Dynamic Funds have 7 mutual funds that have beaten their respective stock index benchmarks over the past 10 years despite sky-high MERs. Jonathan Chevreau suggests that this is reason for index fund proponents to eat crow. Both Canadian Capitalist and Canadian Couch Potato did an excellent job of explaining the problem of identifying outperforming mutual funds before they outperform. I won’t repeat their arguments. But I will show how to replicate the performance of Dynamic Funds with a dead-simple strategy.
Let’s say that we run a mutual fund company that wishes to charge a 4% MER. (Why water-ski behind a small yacht when it could be a big yacht?) But we also want 7 of our funds to outperform the S&P TSX index over the next 10 years. This sounds like a tall order, but it’s actually quite easy.
To begin with we’ll create 112 (7x16) mutual funds in our family. The reason for this number will become apparent later. We’ll invest each one in the S&P TSX index and collect our 4% MER each year. The only thing left to add is some bets.
Initially, we’ll pair off the funds into 56 pairs. Suppose that funds A and B are paired. Fund A will enter into a derivative contract and fund B will take the opposite side of the same derivative contract. We’ll stop the betting when one fund is up 25% and the other is down 25%. The type of derivative doesn’t really matter and it doesn’t matter whether fund A or B comes out ahead.
Once the betting is complete, all the funds will have returns with three components: the stock market return, the 4% per year MER loss, and +/- 25% from the derivative betting (56 winning funds with +25% and 56 losers with -25%).
Next we match the 56 winning funds in pairs and repeat the betting process for another round. The losers from the first round won’t do any further betting. When this round ends we’ll have 28 funds that have won twice and have had two 25% bumps in return.
You guessed it. We will then have another round of betting using the double winners to give 14 triple-winners. A fourth rounds gives 7 quadruple-winners. All 112 funds will get the index return less the 4% MER each year and then plus or minus the results of the betting. Note that all this betting could be spread fairly smoothly across 10 years so that the 25% bumps wouldn’t necessarily be very visible. Here are the resulting per-year returns for the funds over a decade relative to the S&P TSX index:
7 funds: +5.0%
7 funds: -0.2%
14 funds: -2.4%
28 funds: -4.5%
56 funds: -6.6%
Even after paying the huge 4% MER, 7 of the funds outperformed the index by 5% per year for a decade! We collected this high MER for a decade and all we had to do was invest all the money in an index and trade some derivatives. We never had to worry about which stocks or derivatives might perform best. As a bonus we are left with 7 funds that we can tout as long-term stars.
The reader may object that while we’re left with 7 star funds, there were also 105 underperformers. According to Canadian Couch Potato, Dynamic has about 100 funds with only 7 showing outperformance. So, my scenario mirrors Dynamic’s case quite well.
I have no idea how Dynamic Funds achieved their results, but we see that my strategy can achieve similar results with no skill at all.