The Free Lunch Many Investors Fail to See

We all hear, or use, the expression that there is no such thing as a free lunch. However, in the world of investment, there can be exceptions to that golden rule.

If you are comfortable with the risk of an index fund, you can out-perform the index return on a risk-adjusted basis, by investing more money in a less volatile, actively managed fund.

When we invest, we usually need to take on more risk in order to get better return. However, if we can improve return without taking on more risk, that's like eating a free lunch.

Many investors, when they evaluate fund managers, compare their fund's return to that of its benchmark Index. And that's how it typically goes, most of the time : Investor Joe (or his advisor) searches for the top performing, or best rated funds, and selects a handful for his portfolio. Quite often, funds that do well during a certain period start to lag after a year or two. So Investor Joe becomes disappointed. Misguided, he starts buying index funds. Why pay the high fees, he thinks, if you can get better returns with an index fund?

Problem is, Joe is looking at one side of the coin and is thinking that he got stuck with losers. If he looks at both sides, he might actually find that he has some winners in his portfolio.

By looking at both sides of the coin, we mean not only comparing the fund's return to the Index', but also comparing the risk/volatility of both investments. Take a hypothetical example: over the past five years, Fund A has delivered a 10% return, vs 11% for the Index. After five years, a $10,000 investment in Fund A would have reached $16,101, versus $16,851 invested in an index fund. On the surface, Fund A has under-performed. But there is a better way of looking at things.

During that same period, Fund A has been 20% less volatile than the index. What if you had invested 20% more money (i.e. $12,000 instead of $10,000) in Fund A? In that case, your investment would have reached $19,326 ($12,000 compounded at 10% over five years) versus 16,851 for the index fund. More importantly, you would have obtained such superior result without taking more risk than that of an index fund. In the world of investing, more return without more risk is a free lunch, no less.

Granted, the idea of putting more money in an equity fund could make some investors a bit nervous, because on the surface, it feels like taking more risk. But this is just an illusion. During the next market setback, the loss of a $12,000 investment in Fund A will not exceed the loss of a $10,000 investment in an index fund, simply because Fund A is less risky. Thus if you are comfortable with the risk of an index fund, you can use this simple maneuvre to out-perform the Index. All what you do is increase your investment in a less volatile, actively managed fund. By doing that, you earn more money for the same level of risk.

Obviously, we are making an important assumption here. We are assuming that if a certain fund is less volatile than the Index, it will lose less money when the market tanks. In reality , there is no guarantee it will always work with that same degree of precision, but based on past experiences, it does work most of the time. It is also widely known that, during market corrections or bear markets, index funds lose more money than most actively managed funds. That's a fact.

That said, there are factors that might derail the expected outcome, such as a change in the fund's management or investment strategy, or a change of mandate. Changes in the portfolio holding or market dynamics are other factors that you cannot control. This is why we encourage you, unless you are a sophisticated investor, to use this strategy with the help of an experienced advisor, who can help you monitor those factors and make necessary portfolio adjustments as required.

Now, that does not mean that you choose any actively managed fund. You need to find funds that add value, i.e. funds that deliver better return on a risk-adjusted basis. This is where the FundScope Risk-Adjusted Return (RAR) tool comes into play.

The following table illustrates the concept in numbers. In the first two sections, the table shows you the return and risk measures of Fund A versus the index. Then, under the Risk-Adjusted Return part, the table shows you the return that your fund manager could have achieved, if he or she had assumed the same level of risk as that of an index fund. Although this number might sound very hypothetical, it is actually a tremendous decision making tool. In the simplest of terms, if a fund manager achieves a higher RAR than the index, it means he or she has added value from active portfolio management. Those are the funds that you can choose for your free lunch.

The next two lines show you by how much you can out-perform the Index, if you adjust your investment in Fund A for the index risk (i.e. by investing 25% more in Fund A). You will notice the numbers are slightly different from the example we used earlier in this writng because of a minor technicality. Please bear with us because beyond that, things become really simple.

The table shows a Risk-Adjustment Factor of 25% instead of 20% for a simple reason. If Fund A is 20% less volatile than the index, that also means that the index is 25% more volatile than Fund A. That's because 80 divided by 100 renders 80%, whereas 100 divided by 80 renders 125%. So to reach a risk level of 100, which represents the risk of the index fund, we need to increase the risk of Fund A by 25%. Now it's time to find the winners.

Comparing Apples to Apples
Fund A10%
Index 11%
Fund A80%
Risk-Adjusted Return(RAR)
Fund A's RAR 12.5%
Value of $10,00 invested in an Index Fund (11% compounded return over 5 years)$16,851
Value of $12,500 invested in Fund A (10% compounded return over 5 years)$20,131
Risk Adjustment Factor25%

First, go to the FundScope Fund Filters page, which allows you to filter funds based on several criteria. In fact, this unique tool allows you to play with various risk/return criteria, until you find the fund(s) that suit you best, both from a risk and a return perspective. For the purpose of this article though, we will concentrate on the RAR tool.

Let's say you choose the Canadian Equity category. The page will then display several fields by which you can filter our database for selecting the fund(s) that meet your objective. Here, we will suggest that you use the 5-Year Risk-Adjusted Return (RAR) field. Next to it, you will see the 5-year index return for the category, which is the number you want to beat. Plug-in the RAR that you want to achieve (we suggest something similar to, or higher than the Index return) and the Filter will generate a list of funds that meet your criterion. The list will also show you, among other things, your fund's Risk-Adjustment Factor, which is the percentage by which you can increase your investment in the fund in order to enjoy your free lunch.

Bon appetit!