Couch potato investing

I recently received a question from a reader who asked how I felt about the idea of building a portfolio exclusively with exchange-traded funds (ETFs) as opposed to using individual stocks and/or mutual funds.

“Is this a valid approach for the investor who does not want to do a lot of active investing and does not want to pay the relatively high MERs charged in Canada on actively-managed mutual funds the majority of which, in the long run, I understand do not do a whole lot better than their benchmark indices?”, he asked.

It’s an excellent question and one which has sparked a lot of debate in the investment community in recent years. This passive approach is often referred to as “couch potato” investing and the concept is generally credited to Scott Burns, a personal finance writer for the Dallas Morning News.

There are many variations on the couch potato approach and a range of asset mix recommendations but all basically involve using some combination of ETFs or index funds to track the performance of key benchmark indexes like the S&P/TSX Composite and the S&P 500 in New York.

For ample, the March issue of MoneySense magazine suggested a mix as follows. The equity side of the portfolio (60 per cent of the total) would be divided equally among three types of iShares: the CDN Composite Index Fund (TSX: XIC), the CDN S&P 500 Index Fund (TSX: XSP), and the CDN MSCI EAFE Index Fund (TSX: XIN). The other 40 per cent would go to the CDN Bond Index Fund (TSX: XBB). That’s just one approach; there are many more.

Prof. Eric Kirzner of the Rotman School of Management, University of Toronto was quoted by MoneySense as saying that over a long time horizon a well-balanced ETF portfolio could be expected to produce an average annual return of around 8 per cent. That is certainly a reasonable target.

I can see the attraction of the couch potato approach, however I have some problems with the idea, starting from what I see as a misleading basic premise. Canadian Business magazine in a recent article on the strategy said: “When you look at results over several years, about 80 per cent of actively managed funds lag behind the market.” That may be true but what no one bothers to say is that 100 per cent of all ETFs and index funds lag the market, at least if they are being run correctly. The reason is simple: expenses and fees. Even if a fund achieves a 100 per cent correlation with its benchmark index, that has to be discounted by the management expense ratio (MER). So don’t build the case for being a couch potato investor on the idea that index-based securities are somehow better than actively-managed funds when it comes to beating (or even matching) the indexes.

Another concern I have is human psychology. It may well be true that if you stick to the formula through good times and bad, the end result will be a respectable long-term gain. Unfortunately, we aren’t made that way. An index fund offers nowhere to hide. When the stock market plunges, any index fund or ETF that tracks it will plunge too. That’s exactly what happened during the 2000-2002 bear market. Any couch potato without a cast-iron stomach might have lost his/her nerve and sold as the indexes crumbled. Ask yourself honestly: what would you have done? Meantime, conservative money managers like Kim Shannon, Peter Cundill, and Francis Chou piloted their mutual funds through the carnage safely. Not only did they not lose money; they actually made profits for investors during that period.

So the debate can be argued both ways. The bottom line is that investors have to decide which approach is most comfortable and best suited to their needs.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go to