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Canadian Investors Are (Mostly) Losers

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I have nothing but great respect and admiration for our neighbors up north. If you spend any time in Canada, you will be struck by the kindness, civility and charm of its people. Canadians enjoy long life expectancy, high average incomes and extensive social ties. The country ranks very highly on lists of the world's happiest citizens, significantly outperforming the United States.

Clearly, there are some things about the way Canadians live their lives that would be helpful for us to emulate. Unfortunately, investing is not one of them.

Canadians seem so clueless about basic principles of investing that it's hard to know where to begin. Consider the following example:

You are a Canadian investor and wish to diversify your portfolio by adding a mutual fund that invests in the stock of companies selected from the S&P 500 index. You have a choice between an actively managed fund, where the fund manager attempts to beat the benchmark index, and an index fund, which simply tracks it.

Approximately 90 percent of investors in Canada would choose the actively managed fund. Apparently, these investors pay no attention to the data, which makes them similar to the majority of their American counterparts.

According to a scorecard prepared last year by Standard & Poor's, for the five-year period ended June 30, 2013, just 2.35 percent of actively managed funds in Canada that used the S&P 500 total return as its benchmark outperformed the index. That's not a typo. More than 97 percent of these actively managed funds underperformed their benchmark.

In every other asset class studied by Standard & Poor's, the majority of Canadian actively managed funds also underperformed their benchmark index. Even in funds limited to Canadian stocks, where you would think Canadian fund managers have special expertise, approximately 70 percent of actively managed funds underperformed their benchmark.

You don't need a Ph.D. in finance to understand the reason for this dismal track record. Canadian funds have some of the highest expense ratios in the world. The typical investor in a Canadian stock fund pays a management fee of between 2 percent and 2.5 percent. In addition, beleaguered Canadian investors may be charged sales commissions when buying or selling mutual funds. These fees are staggering and indefensible.

Index funds and exchange-traded funds are readily available to Canadians. Some have expense ratios that are markedly lower than comparable actively managed funds.

Canadian investors also have access to funds managed by Dimensional Fund Advisors, but they are only available through designated financial advisers. These advisers, who charge an advisory fee for their services, structure portfolios built on the well-known Fama-French Three Factor Model. The blended expense ratio of the funds in these portfolios, not including investment advisory fees, is typically around 0.3 percent. [Full disclosure: I am affiliated with Buckingham, a U.S.-based registered investor adviser. Buckingham uses Dimensional funds in the portfolios of its clients.]

There is compelling evidence that investors in portfolios of Dimensional funds are far more successful in capturing the returns of these funds. This is due in large part to the rigorous training of their advisers, who understand the merits of passive investing and portfolio construction. According to the 2005 Morningstar Indexes Yearbook, the dollar weighted return of all index funds in the preceding decade was only 82 percent of the time-weighted returns investors could have captured with those funds. Investors in Dimensional funds captured 109 percent of the time-weighted returns.

The Morningstar Yearbook explained that investors in these funds were able to capture more than 100 percent of the fund returns because their advisers encouraged regular rebalancing, which involves the counterintuitive process of selling segments of the market that have been going up and buying those segments that have been declining.

Canada's financial services industry is dominated by five large banks. These banks control more than 90 percent of bank deposits. The loyalty most Canadians have to their banks may blind them to the reality that actively managed funds are dumb investments. According to Canadian Couch Potato, switching to an index based strategy can reduce a typical investor's costs by 90 percent and beat the majority of actively managed portfolios.

It's time for Canadian investors to overcome the cognitive dissonance affecting their judgment and endangering their plans for retirement with dignity.

2014-04-01-Hiresfrontbookcover.jpgDan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.