A mutual man strikes back

Tired of seeing mutual funds getting beaten up in the business press, David Feather goes mano-a-mano against Report on Business columnist Rob Carrick on the benefits of actively managed funds vs. index-hugging ETFs

Globe Investor Magazine online, February 19, 2009

CARRICK » I've been writing favourably about ETFs since 1999 [when they were still called index participation units]. David, you're a man who makes his living selling funds. Tell us why those funds of yours are a better choice for investors than ETFs.

FEATHER » The active management approach lends itself to a steadier course of investing. A shortcoming of many investors is that they get bumped off course because of a significant downside event in the market. Now, I'm not saying there aren't mutual funds that haven't lost money. But, on average, the active management approach over the long term will often get you to the same place as an ETF, sometimes better and sometimes worse, but with a smoother ride.

You seem to be claiming that mutual funds are a calmer investment, with lower highs than ETFs, and higher lows. Am I understanding you correctly?

Yes. Our point is that there aren't too many investors out there who wouldn't take that trade.

But what about all those comparisons that show a strong majority of mutual funds lag the index over both short and long time-frames?

Most of the commentary you see in the Canadian marketplace on this debate does not adjust for the fact that the index is not free for anybody. The comparisons are completely inappropriate, a comparison of apples to oranges, to use a cliché.

First job in the financial industry Financial analyst, corporate and government banking, Bank of Montreal Lesson learned Right out of school, I took a gamble on a penny resource stock. It went to $0. The problem was no liquidity and low quality-two things most investors should require. Best investing advice Start investing early, and realize that the best investment decisions are often not the most popular ones. Personal investing philosophy Talented people can make a difference. Invest with teams and approaches you understand and that make sense over an enduring period of time, rather than attempting to capitalize on immediate trends. Achievement he's most proud of Our focus on investor education is one. Also, the fund industry's leadership in all forms of disclosure risk, performance and distribution compared to other managed-money alternatives. I would love to see other managed products, such as hedge funds, raise their businesses to similar standards. Where he invests A significant proportion of my portfolio is in Mackenzie managed funds. I believe in the investment people we have and that we should be investing in our own products. I am roughly 80% equity, and about 70% foreign. I also own some stocks.North American companies I like that have a strong business model. I do some shorting of indexes and some stocks on a very selective basis.

You're referring here to the fact that ETFs have small fees that cut into the index returns they deliver. Investors also have to pay brokerage commissions to buy and sell ETFs. Do they affect the cost equation?

The media never raises transaction fees when it makes the comparison between active and passive investing. There are small investors who are using ETFs and putting in some money every month, and their effective MER [management expense ratio] with transaction fees included may even be higher than a mutual fund.

But what about the upfront sales commission-maybe 1% or 2%-that investors pay to buy mutual funds from advisers, or the deferred sales charges that apply in some cases, which can be as high as 6%?

The vast majority of fund investors in this country are not paying a going-in fee or a going-out fee. So the MER is the fair approximation of what the cost of mutual fund investing is. It's an entirely all-encompassing fee that is very transparent. It subjects itself to very easy comparison and analysis. ETF pricing is much more complex.

But ETFs, all in, are still cheaper than mutual funds in most cases. How important do you think costs are when selecting an investment?

Cost is one of many factors an investor should review when looking at a fund. I think an investor should immediately rule out any funds that are outliers on cost. Anything with an MER above 2.70%, just stroke if off your list. But I don't think it's the most important variable.

What do you make of the fact that mutual funds so often come out secondbest when compared to the benchmark Canadian stock index, whereas the competition seems to be tighter in global markets?

If you and I were debating the best way to determine whether active or index investing performs best over the long term, I doubt we'd want to take the country [that is, Canada] that represents 2% of the world and has an extremely high concentration and limited number of names among the top companies. Why does the analysis always focus on this 2% market?

Well, we do live in Canada, and you know about the home bias that many investors have. Is it fair to say that the U.S. and global examples are more telling?

You take the broadest mandate possible, and you go head-to-head to see who comes out on top. I would challenge people to find a meaningful global equity fund in this country that over the past 10 years has not beaten the index.

Barclays Global Investors, the biggest ETF company in Canada, has used a marketing pitch based on the idea that ETFs offer superior simplicity and transparency over mutual funds. It's an interesting approach, given all the toxic investments, such as shares of U.S. banks and brokerages, that kept turning up in mutual funds in 2008. What's your response to that?

There isn't a more regulated product in this country than mutual funds. There are rules and procedures that aren't necessarily our doing on portfolio disclosure.

We release information quarterly, we release a full portfolio twice a year, and companies like ours release our top holdings for every fund within 15 days of month's end. That's a lot of information.

The other argument against a fund disclosing all its positions is that if a good manager is starting to accumulate a position, it's in the interest of the investor to not have it disclosed. Any good investment team would hesitate to release the names of a stock it's accumulating, to protect the end investor.

You have raised quite a number of points arguing that funds are a superior choice for investors. Do ETFs have any use at all for investors, in your view?

Yes, for some investors, they do. There's some use for them in hedging portfolios; some people like to short them.

What about as a core product that is part of long-term plans?

I don't buy them, and the reason is that I believe good managers make a difference. I believe that good investment people make a significant difference over the long term.