How Index Funds Compare To Equity Mutual Funds

Most Canadian investors use a financial advisor to help them make investment decisions and, more often than not, the advisor directs their clients’ investments toward mutual funds with a high management expense ratio (MER).

Despite numerous studies showing that Canadian mutual fund fees are among the highest in the world, and that actively managed mutual funds tend to perform worse than low cost index funds, more and more Canadians continue to invest their money in expensive funds.

Index Funds vs. Equity Mutual Funds

The equity mutual funds offered by the big banks have management expense ratios (MERs) between 2.14 and 2.42 per cent.  They are sold to investors as a way to beat the market by using a professional management team to actively manage the portfolio.  Conversely, index funds are designed to track a specific index and deliver market returns, minus fees, which are typically around 1 per cent or less.

I looked at the mutual funds that are offered at each of the 5 big banks and compared the 10-year performance of high cost Canadian equity mutual funds to the equivalent low-cost index funds.  Here are the results:

Fund MER Ten-Year Growth of $10,000
TD Canadian Index e-series 0.33% $20,132
TD Canadian Equity 2.18% $19,286
RBC Canadian Index 0.71% $19,056
RBC Canadian Equity 2.42% $15,644
Scotia Canadian Index 0.99% $18,801
Scotia Canadian Growth 2.14% $12,613
BMO Canadian Equity ETF Fund 1.01% $17,834
BMO Equity 2.29% $17,113
CIBC Canadian Index 1.12% $18,445
CIBC Canadian Equity 2.33% $13,551

The banking industry has led Canadian investors to believe that paying higher investment fees will result in superior returns for their portfolios.  Yet in each of the five examples shown above, returns from the high MER equity mutual funds lagged behind returns from the cheaper index funds, often by a wide margin.

For decades, low cost index funds, and more recently low cost index ETFs have provided higher returns when adjusted for investment risk.  Market indexes will outperform 80 per cent of actively managed mutual funds over the long term.  Unfortunately, index funds are not marketed very well by the financial industry, as advisor’s have little incentive to sell them to you.

Mutual funds are still a great place for investors to start building their portfolios, but Canadian investors need to do a better job understanding the high MERs that we are paying.

You don’t have to settle for the expensive equity mutual funds recommended by your financial advisor.  Ask questions, shop around for cheaper index funds, or look into ETFs as a low-cost investment alternative.  Don’t let your portfolio get eaten away by unnecessary fees.

 


16 Responses to How Index Funds Compare To Equity Mutual Funds

  1. We’ll make an indexer out of you someday. :) Nice analysis. I hope people will print out this post and bring it to their bank for when their adviser says, “We have funds that will outperform the indexes.”

  2. Tyler Evans says:

    Is the 10 year performance of those banks recent, what ten year range is it? If its from this past decade, then I think your point can be taken doubly.

    Related to this, historically, how do index funds perform during downturns in the market? Obviously they’re going to respond like the equities that make up the indices, but do they recover in a similar fashion?

    • Echo says:

      @Tyler – Yes, this is the 10-year performance from Jan 2002 – Dec 2011.

      Index funds match the index they are tracking, so the performance will ebb and flow through good and bad times (minus fees).

      Actively managed funds “claim” they can time the market to move out of equities during crashes while moving back in during the recovery. The problem is that it’s impossible to time the market perfectly, and by missing even a few days of a rally you can miss out on some of the biggest gains.

  3. Boomer says:

    I see that TD and BMO returns are quite similar and the growth funds would likely have outperformed the index if the MER wasn’t so high. Obviously MERs, especially compounded over 10 years, take a huge bite out of earnings.

    The other banks have a lot of explaining to do given their results.

    • Echo says:

      @Boomer – it’s interesting to note that the fund with the cheapest MER had the highest returns (TD eSeries).

      I’m not sure how advisors at CIBC/Scotia/RBC can sell those funds to people, given the high MER and dismal performance. What are they paying for?

  4. James Whyte says:

    Good article. Can you provide any evidence to support your claim that “Market indexes will outperform 80 per cent of actively managed mutual funds over the long term”?
    Thanks!

    • James Whyte says:

      That is, in addition to the evidence already provided. Your 80% claim is rather specific, and I’d like to see how you arrived at that figure.
      Thanks.

      • Echo says:

        @James – sorry I should have included a link, as that statistic is somewhat anecdotal. Maybe Dan (Canadian Couch Potato) can provide a resource for us.

        In the meantime, this study (http://bit.ly/xShGHt) shows that in the past five years, only 7.4% of actively managed funds in the Canadian Equity category have outperformed the S&P/TSX Composite Index.

        So the 80% that I mentioned in the article is probably understated.

  5. SE Book says:

    Its times like these I am glad I have a family member who knows his stuff. While he does focus on mutual funds, I have a d=pretty diversified portfolio.

  6. Great, comparative piece! Well done!

  7. Zoe says:

    I hope you would have more write-up about the TD e-series! It is very helpful for starting investors like me.

  8. Ed Rempel says:

    Hi Echo,

    Your comparison is not a comment on active management. You have compared several closet index funds to indexes. Of course the closet indexers underperform – they are not truly actively managed. They are just trying to be similar to the index.

    In Canada, about 70% of mutual funds are closet indexers. In the US, only about 15% of mutual funds are closet indexers.

    We tend to think of closet indexers as “gimps”. :) I think we need to come up with a better term, but restricting yourself to investing similar to the index while calling yourself “actively managed” is like a one-legged runner.

    If you want to compare active management to indexes, you need to choose funds with holdings very different from the index. Non-closet-indexers beat the index on average, based on the comprehensive study at Yale called “Active Share”.

    My favourite math stat is that the “average” person has one breast and one testicle. The studies that show the “average fund” underperforms the index are similar. They compare 70% “gimps” and 30% fund managers to indexes.

    Ed

  9. Keith says:

    You say “The banking industry has led Canadian investors to believe that paying higher investment fees will result in superior returns for their portfolios.” I say that the whole mutual fund industry spins that fable.

    Just a few other thoughts:

    * The phrase ‘buy and hold’ is not applicable mutual funds and ETFs that have 50-100+% turnover in stocks. Don’t lecture me on getting out of duds to move my money to where it can get better returns. But chastise me if I am following the crowd after the fact rather than anticipating.

    * The ins and outs of those high cost corporate class mutual funds are worthy of an article in themselves. They are tax efficient but at a cost that goes beyond MER, potential loss of flexibility.

    * Investing in fixed income mutual funds and ETFs is just as risky as investing in equities. A mutual fund is an equity no matter what is in it. So are ETFs, which happen to be traded the same as stocks.

    * Diversification is key – that is one thing the advisor industry has right.

    * But so is an advisor who anticipates rather than reacts. You have to be self aware but it would be helpful to have a person who takes the initiative to call or come to you to provide advice – not the other way around. It just befuddles me when my ‘advisor’ gets 0.5% for what?

    I have learned from reading your articles, newspapers, books and watching videos on the Globe web site. However the way I learn best is by doing – I have learned a lot by investing in ETFs and stocks. Now that I have a better understanding I am ready to go back to investing in mutual funds. However I am going to be better at picking my ‘service providers’.

    Thank you,
    Keith

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