 2006, only 25 per cent of these active funds outperformed the index.

For investors who have been steered by their advisors into actively managed funds, these numbers should be disturbing. Investors need to check the returns they are getting from their funds versus the index at such websites as

If your funds are consistently underperforming, you may ask yourself and your advisor: “Why am I paying a management fee of 2.5 to 3 per cent a year to an active manager who is underperforming the index?” It’s definitely worth a thorough review.

The underperformance problem is already causing significant movement of investment money into index funds.

At Barclays Global Investors Canada, which manages 16 exchange traded funds (ETFs) linked to indexes, total assets now exceed $13 billion, a significant climb from $3 billion in 2002. The ETFs (see have annual management fees generally under 0.5 per cent.

One thing for investors to consider is that the S&P/TSX Composite is heavily weighted to energy, metals and financials and the reason that active managers have generally underperformed may be due to a broader diversification of their portfolios.

A recent check of the best fund performers over five years compiled by Morningstar Canada shows that resource funds led the list. The worst performers tended to be invested in technology stocks.

Another consideration is that active managers historically have performed better than the benchmark index when the index plummets during market corrections. Active managers may therefore provide you with some protection is bad markets.

So, on the whole, it may not make sense to put your entire portfolio in index-linked ETFs or index funds offered by the banks. But the SPIVA report suggests some seems justified.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2006 Wayne Cheveldayoff