Stingy Investor Contact - Subscribe - Login
  Home | Articles | Screens | Links | SNW | Rothery Report
Intelligent Indexing

Investors hurt by the speculative bubble in internet stocks have turned from high-fee technology funds to lower-fee index funds. The relative advantages of intelligent indexing are super-low fees, broad diversification, and relative simplicity.

The low-cost advantage of intelligent indexing can be quite powerful. The fees charged by many common Canadian equity funds are in excess of 2.5% per year. At first glance 2.5% per year might not seem to be too high. After all, overly hopeful investors continue to believe that 15% annual returns are common place and that 2.5% is a small price to pay. As a result, the savings offered by the iUnits S&P/TSX60 exchange-traded fund (XIU on the TSX), which charges only 0.17% per year, might appear to be minor.

Before taking a closer look at the impact of fees, it is useful to digress a bit and comment on expected returns. It is a truism that investors as a group should achieve average (or market) returns less costs. There will be some investors who will outperform and others who will not. In addition, as the amount one has to invest grows it becomes harder to outperform the market. At a certain point a very wealthy investor, or mutual fund, is forced to buy only the largest businesses and the resulting portfolio will look very similar to the market portfolio itself.

The next step in the expected-return puzzle is to acknowledge that the very success of mutual funds has made them a dominant feature of the stock market (along with pension and other pooled funds). The largest mutual funds have little option but to hold a portfolio that is largely similar to the market portfolio. Unfortunately, the expected return of the average large mutual fund is likely to be very close to that of the market before fees and expenses. The match isn't perfect and there is some room for debate but for the moment let's assume that the return of the average large mutual fund mirrors market returns before fees.

Now the potential for an index-oriented approach becomes quite noticeable. The annual fee difference between the 2.5% per year charged by many mutual funds and the 0.17% fee charged by the iUnits S&P/TSX60 exchange-traded fund is about 2.33%. The exact comparison is complicated because funds don't explicitly include brokerage costs in their quoted fee rates (or management expense ratios). Also, buying an exchange-traded fund necessitates paying a brokerage commission. More subtle costs differences such a those due to market impact and tax efficiency are also ignored in this calculation but are likely to exacerbate the difference. Nonetheless, a 2.33% annual fee differential is potentially very significant. On a fixed $100,000 portfolio the index investor could save $2,330 each year by switching to the exchange-traded fund.

I can't help but muse that such savings would pay for my two-week pilgrimage to the scenic summer town of Lion's Head. Such considerations are all the more immediate as I sip a beverage and stare across the waters of Georgian Bay while writing this article.

After a decade one could save $23,300 and be able to send a child to university for a year or to afford a modest car (again ignoring portfolio growth and inflation). It is fairly easy to see why low-cost investing is popular.

Although the preceding argument is motivational it is also incomplete. An overlooked factor in the comparison are the potential benefits of advice. Most mutual funds that charge 2.5% use some of their fee to pay fund advisors for providing investment advice. Generally speaking, the cost of an advisor's counsel amounts to about 1% annually for equity funds. It may be a touch lower, it may be paid early, but it is usually about 1%.

While the cost of advice is certain, the value of the advice given is not. At least I've yet to run across a good way to account for it. Undoubtedly, in some cases the price is very reasonable indeed. For instance, unsophisticated investors, or those without an interest in financial matters, may very well benefit from conscientious advice. In other cases, the advice provided may be self-serving, perfunctory, poorly matched to the investor's needs and generally not worth the price of admission. However, the lack of a clear way to measure the overall result of most financial advice does not mean that such benefits don't exist.

It is worth noting that there is an unusual breed of financial advisor who clearly separates the cost of their advice from the investments that they recommend. Many of these advisors also charge about 1% for their advice but use index funds, or other low-fee active funds, to reduce the total cost to their clients. Using a very simplistic comparison, an advisor-assisted investment in the iUnits S&P/TSX60 exchange-traded fund would cost about 1.17% compared to the average advisor-assisted mutual fund at 2.5%. In both cases the investor is guided by a professional but paying for advice separately may save the investor over 50% each year.

Since the case for indexing (with or without an advisor's assistance) appears to be quite strong, it may surprise you to learn that I have some serious misgivings about the approach. My biggest misgiving is about price. Not the annual fees charged by index funds but the price of what is actually being bought – namely a diversified selection of stocks.

Buying an index fund is a little like going to your local farmer's market and buying one of everything. There are two obvious problems with the one-of-everything approach. The first problem is the assumption that the merchants, under competitive pressure, have fairly priced everything that they are selling. The second problem is that you might not actually want, or need, one of everything. A less obvious problem arises when the merchants change their prices after you repeatedly go on spending sprees each week. But let's stick to the deceptively simple question of price.

