The Power of Index Funds:Canada's Best-Kept Investment Secret
Ted Cadsby, CIBC's vice-president responsible for mutual funds has written an excellent
introductory book on indexing for Canadian investors. The Power of Index Funds:
Canada's Best-Kept Investment Secret starts off by explaining what index funds are and
how they work. Cadsby then explains why they're better than actively managed funds. He
systematically refutes every conceivable objection that a skeptic might have. Finally
Cadsby goes through the process of building portfolios and selecting specific funds for a
variety of investor profiles.
Index Funds is written in the same conversational style that was popularised by David
Chilton in The Wealthy Barber. While some may object to this style, in my opinion it
works quite well. This is a book without the jargon and endless references to obscure
academic studies that one finds in most books on investing . While the book's primary
appeal will be to beginning investors, Cadsby's arguments will ring true with more
advanced readers who perhaps have seen some of them before in magazine articles or
newspaper columns .
The case for indexing is actually even more compelling than what's presented in Index
Funds. That's because Cadsby uses index returns minus an MER of 0.90% as his
benchmark. (CIBC's index funds charge a 0.90% MER.) But in reality it's possible for
individual investors to run index portfolios for much less using competitors' index funds.
For instance Altamira and Royal charge 0.50% for most of their index funds. And one
can also use Index Participation Units like the new S&P/TSE 60 iUnits or the US S&P
500 SPDRs which charge less than 0.20%. Even CIBC rebates their MERs down to
0.30% for accounts that hold at least $150,000 in their index funds.
In discussing how difficult it is to distinguish skilled fund managers from lucky ones,
Cadsby uses the oft-cited example of 1,000 people flipping coins. After 10 tosses it's
likely that at least one person will have flipped 10 heads or 10 tails in a row. But this is
the result of luck, not skill. Cadsby then uses this logic to contend that it's possible for
10% of all mutual funds to beat the average fund's returns for three consecutive years due
only to chance. Then he adds the coup de grace: "Given a sample size of 1,000 [ fund
managers], there is some consensus that it would take around 25 years to be able to
conclude that a manager is likely to be talented, rather than just lucky. Even then we're
talking about a higher probability -- not a certainty." Who needs those odds?
Yet despite this analysis Cadsby argues that indexing doesn't work for certain asset
classes like small caps, and in Pacific Rim and "emerging market" countries because the
markets on which they trade are less efficient than the large cap markets in North
America and Europe. The inefficiency may be true, but it's not the only criterion. Trading
costs (brokerage fees, bid/ask spreads, securities taxes and the like) are also much higher
in these markets. Other indexing proponents like Malkiel and Swedroe argue that any
edge an active manager may have in a less efficient market is more than offset by those
higher costs. Cadsby on the other hand concludes that it's better to use actively managed
funds in these classes.
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