Index funds: Look carefully

The idea that index funds consistently outperform actively managed funds is a myth. In fact, over the past decade not one Canadian index fund could even match the performance of the average fund in the category.

U.S. index funds have done much better by comparison over the long haul and some even managed to outperform the averages during the bear market. The main reason for their better results is that U.S. indexes do not become overweighted towards one or two stocks the way the TSE is prone to do. However, U.S. indexes can become overweighted towards a single sector, as Nasdaq is towards technology.

Index comparison
Results also vary tremendously depending on which U.S. index is used. Any funds based on Nasdaq obviously were clobbered in the past year. But it may come as a surprise that there was a big difference between S&P 500-based funds and those that use the Dow 30 Industrials as a reference point.

All the S&P funds were losers during the bear market, to varying degrees. But funds based on the Dow Jones Industrial Average made money in the year to April 30, 2001. The National Bank American Index RSP Fund rose 3.7 per cent ding the period while the TD Dow Jones Average Index Fund gained 4.9 percent. (Again, note the difference in return even though both funds track the same index.)

There’s another wrinkle to U.S. index funds that may catch many people by surprise. The RRSP versions from some companies are producing much different results from the non-registered funds.

Some examples
For example:

• The TD U.S. Index Fund, based on the S&P 500, recorded a loss of 10.4 per cent for the year to April 30, 2001.
  
• The TD US RSP Index Fund, also based on the S&P, lost 15.2 per cent.

How can this be possible? Currency exchange, says TD. The U.S. Index Fund has a portfolio of securities denominated in U.S. dollars. When the loonie tumbled against the greenback, the currency gain helped to offset the index losses.

The RSP Index Fund is a clone, which invests in future contracts that track the parent U.S. Index Fund. Those contracts are all in Canadian dollars, so there are no currency exchange gains or losses. Thus the RSP Fund more accurately reflects the performance of the S&P 500 – but that didn’t help investors over the past year.

The Royal U.S. Index Fund (-10.4 percent) and the Royal U.S. RSP Index Fund (-15.2 percent) also produced widely varying results, for similar reasons.

Some conclusions
So what to make out of all this? Here are some conclusions:

1) Canadian index funds have not proven they can outperform actively managed funds over the long haul. If you must use them, they should only be a small percentage of your portfolio.

2) U.S. index funds are better bets but performance numbers vary considerably even among funds based on the same index. Look for the funds with the best longer-term consistency or consider using exchange-traded funds like SPDRs (S&P 500) or DIAMONDS (Dow Industrials).

3) Diversify your U.S. index fund holdings. Include one Dow fund, one S&P fund and, if you’re feeling adventurous, a Nasdaq fund.

4) Before you invest in a U.S. RRSP index fund, find out exactly how it differs from the non-registered fund in the same family (if there is one) and see which has done better over the longer haul. You don’t have to buy the RRSP version for your registered plan if you have foreign content room available.