Index fund strategy should include diversification

Buying just a Canadian index fund is not good enough. You need to diversify further, especially in Canada where three sectors—financials, materials and energy—are so heavily weighted in the S&P/TSX composite index.

Indexing, whether you do it through an exchange-traded index fund or a mutual index fund, has  produced a lot of discussion over the years. Among the most eloquent participants in the discussion has been John Bogle, founder and retired CEO of the Vanguard Group.

Many credit Mr. Bogle with inventing the concept of the index fund in his PhD thesis in the 1950s. But there’s no doubt he went on to popularize this passive form of investing, starting the Vanguard 500 Index fund, the first index mutual fund, in 1975, and building the Vanguard Group into the second-largest mutual fund company in the world.

Mr. Bogle’s investment advice has been simple and constant for more than 50 years. No one can beat the market consistently. So the investor who accepts market performance with the lowest cost will, over time, come out best.

We think there’s much to be said for Mr. Bogle’s approach to investing. But Canadians enamored with indexing at the turn of the century were burnt. That’s because one company, Nortel, became so large, it accounted for more than one third of the TSE 300, the forerunner of the S&P/TSX Composite Index.

Nortel’s rise to that lofty status gave index investors a thrill as their funds soared in value. But alas, good fortune did not last. Nortel lost 94 per cent of its value, taking index funds down with it. TD Canadian Index Fund, which gained 45.9 per cent in the year ended June 30, 2000, lost 22.3 per cent in the following 12 months. And many investors participated in the fall and not the rise.

After this debacle, capped index products were introduced, wherein no single company usually accounts for more than 10 per cent of an index. But one problem that remains with an index like the S&P/TSX is that it’s heavily concentrated in just a few sectors — financials, materials and energy. So be sure to take this into account if you plan to include a broad Canadian market index fund in your portfolio. Diversify by adding managed funds or international index funds too.

You can’t buy an index

Many investors like to compare a mutual fund’s performance with that of a suitable index. It seems a reasonable thing to do. But if you do so, keep a few things in mind.

First, you can’t buy an index. You can buy the stocks in the index. Or you can buy an index fund. But the index itself is not an alternative if your fund stacks up poorly against it. Any attempt, through a fund, or otherwise, to replicate an index comes with costs. Think of the index as a wholesale product while your fund is a retail product. A lagging performance by the fund, at least in part, reflects those costs.

If you compare two or more funds with a common index, you are, in effect, comparing the funds with each other. Comparing investments you can actually buy is a more meaningful exercise than comparing individual funds to a hypothetical investment you can’t.

Two features of index funds

Index funds, whether they be exchange-traded funds or mutual funds, have two important distinguishing features.

First, there’s the ‘tracking error’. With new money coming in and redemptions taking place all the time, an index mutual fund manager may not be perfectly in synch with the underlying index all the time. What’s more, trading spreads almost guarantee that index funds will do worse than the actual index. And that’s before any expense at all. Some index funds seem to do better than others at tracking their index.

The second important feature of index funds is, quite simply, the management fee. In most cases, the lower the fee, the better the index fund. Among mutual index funds, TD e-series funds are your best choice if you’re willing to open an online account with either TD Canada Trust or TD Direct Investing, the bank’s discount brokerage. TD Canadian Index-e has a management expense ratio, or MER, of just 0.33 per cent. That compares quite favourably with similar offerings from all the big banks. CIBC Canadian Index Fund, for example, has a rather high MER of 1.13 per cent.

By contrast, ETFs, which trade on stock exchanges, offer much more compelling MERs. iShares S&P/TSX 60 Index, for example, has an MER of just 0.18 per cent.

 

Money Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846