Dear Canada,
We’ve had quite a ride over the past decade, capped off with some particularly lucrative domestic equity market returns in 2019. At the time of this writing, the S&P/TSX Composite index has posted a 21.8% total return year to date. These spectacular short-term returns may convince investors to overlook the fees they pay to be invested with a skilled manager. After all, what is a measly 2% fee to managers that have returned well over double digits this year? If this is you, I’d like to point out a few things that you might have missed.
It's raining double digit returns! Or is it?
Yes, a 22% return is fun to talk about around the water cooler, but did you make the entire amount? The probability that you invested exactly at the right point to take full advantage of this rally is quite slim especially considering the large market drawdown at the end of 2018. More to the point, if one were to randomize the month that you started invested in the Canadian equity market over the last 15 years, and then measured the annualized return of your investment over the following 3 years, the distribution would look something like this:
There were only 10 starting months out of a possible 220 where an investor would have achieved in excess of a 22% return in the following 3 years. Meaning most of the time, our returns are far below the returns of this calendar year. The YTD returns of North American equity benchmarks this year also easily overshadowed by looking at the annualized total returns of the index over longer time frames:
As difficult as it can be, when investing in equity markets, it serves investors well to have a medium to long term outlook on investment returns, as well as reasonable expectations on said returns. After all, what matters most is whether you meet your financial goals, not whether you can beat the market in a given calendar year.
Why fees matter
Management fees charged on funds are typically charged regardless of how the fund performs. Paying a higher fee to a manager does not translate into higher returns. Case in point, I used Morningstar’s database to look at the category of Canadian Equity funds (inclusive of active and passive mandates with an inception date prior to January 1st, 2004) and plotted their medium to long term net-of-fees annualized returns against their management expense ratios (as reported in the fund company’s own prospectuses) as a simple illustration of this point:
Using a line of best fit across these data points, the charts above show us that although there are some obvious outliers, in general there is a slight inverse relationship between fees and annualized returns amongst Canadian equity managers as an example.
All about advice
According to Morningstar’s 2019 Global Investor Experience survey, Canada’s investment industry has one of the highest fee structures in the world compared against 26 different global markets. The structure of the Canadian investment industry continues to home in on bundled advice, where fees are charged for advice and distribution of funds, along with the actual management of assets.
This is not necessarily a bad thing, especially if you are in the hands of an advisor who adds significant value through financial planning and coaching through major financial events, quantified by what my colleagues at Morningstar call Gamma (the value of sound financial advice). But if this doesn’t describe your situation, it never hurts to talk to your financial advisor and ensure you are happy with the way you are being charged.
In roaring equity markets like 2019, staying humble is hard. Let’s not forget 3 key things that will ultimately contribute to our true financial success: reasonable expectations, a close eye on fees, and great financial coaching.
Sincerely,
Ian Tam, CFA
Director of Investment Research, Canada
