One of the core principles of Chalten’s Evidence Based Approach is that investors should not pay a professional money manager to beat the market by picking stocks or trying to time the market’s ups and downs. Over the long run, it doesn’t work. The investment returns you can expect to receive should depend only on how much and what type of risk you take, not on which stock you pick or which fund manager you use. Furthermore, access to the stock market in a diversified, low cost manner is as easy as it’s ever been through passive index funds and ETFs. So why hasn’t “passive” investing taken off in Canada the way it has in the US? (When I say “take off” there is still room for growth in passive investing south of the border, with only about 15% of market capitalization of US equities tied up in passive vs active funds and 3% of fixed income, according to Vanguard). Index investing in Canada is relatively more obscure. Using the size of the ETF industry as a proxy for the prevalence of passive investing, according to ICI, the Investment Company Institute, the US ETF market is $1.7 trillion compared to $15 trillion invested in mutual fund assets, representing just over 11%. In Canada it’s $78 bn vs $1.2 trillion or 6.5% of assets in mutual funds according to the Canadian ETF Association.
While the prevalence of ETF funds may not be the best representation of passive vs active investing and ETFs are used for many other purposes, it is one of the indicators and passive investing in Canada continues to lag behind the US. At the end of last year John Rekenthaler at Morningstar Canada published an interesting insight, “What European — and Canadian — fund investors can learn from the United States” in which he lays out potential differences in the markets and why index investing has taken off in the US while remaining relatively obscure in Canada and Europe. He highlights three conditions he believes are necessary for index investing to become more mainstream.
1) The availability of funds (√) – in Canada there is now a large variety of low cost Exchange Traded Funds and index mutual funds. Just recently, Blackrock added some new ETFs to its low cost Core family and Vanguard, the US giant of passive investing, has entered the Canadian market and is growing.
2) Performance data (√) – fund returns in Canada are widely available and the evidence of the underperformance of active mutual funds is clear – we set out some of that evidence in Chalten’s Evidence Based Approach.
3) Competition among advisors (?) – the third condition necessary for indexing to flourish is that advisors embrace indexing. In the US, indexing didn’t really take off until competition among advisors brought passive investing out of the shadows and into the mainstream. Advisors stepped forward to challenge the status quo and gave their investing clients the choice to invest in low cost market access products like those offered by Vanguard, Blackrock and Dimensional Fund Advisors. In Canada, the number of fee only advisors advocating these types of products is very low relative to the number in the US. Furthermore, many Canadians don’t seem to be aware of the high fees they pay for mutual funds, often over 2% per year of assets under management.
So how does the situation in Canada change? In the US it evolved because of increased competition and innovation among the advisor community and investment industry. In Canada, regulators may seek to give the industry a bit of a nudge from behind. The new rules in Canada being put into place by the Canadian Securities Administraors called the Client Relationship Model (or CRM) will seek to provide better disclosures on fees and how advisors are compensated. Many Canadians don’t know how much they pay or how they pay. According to Environics Research, two thirds of Canadians who have a financial advisor either have no idea how much they pay in annual fees for the advice they receive or believe they pay no fees at all. This strikes me as unfortunate considering that annual investment fees could be one of the largest household expenses incurred and for some might be the largest annual expense after their mortgage payment. CRM will seek to change this. While we think that Canadians are diligent and innovative enough to seek out a better deal for themselves without help from regulation, the increased transparency that will come with CRM should help facilitate the move to a better place.