By Scott Ronalds

Our recent piece on Steadyhand vs. ETFs (undexing vs indexing) has prompted some interesting questions and comments from investors.

One reader in particular posed some questions that make for good discussion.

"Your comparison of Steadyhand funds to broad market ETFs is not an apples to apples comparison. On the bond side your funds have much higher credit risk - your income fund is only 20% government bonds whereas XBB has 70% government bonds. More importantly, on the equity side you have some small cap exposure and likely some exposure to the value premium. This exposure would be expected to lead to outperformance over the broad market over the long term, but also with higher risk than the broad market. If an investor wished to take this route of higher risk/higher return they could do so at lower cost by buying small cap and value ETFs."

The Steadyhand portfolios have intentional biases. The commenter has noted two, corporate bonds and small-cap stocks, and there are others. For instance, our managers have no desire to replicate the Canadian stock market with its strong emphasis on financial services, energy and materials stocks, so Steadyhand portfolios will tend to have less exposure to these sectors. Overall, our equity funds are style agnostic, so if there’s a tilt towards value, it’s very slight.

As for higher risk, I can’t agree with the commenter. Yes, our bonds are more aggressive, but our absolute return approach to stock investing is less aggressive than the broad indexes. We would expect to see our equity funds hold up better in weak periods.

Certainly, sophisticated investors (such as this reader) can implement all kinds of strategies with ETFs, but as we describe Julie and Jake in the piece, “They’re interested in investing, but not passionate about it. Neither has the time to make it a hobby or leisure pursuit.” If we wanted to exactly replicate Julie’s Steadyhand portfolio with ETFs, we’d have to make Jake’s portfolio more complicated and be willing to change it from year to year. Both of these enhancements would make the comparison less useful.

"You chose very expensive ETFs in your ETF portfolio. Using VAB, VCN, VDU (or XEF for a broader exposure) and VUN, you would have the same portfolio for a blended cost of only 0.14%. Brokerages no longer charge admin fees, commissions are free at some brokerages now and $9.99 per trade at all others, and the broad market ETFS have very minimal tracking error, so these costs are extremely low and certainly not 0.15%."

The iShares ETFs we chose in our analysis are among the largest, most popular and long-standing ETFs in Canada. We have conducted our comparison for four years running and have used the same broad-market ETFs each time. The Vanguard ETFs mentioned (VAB, VCN, VDU) are excellent products, but were not in existence when we started our analysis and do not have a sufficient track record that allows for a comparison with our funds. We should note, the ETF we use for exposure to the Canadian market (XIC) has a management fee of 0.05%, which is amongst the cheapest in Canada.

While it’s true that some of the Vanguard products have lower fees than their iShares counterparts, the differences would not have materially changed the results of our analysis.

The comment about the other costs (trading, administrative and tracking error) being on the high side (at 0.15%) has been noted. When we originally published the Jake vs. Julie comparison, we had the report peer reviewed by index-oriented investors. They believed our estimates on the cost of running an index portfolio were reasonable. Trading and admin fees have come down in recent years, however, and we will reassess this for next year.

This question has unearthed a mistake in the report. We relate the 0.15% to trading, administration and tracking error (the difference in performance between the ETF and its benchmark), but the latter was not included. It’s true that ETFs don’t always achieve their goal of replicating the index (particularly with international or more exotic funds), but this was not factored into the 0.15%, but rather reflected in the performance of the ETFs.

"I'm sure if you did an apples to apples comparison, that is comparing your funds to a broad based ETF portfolio using the inexpensive ETFs I mentioned above with appropriate small cap and value tilts using small cap and value ETFs, the ETF portfolio must come out ahead due to the significantly lower cost."

It is very dangerous to be "sure" about anything in investing. As an active manager, we’re doing everything we can to stack the odds in our favour, but we can’t guarantee that Julie will beat Jake over the long term. The reader is right to be "sure" about a lower cost, but there’s no guarantee that the suggested adjustments to Jake’s portfolio will enhance returns over the long term.

I should note, in previous years we’ve come across other index-oriented investors who have been surprised (and in some cases, unable to believe) that a low-cost, non-benchmark oriented, concentrated portfolio could possibly beat an ETF portfolio. At Steadyhand, we are fully cognizant of the challenges and curve balls that markets throw at us (even beaten up by them at times). Index investors should be too.

We’ve worked hard to make the Steadyhand vs. ETF comparison fair, and have asked for feedback from many people on both sides of the active vs. passive debate. Most agree that it’s an objective comparison. We should note also that Jake vs. Julie significantly beats the most commonly used comparison by indexers, which is comparing all mutual funds (a majority of which have an advice charge built into their MER) to the market indexes (i.e. no management fees, trading costs, fund expenses or tracking error).

We thank this reader and the others who have sent comments to us. Some good insights have been brought forward on costs and portfolio composition. We’ll continue to challenge our assumptions in future versions of the report.