Ten years ago the NASDAQ composite index was double today’s value. A dollar invested in this US technology index in March of 2000 is worth 68 cents now. During this decade, it happens that our Canadian dollar has advanced about 27 percent against the US greenback, so converting back to Canadian dollars the total would look more like 41 cents. This investment return pain has been shared between technology investors and companies, and perhaps especially, employees. In general most Canadians looking to provide for their families and retirement would have been much better served looking outside of the technology sector.
Diversification improved the outcome. A dollar invested into the US S&P 500 total return index is worth about 66 cents after currency adjustment. Not really compelling, but 66 cents beats 41 cents. A dollar invested globally in MS EAFE in 2000 would be worth about 65 cents, currency adjusted. A dollar invested in Canada, as represented by the S&P TSX60 total return would have actually grown to about $1.72 in 10 years. Bonds as represented by DEX Universe Canadian Bond index, increased from a dollar to $1.62 in 10 years.
A common benchmark for pension return of 7% would have seen a dollar grow to $1.97 in 10 years. Inflation, as represented by core CPI, represents a change of 20 cents from 2000 to the end of 2009. For pension managers, the benchmark return is the rate of investment return that will balance cash inflows with cash outflow and cover for the effects of inflation. As the above statistics indicate, this has been a very challenging period for investors and investment professionals. Many pension plans are now underfunded and similarly, retirement accounts are not achieving the growth that was expected to fund retirement spending. Those most acutely affected include those investors who retired at the beginning of the decade. Many now have to choose between lower spending and/or adding back some sort of employment income. Some will of course follow the path of chasing higher returns and tolerating much higher levels of risk. It is likely that this final choice will be too difficult a path to follow over any meaningful period of time.
Last week Mullins Capital Management hosted a luncheon with the head of BGI Canada, Heather Pelant, as our speaker. You may know many of their products as “i shares” or exchange traded funds (ETF). Ms Pelant’s presentation reviewed the reasons for owning ETFs instead of actively-managed mutual funds. She pointed out that market exposure explained more than 90 percent of investor return. In addition, she discussed how few active managers deliver returns greater than the market. There is a good body of academic research backing up her views. So, a real problem exists for investors trying to find persistent out-performance for their investment portfolios. Return is further challenged when fees and expenses are considered.
Short term stock market performance is not predictable. The risk of “not knowing” is rewarded by investment return for fully diversified portfolios. This investment identity explains some of the under-performance of active management. To paraphrase Heather Pelant, active managers get it wrong by focusing on the seven percent of total investment returns attributed to market timing and stock selection. The math adds up like this: the average investor can beat more than 90% of professional managers by simply achieving the returns provided by the common indexes representing various stock markets. Most pension managers can be considered active managers. The overwhelming majority of mutual funds offered to individual investors are actively managed. Exchange traded funds are designed to track specific reference markets. Their “tracking error” is usually quite small and mostly attributed to the fees they charge to manage the effort. Perhaps somewhat surprisingly then, according to BGI, ETFs are represented in only 5 percent of investor portfolio’s in Canada.
While the attributes of ETFs are compelling, for our investment practice we think there are additional improvements we should and can make for investors in their fully diversified portfolios. For statistically relevant periods, we expect stocks to outperform bonds. We expect small capitalization stocks to outperform large capitalization stocks. We expect low price-to-book value stocks to outperform high price-to-book value stocks. These ideas are embodied in the three factor model of Fama and French and applied to the real investment world through Dimensional Funds. In our 10 year example a dollar invested in US large and small companies through Dimensional US large Value and US small value funds would have turned into about $1.60 or about $1.33 after currency conversion. This is a meaningful improvement when compared to the return of the S&P 500 total return index (a dollar to 66 cents) for the period.
The randomness of short term investment return adds a great deal of confusion to the choices investors must make. It is frustrating when properly diversified portfolios designed to achieve investment goals of clients and their families over a meaningful period simply fail to do so. If the under-performance is a random outcome we should stick to the approach. We assume the return for risk assumed will manifest. Similarly, if our performance is much better than expected based largely on randomness we should consider a change in approach. Like pension funds, individual investors should consider current assets and future savings along with their longer term income requirements to define the appropriate risk level they can assume. After the quantitative definition, an important second check is to determine how much risk you are willing to assume. Your game plan becomes clear if these two definitions are compatible. In addition, keeping costs lower by managing taxes and management fees will provide a permanent, sustainable improvement in the management of your assets.
Finally, I fully expect the financial media to explore the returns to this past decade. In my opinion, there is little insight gained by assuming the past will equal the future in the investment markets. Measuring returns from a date like 2000 to 2010 is a good test but probably not very good roadmap. Good advisors have strategies that consider this when developing game plans for their clients.
