The Canadian Money Roadmap
Investment Fund Performance: Costs, Turnover, and Long-Term Success
In this episode I explore why a significant number of investment funds fail to outperform their benchmarks (let alone survive for the long term).
This episode breaks down the critical factors of high fees and high turnover, offering insights on how these elements negatively impact fund performance.
Invest With Evan
Become more confident with your money - Financial Foundations Course
In this episode I explore why a significant number of investment funds fail to outperform their benchmarks (let alone survive for the long term).
This episode breaks down the critical factors of high fees and high turnover, offering insights on how these elements negatively impact fund performance.
Invest With Evan
Become more confident with your money - Financial Foundations Course
Hello and welcome back to the Canadian Money Roadmap podcast. I'm your host, evan Neufeld. Today we're looking at why so many investment funds underperform their benchmarks and how you can take that data to increase your odds of having investing success for the long term. On last week's episode, I announced a new feature on my podcast that allows you to send in questions via text message. You will find that link at the top of every description of this podcast, and so many of you sent in questions that I was a little bit overwhelmed, to be honest. I got a lot of questions, and a lot of good ones, and some that I can't answer because it's outside of my scope. It'd be better for an accountant or a lawyer who understands your situation to answer those. So unfortunately, I won't be able to answer every single one of your questions on the podcast, but keep sending them in and I will pick a few to answer on the podcast in a future episode. Again, go down to the link in the description of this episode and you'll see an option to text Evan, and when you click on that it'll open up a text message and there'll be a code in there that says don't remove. Don't remove that, so that my podcast host actually sends it to me. Again, I don't get your phone number. I don't get you on any sort of spam list. I can't even respond to you because I don't get that information. I just get your questions. So send those in and I will be picking a few to answer on the podcast in the near future.
Speaker 1:Now today's episode. Like I mentioned in the intro, I'm going to be taking a look at the investing landscape and all the different funds that are available, and I like to assess performance of things over a very long period of time. And that's so tough in our world because you turn on CNBC or BNN or Twitter or whatever and you see what happened today, what happened last hour, and so many of these things just don't matter for long-term investors, and so using data that has a long time horizon on it gives us a better idea of what things are important and what things are just noise. So I'm going to be digging through a document from Dimensional Fund Advisors that they put out every year. They update the data every year and, thankfully, the trends continue on the same direction. So it's not like any earth-shattering new out every year. They update the data every year and, thankfully, the trends continue on the same direction. So it's not like any earth shattering new data every year, but it's just current, as of the end of 2023. And they just put this out a few weeks ago. So this is about as current as I could get.
Speaker 1:Let me introduce some of the concepts here with a bit of a story here. So every year, if you look on some lighthearted news, you're always going to see a story about some old man in Scotland who drinks two pints of Guinness a day and has a shot of Jameson and he's 102 years old. Here's the secret to his longevity. You know that kind of thing. You know grandma smoked a pack a day for her whole life and she died at 95. Grandma smoked a pack a day for her whole life and she died at 95.
Speaker 1:It's like, hmm, man, these are kind of interesting stories about longevity and physical health success and the vast majority of you are not going to say, gee, maybe I should start drinking and smoking a whole bunch, maybe I'll live to over a hundred years old. No, no, no. These people are living long despite the drinking and smoking and the poor diets and whatever, not because of it. These are the outliers. I don't believe you should base your nutrition plan or your fitness plan or anything like that, based on outliers that you observed, so the people that just happen to make it work, despite all the bad habits. You should base it on the things that are most likely to improve your outcomes.
Speaker 1:So this is just like investing. So every day or year or whatever, you'll see a hedge fund manager who had a crazy performance and now they're giving everybody all this advice on some headline, on CNBC, or a mutual fund or an ETF strategy that doubled the index last year and this is what they're buying going into 2025. It's like who cares? Right, when you're selecting investments for your portfolio, should you select investments based on their past performance, especially very, very recent past performance, or are there other things you can do to increase your odds of success over time? Should you drink two shots of whiskey per day for longevity, or should you eat well, exercise and create meaningful connections with other people? You know the answer here, but let's dig into the data, okay. So when it comes to the investing, this type of investment selection criteria is not a guarantee of success over the short term by any means, but aiming for these factors will allow you to increase your odds of success over time, not the other way around.
Speaker 1:So I'm going to go through this document from DFA about the fund landscape in the US. Now, the data should be similar for us in Canada because this is largely behavioral and our systems are very, very similar. But, just for transparency, this is US domiciled funds in this assessment only, and so perhaps it's different in Canada. But the stories should be the same and the concepts should be the same. And the concepts should be the same, but the data samples are actually much larger than the US, so perhaps it's even better and more accurate.
