Most investors utilize a traditional active approach to portfolio management, whereby they hire a portfolio manager to invest in certain securities or industry sectors based on an opinion of value or to attempt to time the market (trying to correctly anticipate whether to be invested or not invested). The goal is to achieve the investor's investment goals and objectives and produce a return that is superior to that of simply investing directly in an underlying equity or fixed income market index. These indexes are often used as benchmarks to evaluate the success of the investment manager's promise to provide superior long-term investment performance.
However, accepting additional risk to perform better than a market index also exposes the portfolio manager to the chance of underperforming it as well. With investment managers competing among themselves in selecting securities, aggregate investment manager returns inevitably parallel those of the market itself. Active investment managers then incur costs for research, marketing, administration and selling agent compensation that result in the vast majority failing to produce returns that exceed those of a passive market index.
The chart below shows the annualized 5-year performance of 345 Canadian Equity Mutual Funds to December 31, 2006. The yellow line is the performance of the S&P/TSX 300 market index. The red bars to the left of the yellow line show the number of funds that have had weaker performance than the index and the red bars to the right of the line show the number of the funds that have had superior performance than the index.
The chart shows that 86.4% of Canadian Equity mutual funds have not been able to outperform the S&P/TSX 300 Index. In fact, the average annual performance of these 345 mutual funds was 9.94% compared to 13.08% for S&P/TSX 300 index.
Very few investors have held their investment managers, or the advisors who recommended them accountable for these poor results. Investors have grown to accept the reality of paying their investment managers and advisors whether markets go up or down and more importantly whether their portfolios have done better or worse than the underlying market index.
Canadian Equity - Five Year
What is Index Investing?
Although institutional investors have utilized index investing for years, it is still a relatively new approach to private client investors.
Index investing seeks to match the returns of an underlying financial market index, meaning that an investor receives the average return of all the securities contained in the index. The investor does not try to determine which securities may perform better than the index, instead the securities that make up the index are purchased proportionally and held indefinitely. Changes to an investor's portfolio are only made when a change is made to the underlying index itself.
Index investing contrasts with the active management approach that is still utilized by most private client investors. There is an overwhelming amount of academic research that shows that the average investor using an active approach to portfolio management fails to perform better than an underlying financial index benchmark. This occurs for two reasons:
Firstly, the returns received by investors in a financial market are zero-sum, since someone must hold all securities in a financial market. Therefore, if some investors receive above average returns, other investors receive below average returns. Not all investors can receive above average returns.
Secondly, because of the extra costs needed for active management (research, marketing, administration and selling agent compensation) even an investor who receives an above average pre-cost return, will have their return reduced to less than that of the underlying financial index once costs are taken into consideration.
Therefore, when it comes to investing, being average can result in being superior!
What Makes Elysium Wealth Management Different?
Since the large majority of active investment mangers provide little sustained out-performance of a financial market index, we believe it makes sense to utilize the superior alternative of index investing.
We construct portfolios for our clients utilizing Exchange Traded Funds (or ETFs) as the core holdings. ETFs are open-ended trusts, which are listed and traded on major stock exchanges.
A portfolio constructed of ETFs offers the following advantages:
- Since an ETF invests directly and proportionally in the securities that comprise an underlying market index, the risk of suffering returns that are dramatically below that of the index is eliminated.
- There are no redemption fees or deferred sales charges when an ETF is sold.
- ETFs offer broad levels of portfolio diversification because they are comprised of all the securities that are included in a market index.
Depending on a client's investment goals, objectives and "risk comfort zone", these exchange-traded funds (ETFs) can then be combined with equity option hedging strategies. Options are contracts in which the terms of the contract are standardized and give the buyer the right, but not the obligation, to buy or sell a particular asset (e.g., the underlying ETF) at a fixed price (the strike price) for a specific period of time (until expiration). Option contracts are listed and traded on major exchanges.
The combination of ETFs and option hedging strategies is designed to deliver an above average rate of return, while striving to minimize short-term volatility consistent with a client's "risk comfort zone".
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