My index portfolio has been trounced but I'll have my day

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A couple of weeks ago, the CEO of an investment firm, AES International, invited me to speak to his team of financial advisers in the Middle East. I flew to Dubai – the glitzy city-state surrounded by sand and Emirati oil.

Last year, he had asked his team of financial advisers to build index fund portfolios for their clients. It would help the investors. But most of the advisers didn't want to do it. Eighty per cent of them left the firm – or were fired for not adhering to a passive investment strategy. The CEO hoped that I could help him convince the remaining 20 per cent to stay.

But why did so many leave? The Middle East is a gold mine for financial advisers who sell high-commission-paying products. I wrote about these – and the commissions they pay – in my book, The Global Expatriate's Guide To Investing.

Such advisers can make out like bandits. A small percentage earn commissions that exceed a million dollars a year. That's the golden ring that so many of them reach for. But their investors get the shaft. In most cases, the investment platforms cost investors 4 per cent or more per year. When these investors get caught up in the fee-burdened riptide, they often can't climb out. Many charge penalties of up to 80 per cent of a portfolio's total value just to sell before a 25-year holding period.

No, these platforms shouldn't be legal. Not every country has Canada's regulatory rules. But clients don't deserve to get tossed under buses. Yes, the advisers' immediate earnings would decrease if they built portfolios of index funds. But their referrals would increase. As a result, so could the advisers' long-term earnings. Fortunately, for the advisers who remained, I was preaching to the choir.

But how do you convince clients that index funds are best? After all, if you look at my Strategy Lab portfolio, it's in last place. My colleagues' hand-picked stock portfolios are leaving it behind. I'm the first to admit that John Heinzl, Norman Rothery and Chris Umiastowski are great stock pickers. But global stock market indexes have also done well.

A full 38 per cent of my Strategy Lab portfolio is in a Canadian bond market index. It's a conservative portfolio – the only Strategy Lab portfolio with bonds and global stock market diversification.

Everybody knows that stocks beat bonds over time. But bonds add stability. When markets fall (and they often do) a portfolio with bonds won't fall as far. This can temper a self-sabotaging reaction to sell when stocks fall. Controlling human behaviour when markets go haywire is investing's golden rule.

Since Sept. 13, 2012, my Strategy Lab portfolio has gained 31.27 per cent.

But an argument for passive investing looks more impressive if we see how global indexes have performed without bonds. I wouldn't build a portfolio without a bond allocation. But for fun, let's see how global stock indexes have performed since the beginning of September, 2012. We can use portfoliovisualizer.com (the site doesn't allow for a mid-month starting point).

Portfoliovisualizer tracks U.S.-listed funds, so enter Vanguard's Total World Stock ETF (VT). This index contains global stocks. They're weighted based on market capitalization.

Between Sept. 1, 2012, and April 30, 2016, the index gained a total of 36.25 per cent in U.S. dollars. The U.S. dollar gained 27 per cent on the Canadian dollar. Measured in Canadian dollars, Vanguard's Total World Stock ETF gained 63.25 per cent.

The Canadian stock market index didn't do as well. But if we had a portfolio made up of 20 per cent Canadian stocks and 80 per cent global stocks, the total gain would be 29 per cent when measured in U.S. dollars, or 56 per cent measured in Canadian dollars.

These returns can help if you're trying to convince an investor or adviser to use index funds. But understanding the science is much more important.

Most of the world's stock market money is institutionally managed. That means, when the U.S. stock index gains 10 per cent in a given year, the average institutionally managed stock market fund would have made about 10 per cent before fees. Institutional investors make up the vast majority of the market. As a result, their returns (before fees) are close to the market's returns.

Economic Nobel Prize laureate William Sharpe wrote about this in detail, in his paper, The Arithmetic of Active Management. By investing with index funds, investors will earn roughly the same return as the average professional investor – before fees. After fees, it's a different story. Low-cost index funds beat most professional investors.

Whether you're a DIY investor or a financial adviser, this is an evidence-based strategy that makes a lot of sense. Build a portfolio of index funds. It's simple. It's effective. Over time, it will leave most actively managed portfolios in the Emirati dust.

Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can read more in the series at tgam.ca/strategy-lab.