Speaker 1:So first, let's take a look at how many funds and this includes ETFs and everything like that how many have survived and outperformed their benchmark over time. This episode might be better as a YouTube video, but, truth be told, I just didn't have time to turn on the camera and edit another thing and whatnot. It's just me here, so I'm going to try to do my best to simplify it for an audio-only podcast. So, looking at funds that have survived over time, meaning they didn't close and outperformed their benchmark, let's take a look at the 20-year period of time only. So 20 years ago, there were 2,860 equity funds in the US, almost 3,000. Then over that 20 years, 55% of those funds no longer exist. They closed. Perhaps they were so bad that they just closed up shop.
Speaker 1:What often happens is underperforming funds get absorbed into other funds that have performed well, so it creates this illusion of like oh, look at this, this fund is doing really, really well, and so there's just this consolidation that ends up happening in the fund industry. But this data just looks more at a high level. So over a 20-year period, only 45% of equity funds survived, and of those 45, only 18% of those actually outperformed their benchmark over 20 years. So if we look at those winners, compared to the beginning figure, it's closer to 8% of those funds that you could have picked at the beginning actually ended up both surviving and surviving beating their respective benchmarks. That number is probably lower than you expected. It's really really really tough to be an active investor and to outperform a benchmark, and so a benchmark would be something like the S&P 500 or the NASDAQ or the Russell 2000,. Something like that, like an index. So this is kind of just defining how difficult it is to be an active investor.
Speaker 1:People often poo-poo mutual funds and ETFs that are active, but if you are a stock picker yourself, you are trying to do the same thing with far less information and far less resources and way higher trading costs. So don't be too quick to laugh at a mutual fund or ETF that underperforms. When you're a stock picker yourself, you are in this camp. Okay, so that's kind of the setting of the stage here for how few funds have actually survived and outperformed over time. It is a fraction of what you would probably expect. Now. Outperforming over a shorter period of time is much more common, and that would make sense. But if you're someone who is picking investments based on past performance, like the person that I mentioned in, say, the headline on BNN or CNBC that's saying the world is ending or this stock is going to be the best and I'm buying it in my fund, whatever, perhaps outside the industry you don't see that kind of stuff all the time, but inside the industry we see it almost every day.
Speaker 1:So the funds that performed well in the past, let's say these are the funds that are in the top 25%, so they're in the top quartile of performers over a five-year period Great. Now let's see how many of those funds are top quartile over the next five years. If past performance was a pure indicator of future performance or of manager skill or a great way to select investments on a go forward basis, you would expect these numbers to be very, very high, right? If a fund is top quartile in the last five years, why wouldn't it be top quartile in the next five years? Because this manager knows what they're doing. They're smart and I'm not being facetious here Portfolio managers if you ever have the chance to hear from them or talk to them in person, these are brilliant people and they have armies of analysts.
Speaker 1:These are not some dum-dums that are just pulling levers and buying and selling whatever comes to mind. They're doing extreme amounts of research and meeting with every company and upper management, and it's insane how much effort goes into building a mutual fund or an ETF. It is just incredibly hard. And so this concept here is the idea of persistence. So if they outperformed in the previous five years, how many of them will outperform in the next five years? And this number is about 22%.
Speaker 1:You might be thinking, hmm, that sounds pretty much like chance alone, right? Because if you group everything into quartiles again, so if you take the ones that were in the top quartile and you just turn that into a new group quartile and you just turn that into a new group. If you just arrange them in a line and chop them into quarters, you would expect with a normal distribution that 25% of them would end up in the top quartile again. But the average amount over the last few decades has been 22%. So it's worse than chance alone. So it is really really, really difficult to select an investment in advance based on past performance alone. Okay, so to summarize this if you outperformed the previous five years and you're a top quartile fund, only 22% of those have historically been top quartile in the next five years. I bet you the math gets worse five years after that. I don't have the data on it, but you know I can kind of see the writing on the wall here a little bit. So, anyways, it is very, very tough to survive and outperform and do it again, okay. So basing investment selection on these criteria is kind of playing from behind a little bit.
Speaker 1:So why is it so hard to actually outperform, like I said before, the companies and people that are running these funds. They're not crooks, largely, I guess maybe some of them are, but just like, by and large, these are people that are trying to make money and they are pouring time and resources and people into this concept of trying to make money pretty aggressively. There's 101 different ways to build a portfolio and all of them are out there and it is just very, very hard to do. The main reason for that is cost, because the higher your costs are, the higher the hurdle is for your performance to be able to outperform right. So if you have pure performance of 10% but your costs were 2%, at the end of the day the return is 8%, right%, and if the benchmark did 8%, well, you worked your butt off to just match your benchmark. So there's two types of costs that are evaluated in this document here. So the first one is explicit costs, so that's the management expense ratio.
