ETFs: Worst Thing to Happen to Finance?

Low cost ETFs and index funds just might be the best thing to happen to your portfolio.

Here’s why.

When I used to work as a financial adviser for one of the big financial services companies in Canada, I had a list of mutual funds to offer to my clients. There were 29 actively managed funds and 1 index fund. The one index fund didn’t pay any commission to the adviser (us) and as you can imagine, the advisers didn’t make any effort to offer that index fund.

Index funds today

When I wanted to help one of my friends to start investing in the stock market we booked an appointment at the local bank. The adviser assessed the risk profile of my friend and then took out a pamphlet with about 40 different bank-branded actively managed mutual funds.

When I insisted that we wanted index funds and low-cost ETFs, the adviser told us that we have to open a self-directed investment account and that she was not able to help us make those decisions. Obviously, if neither the bank nor her were going to make any money on my friend, my friend was not worth talking to.

It’s against the interest of the investment companies to help the clients

It’s obvious that financial institutions don’t want to help client’s get the lowest cost investments. Companies like Vanguard (the leader in index funds and ETFs)  don’t pay commission to advisers who recommend their products. When I was a financial adviser, I would get $0 when a client bought a low-cost index fund. My employer got nothing neither.

That’s why we promoted index funds. There were no trailer fees (Trailer fees is a service commission paid from the mutual fund company to the adviser usually about 1%- for keeping the client invested). Why would we recommend something which didn’t pay a commission? How could we pay for our gas and our rent if we were not compensated in any way?

People are ditching actively managed funds

But the cat is out of the bag. Due to a series of academic papers, investment books and/or blogs, investors have discovered that they were paying enormous fees to actively managed funds, which were not delivering the superior performance they promised. The exodus has been enormous and many actively managed funds are being forced to (a) lower their prices, (b) offer their own version of index funds, or (c) close their doors.

Actively managed mutual funds have not delivered on their promise. Every fund’s mission is to outperform the market, but 90% of actively managed funds underperform the market in a 10 year time period. There are many reasons for this underperformance which we will explain in another blog post.