Index Investing
Part 6: More Reasons to Choose Index Funds
Investing in a fund that tracks an index is quite easy, while picking your own investments to try to do better can be difficult and time-consuming. Nonetheless, many of you may be tempted to try, for the same reason that lottery tickets can be seductive: the possibility of doing better is an attractive idea even if it’s unlikely to work out well for you.
One of the key notes in the research on how actively managed mutual funds performed versus their indexes is “net of fees”. Costs matter in investing, by a huge amount.
Costs Matter… and Compound
Canada is besmirched by some of the highest investing fees in the world. A typical mutual fund here charges over 2% per year. That may not sound like much, especially if you mis-read it to be 2% of the profits – a common misconception, but unfortunately it is 2% of the total amount invested, whether the fund does well or not. If we expect returns of 6% or if we’re being generous, even 8% per year, that 2% fee would be a quarter to a third of the total return we were hoping to get as investors, for management that 90% of the time can’t out-perform their index by enough to pay the fees!
Costs are a certainty in investing, while performance is not. And while there’s no reliable way to pick in advance which investments or investment managers will out-perform, the costs are disclosed up front (perhaps in small print in a fund facts document, but it very much is possible to find them in advance). So choosing low-cost investments can be an incredibly important step when you start investing.
That importance is magnified over time, as the costs compound. A 2% drag from fees in the first year leaves you with just 98% of what you could have otherwise had. Then out of that reduced amount, you have to pay 2% again the next year. And so on. After 30 years of investing (which is a very realistic time period to think about for those who would invest to prepare for retirement and then into it), a 2%/yr fee ends up consuming almost half the total wealth you could have potentially had. And most mutual funds in Canada charge more than 2%!
Stating the fee as a percentage taken each year makes the number sound so small, when fees can really add up to have huge hits on your long-term wealth. So instead of that single-year figure for the management expense ratio (MER), I prefer to think in terms of the total management expense ratio over thirty years, or MERXXX, using the roman numerals for three decades (which also happens to make it look dirty – as fees should be).
| Investment and MER | MERXXX (30 year impact) |
| An expensive but popular mutual fund from a big fundco (2.71% MER) | 56.1% |
| Typical equity fund in Canada (2.4% MER) | 51.8% |
| Fund with 2% fee | 45.5% |
| Steadyhand Founders Fund (1.34% MER) | 33.3% |
| Tangerine funds (~0.7% MER, new for 2020) | 19.0% |
| Robo-advisors (assume average of 0.70% for smaller accounts) | 19.0% |
| Robo-advisors (assume average of 0.50% for larger accounts) | 14.0% |
| TD e-series (0.37%) | 10.5% |
| ETFs (0.15%) | 4.4% |
| Optimized ETFs (0.05%) | 1.5% |
Larry Bates has created a web calculator to help show the effect of fees over time (which he calls a T-REX score).
Simplicity
A lot of ink has been spilled on the merits of the efficient market hypothesis, the performance of index funds versus active managers, and the importance of investment costs. While these all make for strong reasons to invest in index funds, my favourite is much less talked about: index funds make investing much simpler to actually do.
Humans as it turns out are not hard-wired for long-term investing, and we can often be our own worst enemies.
It is very easy to fall prey to “analysis paralysis” when you start investing. There are so many options: should you do it yourself, or buy a mutual fund? If so, which company, which fund, which manager? Will growth or dividend investing be the better choice? Should you diversify broadly to avoid striking out, or make concentrated bets in the hopes of hitting a home run?
And even beyond the first investment decision, analysis paralysis can strike at any time. If your investments are performing poorly, is it a time to stick to the plan or admit a mistake and move on? If they’re performing well is it time to take profits before mean reversion kicks in or should you ride the wave a little longer?
Index investing simplifies the decisions involved, which greatly increases the chances that you’ll actually make a decision and not get stuck in analysis paralysis – and that you’ll stick to the plan through thick and thin. Once you’ve decided to follow an index investing strategy, your options narrows down to just the few criteria that really matter: how easy is it for you to implement, does your potential investment track the indexes you want to track, and how much does it cost?
When your investments are showing losses (and there is risk in investing and at some point you will likely see a decline), it’s a lot easier to stick with the plan knowing that there’s nothing you could have done to predict or avoid a crash, and with a lot fewer moving parts to try to rebuild in the midst of a crisis.
Knowing that index investing will beat most other options net of fees simplifies makes it a good choice for your investing style. But even if you have doubts about market efficiency, the way indexing simplifies decision-making, implementation, and on-going management of your portfolio makes it a good choice even if the returns are merely average (net of fees).