Speaker 1:You probably know that as the MER and then there's implicit costs, or just maybe less obvious costs, and they kind of lump those together as trading costs. All these things are a little bit tougher to measure, and so the way that their data kind of did a proxy for these trading costs is based on turnover. So you can see how often a fund is buying and selling stocks and that is categorized as something called turnover. So the higher the turnover, the more often they're trading stocks. So I'll go back and I'll start with the MER conversation here Again.
Speaker 1:I'm just going to stick with the 20 year figure. The data is virtually the same over 10 and 15 years. It just gets more extreme over a 20 year period of time, which I think is valuable to look at for those of you that are listening that are considered long-term investors. So what they took a look at here was, over that same period of time, over the last 20 years, they lumped together all of the funds and they looked at their expense ratios and they kind of broke those down into quartiles again. So there's the low cost, medium, low, medium, high and high. I won't Muddy the waters with the specific numbers there, but those are kind of the main quartiles For the low-cost funds.
Speaker 1:Over a 20-year period of time. 31% were in the winners category, which is pretty good, but in the high-fee category only 6% were winners. This is mid-single digits, right. So if you can see the graph, it's a declining staircase here. So the higher the fee, the fewer funds outperform. This is true on a 10-year basis, on a 15-year basis, on a 20-year basis and this is true in equity funds and fixed income funds, so that's stocks and bonds the same concept applies. So what is the takeaway here? Investors might be able to increase your odds of success by avoiding funds with very high expense ratios. So on the explicit cost side of things, it makes sense that the lower the fee, the higher the odds of success over time.
Speaker 1:So now, if we look at turnover as a proxy for trading costs, the same thing applies here, believe it or not. As a proxy for trading costs, the same thing applies here, believe it or not. So, over a 20-year period, the highest turnover funds and these had turnover of 125%. So just think about this for a second. As far as turnover goes, if you have a turnover of 100%, that means that every stock that you own in your fund is being bought and sold on a 12-month period on average. So the more you trade, the more the implicit costs, such as brokerage fees, bid ask spreads and price impact can be really, really high. But across these hundreds and thousands of different funds, manager styles are very, very different, and so some might have higher turnover than others, just based on how they like to manage their portfolios. But the data is pretty consistent here over a 20 year period of time that funds that were in the low turnover category 31% were in the winners category, but in the high turnover quartile only 10% were winners. Again, it's the same downward staircase 31%, 22%, 15%, 10%. So the higher the turnover goes, the fewer winners there are. Again, the same is true over a 10-year basis, 15-year basis and 20 years.
Speaker 1:So what's our big takeaway here? Should you pick your investments in your portfolio your ETF and mutual fund or hedge fund investments based on past performance? Probably not, because you would have to get lucky on your selection in advance to even pick one that survives the longterm, let alone outperforms over the longterm. If you pick a fund that doesn't survive and you have to pick a new fund now, you're in the same game again you have to pick one that's going to survive and hopefully outperform. Outperformance isn't the only thing that matters, but it's often the goal of the portfolio manager. So, anyways, it's difficult to do so when you're picking investments.
Speaker 1:Two factors that you can look for that might lead to greater success in the future are low fees and low turnover. Again, they're not guarantees of success. Low fees alone don't lead to successful outcomes, but it helps. And low turnover alone doesn't lead to successful outcomes, but it helps. These principles are how Dimensional has built their portfolios for clients, and the actual nuts and bolts of their strategy are evidence-based as well. I've talked about these ideas on the podcast before, but they revolve around factors and indexing, and so if you'd like to work with an advisor that believes in these principles for clients, feel free to reach out on my website Link is in the show notes or you can head over to evannewfieldcom, and Jordan from our team will connect with you to see if it might be a good fit to work together. But even if you're a DIY investor, hopefully this was helpful for you or if you work with another advisor, this could help in questions to ask your advisor so that you have some better clarity on what's actually going into your portfolio and why.
Speaker 1:So that's it for this week. Thanks so much for listening listening, and we will catch you next week on another episode. Take care. Thanks for listening to this episode of the Canadian Money Roadmap Podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal and tax advisors before making consult with your financial, legal and tax advisors before making changes to your financial plan. Evan Neufeld is a certified financial planner and registered investment fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.