The index fund debate

The Great Indexing Debate, which was relatively muted during the bear market, is back again in full force.

As expense ratios (MERs) for actively-managed funds continue to escalate, more people are looking to low-cost indexing alternatives.

The growing popularity of index-based exchange-traded funds (ETFs), such as the iUnits offered in Canada by Barclays Global Investors, has added fuel to the fire.

Advocates of indexing point out that they can save up to three percentage points annually by going the route of what is known as “passive investing”. For example, the iUnits that track the S&P/TSX 60 Index, which comprises the 60 largest companies on the TSX, has an MER of just 0.17 per cent. Most actively-managed Canadian equity funds have an MER somewhere north of 2.5 per cent and many are over 3 per cent.

The MER covers such costs as management fees, brokerage charges, marketing expenses, etc. In most cases, it is deducted from a fund’s gross return to arrive at a net figure, which is the gain or loss the individual investor actually sees. So the lower the MER, the better it is for your personal bottom line.

So why doesn’t evyone invest exclusively in index funds and tell the active managers to take a hike? Because if you choose wisely, active managers can outperform the indexes over time.

Consider the numbers
Not convinced? Consider these numbers, which were generating by using the filter system on Out of 425 Canadian equity funds reporting a three-year-average annual compound rate of return to Sept. 30, no fewer than 341 (80 per cent) beat the S&P/TSX Total Return Index, which recorded an annual loss of just over 9 per cent during that period. Not one was a broadly-based index fund!

Over longer terms, the majority of actively-managed Canadian equity funds failed to beat the benchmark index. For the decade to Sept. 30, a total of 45 out of 114 reporting funds (about 40 per cent) did better than the S&P/TSX Total Return Index. But not one was an index fund!

The problem with index funds is that managers have nowhere to hide in falling markets. They must stay fully invested, with their weightings matching those of the target index. Active managers can raise their cash positions or move to lower-risk securities.

As a result, index funds tend to underperform when stock markets decline. They are at their best when the broad indexes are on the rise. But even then they have trouble beating the benchmarks.

Next page: So is it worth buying index funds or not?

So what about exchange-traded funds? How do they stack up? Unfortunately, we don’t have much history to work with because only one Canadian ETF has a track record of three years or more.

It is the iUnits S&P/TSX 60 Index Fund (TSX:XIU) and it has done relatively well. The units have beaten the benchmark in all time frames from six months out, going back to their launch in September 1999. That makes them the best bet if you want a fund that will faithfully track the 60 Index.

Looking at the iUnits with shorter histories, they tend to be pretty good at tracking their benchmarks, but the benchmarks themselves may be flawed. For example, iUnits S&P/TSX Capped Gold Fund (TSX:XGD) showed a one-year gain of 27.2 per cent to Oct. 31. That’s consistent with the S&P/TSX Capped Gold Index itself.

However, Barrick Gold is the largest single component of that particular index, and it has been a drag on returns because of poor performance. The Globe Precious Metals Peer Index, which is not so heavily weighted to Barrick, gained 61.4 per cent for the year to Oct. 31. The average actively-managed gold and precious metals fund was ahead 63.4 per cent during that time. So in this case, the iUnits underperformed despite a low MER of 0.55 per cent.

Rules for success
So is it worth buying index funds or not? Yes, if you don’t want to be constantly juggling your portfolio and are willing to stick with them when they slide in bear markets, as they inevitably will. But you need to follow a few basic rules.

1) Go for the lowest MER you can find. Presumably, you are not going to trade in and out of these funds. If you’re in for the long haul, a low MER is essential. For mutual funds, look closely at TD’s “e” units and at the Altamira Precision funds. Otherwise, go for an ETF if there is one available that tracks the index you want.

2) Diversify, just as you would if you were creating a portfolio of actively-managed funds. There are now bond index funds available, as well as iUnits that emulate the returns of five and 10-year Government of Canada bonds. There are also iUnits that track income trusts and REIT indexes. For geographic diversification, you will find plenty of U.S. and international index funds from which to choose. However, if it is international ETFs that you want, you’ll have to look to the U.S. exchanges.

3) Check the track record. Look to see how closely the fund has tracked its benchmark index – and make sure that the index being used for comparison is indeed the one the fund is designed to emulate.

4) For sector index funds and ETFs, look closely at the make-up of the underlying index. You may find that it is heavily weighted towards only a few stocks. More than 46 per cent of the iUnits Gold basket of shares is invested in just two stocks: Barrick and Placer Dome. Over half of iUnits Capped Energy is in three securities: EnCana, Petro-Canada, and Suncor. I seriously question whether such weightings represent true indexing.

5) If you want to indulge in some tactical asset allocation, consider reducing the weighting of your equity index positions during times of market declines and increasing bond weightings correspondingly.