I talk a lot about index funds in this video
series. I have told you that low-cost index funds are the most sensible way to invest,
and that you should do everything that you can to avoid the typical high-fee mutual
funds that most Canadians invest in. Great, well that’s easy then. Buy index funds.
Where do I sign up? Unfortunately the financial industry does not like
making things easy for investors. With the increasing popularity of index funds,
index creation has become big business. There are sector index funds, smart beta index funds,
equal weighted index funds, and many others, making it that much more challenging for
investors to make sensible investment decisions. I’m Ben Felix, Associate Portfolio Manager
at PWL Capital. In this episode of Common Sense Investing, I’m going to tell you why
not all index funds are good investments. Let’s start with the basics. An index is a
grouping of stocks that has been designed to represent some part of the stock market.
Most of the indexes that you hear about day to day are market capitalization
weighted. Standard and The S&P 500, an index representing the US market is a
cap weighted index. This just means that the weights of the stocks included in the index
reflect their relative size. A larger company, like Apple, holds more weight in the S&P 500
than smaller companies, like Under Armour. You can buy a fund that just buys the
stocks in the index. When the index changes, the holdings in the fund change. This all sounds
great so far. Low-cost index investing is what it’s all about. One problem for investors
is that the big name indexes like the S&P 500 only track large cap stocks. Historically,
large cap stocks have had lower returns than small and mid cap stocks, so excluding them
from your portfolio could be detrimental. The Center for Research in Security Prices,
or CRSP, is another index provider. The CRSP 1 - 10 index is a market cap weighted
index covering the total US market. While the S&P 500 offers exposure to 500 stocks
covering 80% of the value of the US market, the CRSP 1 - 10 offers exposure to over
3,500 stocks, covering the vast majority of the value of the US market, including
the smaller stocks missed by the S&P 500. An index fund tracking the CRSP 1-10 is
what you would call a cap weighted total market index fund. This is the building
block for an excellent portfolio. There are total market indexes, and index funds
that track them, available for Canadian, US, International, and Emerging markets
stocks. The MSCI All Country World Index is.. What it sounds like. A total market index
covering the whole world. An ETF tracking this index can be found in the Canadian Couch
Potato ETF model portfolios. Total market index funds are well-diversified and extremely
low-cost to own. That is exactly what you want as an investor. The Canadian Couch Potato
ETF model portfolios, which are globally diversified total market index fund portfolios,
have a weighted average MER of around 0.15%. That is exactly why fund companies have had
to come up with other index products to try and sell you. They need a reason to make you
pay higher fees. One way that fund companies have been able to increase the fees on their
index funds is by focusing on indexes that track specific sectors. The Horizons MARIJUANA
LIFE SCIENCES INDEX ETF captures a sector that many people are interested in right now. It
has an MER of 0.75%. There is no rational reason to buy this ETF other than to speculate
on a hot sector, but Horizons is cashing in. Another buzz word that fund companies have
been using to charge higher fees on index funds is smart beta. Smart beta funds attempt
to find characteristics of stocks that seem to have explained higher returns in the past. Some
of these factors are extremely well-researched. A 1992 paper by Eugene Fama and Kenneth French,
“The Cross-Section of Expected Stock Returns,” pulled together past research to present
the idea that a large portion of stock returns could be explained by company size
and relative price. In 1997, Mark Carhart, in his study “On Persistence in
Mutual Fund Performance,” added to the Fama/French research to show that
momentum further explains stock returns. Finally, in 2012, Robert Novy-Marx’s June
2012 paper, “The Other Side of Value: The Gross Profitability Premium,” showed that
profitability further explains stocks returns. Together, those characteristics are responsible
for the majority of stock returns, so owning more stocks with those characteristics in your
portfolio might be a good idea. Fund companies have tried to build products around this research,
but the execution has not always been great. In a 2016 blog post, my PWL colleague Justin
Bender analyzed the iShares Mutifactor ETFs, ETFs tracking indexes that target some of
the well-researched factors. Justin found that they did not deliver on their promise of
factor exposure - disappointing considering their relatively high cost compared to a total
market ETF. There are other fund companies, like Dimensional Fund Advisors, with a long
history of capturing the well-researched factors. I recommend products from Dimensional
Fund Advisors in the portfolios that I oversee. I keep saying well-researched factors because
there are companies building indexes based on factors that are not as well-researched.
They may be based on bad research, bad data, or data mining. In their 2014 paper, “Long
Term Capital Budgeting,” authors Yaron Levi and Ivo Welch examined 600 factors from both
the academic and practitioner literature. Not all of these factors would be expected
to give you a better investment outcome, but they do give fund companies a
reason to charge you a higher fee. For most investors, a portfolio of market
cap weighted total market index funds is all that you need. Many of the other
index fund products out there claiming to track some special index are gimmicks
designed to convince you to pay extra. Thanks for watching. My name is Ben Felix
of PWL Capital and this is Common Sense Investing. I’ll be talking about a lot more
common sense investing topics in this series, so subscribe, and click the bell for
updates. I’d also love to read your thoughts and questions about
this video in the comments.