To start, most people don't buy stocks like they buy apples at the farmer's market. Consider a quick pop-quiz. If you go to your local farmer's market and discover that apples are on sale at $1/kg this week compared to the regular price of $2/kg then are you likely to buy more apples or are you likely to buy less? Provided that the apples themselves are of similar quality, most apple lovers would be likely buy more. Now what if a stock that you've been following has gone from $20 per share last week to $5 per share this week on no news. Are you likely to buy more, less, or sell what you already have? When it comes to stocks, most people view price decreases as unfavourable whereas price decreases for other goods are often viewed as beneficial.

A potential problem with indexing is its overly myopic focus on fees as opposed to what is actually being bought. As Warren Buffett says, “Price is what you pay, Value is what you get”. However, the best approach to use when trying to determine the value of an index fund is anything but obvious. As with most valuation techniques, an accurate determination of value is likely impossible but rough measures are available: one can use a dividend discount method, the historical trend of various ratios (such as the popular price-to-earnings ratio), or a discounted cash flow model. Regrettably, these techniques generally indicate that broad North American stock markets remain richly valued and inflation-adjusted returns of more than 3% over the next decade appear to be unlikely. Furthermore, there is the possibility of significant setbacks should the markets fall to typical bear market lows. As a result, I would not be an enthusiastic buyer of the big North American indices at this time.

Regrettably, the outlook for many other investments is also fairly miserable. The yields paid by quality bonds remain low and the possibility of increasing interest rates may impact bond prices negatively over the next few years. Stocks are largely overvalued and could be in for a bit of a correction. So what is an investor to do?

It's a good question that is difficult to answer with certainty. My personal approach is to maintain a conservative methodology with a reasonable allotment in cash and shorter-term bonds. On the stock front, I've always preferred companies trading at deep discounts to their intrinsic value which often also provide a nice dividend yield. While my personal approach focuses on individual businesses (and is highly concentrated), the intelligent index investor has a few options if they are willing to pay just a little bit more.

Of special note, the well-regarded Dimensional Funds Advisors (DFA) funds have recently come to Canada. These funds are distributed through advisors with annual fees typically ranging between 1.25% and 1.50% which includes the cost of professional advice. DFA funds generally invest in smaller-stocks with high book-to-market values. I often find that my personal stock selections are also held, or are subsequently purchased, by DFA funds.

Another fairly new offering is the Dow Jones Select Dividend Index Fund fund (DVY on the NYSE) which charges 0.40% annually. The DVY exchange-traded fund holds fifty of the highest dividend-yielding securities in the Dow Jones U.S. Total Market Index which also includes a few of my favourite stocks. On the down side, U.S. dividends are not taxed favourably for Canadian investors.

Canadian equity index investors are not offered a wide range of specialty funds due to the small size of the Canadian market. The TD Select Canadian Value exchange-traded fund (TAV on the TSX) is the best candidate but it has only managed to attract $27.5 million in assets and it will need to attract more money to be a long-term survivor. The approach the fund uses is reasonable with stocks selected to mirror the Dow Jones Canada TopCap Value Index. It also has a fairly low annual fee of 0.55%.

Investors who don't mind spending more might also consider low-fee actively-managed value funds with good candidates on offer by Saxon, Chou, Mawer, and Leith Wheeler.

As indexing becomes more popular, Wall Street will vigorously create many new index funds. Some new index funds are likely to be very good but others may be quite poor. As always one should look at each fund carefully with an eye to its cost and the value that it provides. Do a little digging and ask yourself if you want to hold the stocks that are in a particular index. In the end, super-low cost should not be the primary driver of portfolio construction. The intelligent use of low-fee high-value funds is a more prudent course of action.

First published in October 2004.

