Subtitles section Play video Print subtitles - I generally assume that most of you watching these videos are already fully on board with the idea that index investing makes sense. While stock picking and actively managed funds should be avoided like the plague. Most Canadians are apparently not on board with that idea. As at the end of 2018, only 11.5% of Canadian investment fund assets that is mutual fund and ETF assets domiciled in Canada were invested in index funds. Clearly more people in Canada should subscribe to my channel. I'm Ben Felix Portfolio Manager at PWL Capital. In this episode of "Common Sense Investing" I'm going to tell you that there are no good reasons to avoid index funds. (upbeat music) Anecdotally, I can tell you that there are lots of financial advisors out there who genuinely believe that index funds are terrible investments. They have their reasons to believe this. And I'm willing to bet that it's this type of misinformation from supposedly financial professionals that is keeping so many Canadian dollars invested in actively managed funds. Let's start with the classic fallback line for any advocate of active money management. Index funds are risky. The premise of this argument is that when you own the whole entire market, you will get all of the ups and all of the downs that the market delivers. The alternative would of course be investing with an active manager that is able to feel out the market and use their analysis and intuition to protect you from a downturn. The active management story sounds way better than writing out, down markets with index funds. But the story does not hold up when we look at the data. Vanguard did a study in 2018 to look at the performance of active managers in bull markets when stocks are doing well, and in bear markets, when stocks are doing poorly. Critics of index funds would suggest that active managers should outperform the index in a bear market. The data show that more than 50% of active managers outperform the index in some historical bear markets, but in other bear markets less than 50% manage to be the index. This should not instill confidence in anyone betting on active management to save them in a downmarket. If active funds do not offer any protection when stocks fall, then there is no basis to say that index funds are a relatively risky investment. Active management also introduces a whole other element of risk. We know that the market as a whole is risky. It goes up and down in value as investors expectations about the future change. For taking on the risk of the market, investors expect a positive return. In other words, the risk of the market is a priced risk. An active manager is still taking on market risk but they're also taking on active risk. The risk that their bets will end up paying off. Active risk is not a priced risk. I would argue that active management is far riskier than index investing because active management introduces an additional level of risk. And it is a type of risk that does not have a positive expected return. Another common reason to avoid index funds is that you get no control over your holdings. You end up buying all of the bad stocks along with the good ones. With the right active manager, you will only get the good stocks while avoiding the bad ones. This is another great story without any data to back it up. The problem with only picking the good stocks is that there is no way to tell what a good stock is. There is a massive difference between the quality of a company and the quality of its stock returns. For example, from 2010 through 2017 a time when and Google, Apple, Amazon and a Netflix shares were on a massive growth path. Domino's pizza had stock returns that dominated all of the tech giants. It takes some serious predictive ability to successfully bet on a company like Domino's. This is not a small issue either. My example is descriptive of how stock returns work. Of the roughly 26,000 stocks that appeared in the CRSP database, a comprehensive database of U.S. stocks from 1926 through 2015, only 1000 of them were responsible for all of the market returns in excess of treasury bills over that time period. That was like finding a needle in a haystack. We can think about this issue another way. Global stocks as whole returned 8% per year on average from 1994 through 2017 if you missed the top 10% of performers each year your average return drops to 3.6% per year. It is easy for an active manager to say that indexing results and owning all of the good and bad stocks. What they're not able to tell you is which stocks are good and which ones are bad. The reality is that it is a relatively small number of stocks that drive the market's returns. And it is next to impossible to consistently identify those stocks at least ahead of time. When proponents of active management give these reasons for avoiding index funds, it is always on the basis that active management is a superior. This is where the data comes in. The SPIVA Scorecard shows us the percentage of funds in each category that were able to beat their benchmark index over a given time period. The SPIVA Canada mid-year 2018 report shows that the vast majority of actively managed funds were unable to beat their benchmark index over one, three, five, and ten-year periods. Of course, the rebuttal to this data is that but he would invest with any old active manager. Smart investors only invest with skilled active managers. If you can find a skilled manager, index funds don't make sense. Let's dig into that for a moment. The idea that a successful active manager might be skilled needs to be considered alongside the fact that their success may have been due to luck. Even over long periods of time some active managers will beat the market due to luck rather than skill. This makes the process of finding a skilled manager exceptionally challenging. In a 1997 paper Mark Carhartt demonstrated that any persistence in mutual fund outperformance was not due to manager's skill, but due to exposure to the common factors in stock returns, including size value and momentum. The abstract to the paper concludes the results do not support the existence of skilled or informed mutual fund portfolio managers. In 2010 Eugene Fama and Kenneth French, again studied mutual funds in their paper luck versus skill in the cross section of mutual fund returns and found that before costs there are both skilled and unskilled managers but the skilled managers are not skilled enough to cover their own costs. Over the years, there have been many anecdotal examples of superstar fund managers who flamed out hard to finish their career, were they lucky or skilled? If they were skilled, why did their skill run out? Take David Baker who managed the 44 of Wall Street Fund to be the top performing us equity mutual fund in the 1970s. He even beat the famed Magellan Fund managed by Peter Lynch over that time period. For the following decade the 44 Wall Street Fund was the worst performing fund with investors losing a 73% for the full time period while the S&P 500 grew 17.6% per year on average. Or how about the Legg Mason Value Trust Fund managed by Bill Miller. He beat the S&P 500 for 15 consecutive years ending in 2005. Starting in 2006, he led the fund to five years of mostly awful performance before handing the management over to a new manager. None of this should come as a surprise statistically it would take 36 years of 2% alpha.