  MoneySense Articles
 Cdn Top 200 2016
 US Top 500 2016
 Retirement 100: 2015
 Cdn Top 200 2015
 US Top 500 2015
 Retirement 100: 2014
 Cdn Top 200 2014
 US Top 500 2014
 Retirement 100: 2013
 Cdn Top 200 2013
 US Top 500 2013
 Retirement 100: 2012
 Buffett Buys
 Stocks that pay
 Value in the S&P500
 Cdn Top 200 2012
 US Top 500 2012
 Retirement 100: 2011
 Where to invest $100k
 Where to invest $10k
 Summer Simple Way
 A crystal ball for stocks?
 Cheap & safe
 Risky business
 Cdn Top 200 2011
 US Top 500 2011
 Retirement 100
 Dividend investing
 Value investing
 Momentum investing
 Low P/E P/B
 Dividend growers
 Cdn Top 200 2010
 US Top 500 2010
 Graham's prescription
 Income 100: 2009
 The case for optimism
 Cdn Top 200 2009
 U.S. Top 500 2009
 Wicked investments
 Simply spectacular
 Income 2008
 Small stocks, big profits
 Cdn Top 200 2008
 US Top 500 2008
 Value that sizzles
 So simple it works
 Income 100
 No assembly required
 Investing by the book
 Cdn Top 200 2007
 US Top 500 2007
 Invest like the masters
 A simple way to get rich
 Top Trusts 2006
 Stocks for cannibals
 Car bites dogs
 Cdn Top 200 2006
 US Top 1000 2006
 So easy, so profitable
 Top Trusts 2005
 Dogs of the Dow
 Top 200 2005
 Money for nothing
 Yield of dreams
 Return of the master

MoneySaver Articles
 2 Graham Stocks for 2017
 3 Stingy Stocks for 2016
 5 Graham Stocks for 2016
 3 Stingy Stocks for 2015
 3 Graham Stocks for 2015
 3 Stingy Stocks for 2014
 4 Graham Stocks for 2014
 8 Stingy Stocks for 2013
 6 Graham Stocks for 2013
 9 Stingy Stocks for 2012
 8 Graham Stocks for 2012
 Simple Way 2011
 5 Stingy Stocks for 2011
 7 Graham Stocks for 2011
 Simple Way 2010
 5 Stingy Stocks for 2010
 8 Graham Stocks for 2010
 Simple Way 2009
 Timing Temptation
 19 Stingy Stocks for 2009
 4 Graham Stocks for 2009
 Simple Way 2008
 Active at Passive Prices
 Unbundling ETFs 2008
 5 Stingy Stocks for 2008
 5 Graham Stocks for 2008
 Is your index too active?
 Graham's Simple Way
 Canadian Graham Stocks
 5 Stingy Stocks for 2007
 8 Graham Stocks for 2007
 Top SPPs
 The Simple Way
 A hole in your IPO?
 Monkey Business
 8 Stingy Stocks for 2006
 Graham Stock Gainers
 Blue-Chip Blues
 Are Dividends Safe?
 SPPs for 2005
 Graham's Simplest Way
 Selling Graham Stocks
 RRSP Money Market Funds
 Stingy Stocks for 2005
 High Performance Graham
 Intelligent Indexing
 Unbundling Canadian ETFs
 A history of yield
 A Dynamic Duo
 Canadian Graham Stock
 Dividends at Risk
 Thrifty Value Stocks
 Stocks in Short Supply
 The New Dividend
 Hunting Goodwill
 SPPs for 2003
 RRSP: don't panic
 Desirable Dividends
 Stingy Selections 2003
 10 Graham Picks
 Growth Eh?
 Timing Disaster
 Dangerous Diversification
 The Coffee Can Portfolio
 Down with the dogs
 Stingy Selections
 Frugal Funds
 Graham Revisited
 Just Spend It
 Ticker Temptation
 Stock Mortality
 Focus on Fees
 SPPs for the Long Term
 Seeking Solid Stocks
 Relative Strength
 The VR Approach
 The Irrational Investor
 Value Investing

Globe & Mail Articles
 Indexing advice
 Media-shy stocks
 Curse of size
 Market uncertainty
 Be even lazier
 Scary beats safe
 Small, illiquid, value
 Use the numbers
 What value is good value?
 Sculpt for value
 Value vs CAPE
 Graham Rules
 CAPE vs PeakE
 Top value ratio
 Low Beta
 Value and dividends
 Walter Schloss
 Try unloved AIG
 Why I'm a value investor
 New world of ETFs
 Low P/Es possible
 10 yielders
 Be happier
 Dividend Downside
 Shiller's P/E
 Copycat investing
 Cashing in on class
 Index roulette
 Theory collides
 Diving too deep
 3 retirement villains
 Scourge of inflation
 Economic omens
 Analyst Expectations
 Value stock scarcity
 It's all in the index
 How to pick good funds
 Low Beta Wins
 Hunt for dividend stocks
 Think garage sale

Advisor's Edge Articles
 Passive Rebundling
 Doing the math

Norm Speaks
Flip Books

 Asset Mixer
 Periodic Table
 ETF Fee Calculator

About Us | Legal | Contact Us
Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...