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We’re huge fans of investing using cheap Index ETFs here at Young and Thrifty. If you have checked out our free eBook you already know that we think it’s really easy to build a DIY portfolio that has almost no fees attached to it and that easily diversifies your investment dollars all around the world. Even better, with the Questrade discount brokerage you can basically invest for free since they don’t charge you anything when you purchase ETFs.
The appeal of index investing stems primarily from its simplicity. In the eBook I make the case that by blindly buying a few ETFs that cover the major indexes and doing that over and over again for 30 years, you will not only beat most investors out there, you’ll trounce them. You’ll even beat most professional investors. Investing in an index ETF is a great investment, but the best part is that I can explain it so easily to people. All you have to say is that it is an investment product that takes your investment dollar and splits it up among all the companies in a certain area (60 companies if it’s a TSX 60 index, 500 companies if it’s the S&P 500, etc.). This guarantees you’ll get exactly the market average – less an extremely small (nearly insignificant) fee. When I explain it to my high school students most of them have it more or less figured out in one or two classes. For people more familiar with investing terms, it can be easily explained in 15 minutes.
For simplicty’s sake I have shied away from products that market themselves as “fundamental indexing”, “weighted indexing”, “smart beta”, and/or “strategic beta”. There is just such an unbelievable amount of noise out there in the world of investing and so many great salesmen trying to sell you garbage products, that if you deviate from super-simple approaches peoples’ eyes tend to glaze over and you recede back into the mix of all the guys trying to be the Wolf of Wall Street.
In doing some research for this article however, I ran into some stuff written by guys I really respect in the personal finance world such as Andrew Hallam, author of Millionaire Teacher and Preet Banerjee (all around expert on everything personal finance – find him almost anywhere). Enough people thought there was merit to this idea that I figured I’d better look into it. Here’s what I found and how it compares to what I’ve written about index ETFs throughout this site and in the eBook.
Is an Index By Any Other Name Still an Index?
I ran into many different definitions of what an index was supposed to be as well as what qualified as “active management” versus “passive management”. Trying to explain all the different theories would hurt my head and probably confuse everyone more than it would help. Here are the facts I think almost everyone would agree on in the debate on all of these new things that call themselves fundamental index ETFs or smart beta relative to what we might call traditional ETFs.
1) Your traditional index ETF mimics or tracks a specific set of predefined investment products. The most common ones when it comes to stocks track a World Stock Index, all of the stocks in the TSX 60, or the S&P 500, just to give a few examples.
2) Because a traditional ETF tracks these indexes, it is called “cap weighted”. This refers to the idea that the way the ETF splits up your investment dollar depends on how large a percentage specific companies are in the overall index. For example, the Royal Bank of Canada (RBC) is the biggest company in Canada if you measure using market capitalization (aka market cap). So when you invest a dollar in a TSX 60 ETF about 8 cents of it would go to RBC. Another 3 cents or so would go to Enbridge, and then down from there as companies took up a smaller percentage of the overall Canadian market.
3) Cap weighting keeps things very simple and easy to track.
4) Cap weighting isn’t necessarily a perfect way to build an index because it is susceptible to people buying too much of a stock if it gets really popular for some reason and grows its market cap. Think about a company like Nortel in the year 2000. At that point if you had invested a dollar in a TSX 60 index, around 30-35 cents would have been invested in Nortel. Consequently it was a huge part of many Canadians’ portfolios… right before it collapsed.
5) So the question becomes: Is there a better way to create an index than basing it on cap weighting? Some think yes, others think no, and let’s be honest, most people really couldn’t care less.
6) Smart beta and the rest of these buzzwords (hereafter collectively called smart beta) refer to a type of investing that is definitely NOT stock picking. It is not a mutual fund, there is no one sitting there saying we should buy one stock and sell another. It shares this in common with traditional index investing.
7) Smart beta indexes are a basket of stocks that are determined by some combination of metrics or measurements other than cap weighting. A few metrics that could be taken into consideration are P/E ratios, cash flow, and/or book value, just to give a few examples. The idea is to give the “good stocks” a bigger part of the index than the “bad stocks”, as well as the theory that what determines “good” and “bad” should be something other than the market cap.
8) For smart beta to outperform the traditional index what needs to happen is that investors that pick stocks must create inefficiencies in the overall market. For example, Apple comes out with a new product and everyone goes crazy and invests in Apple, making it a huge company and a big part of your traditional index even though it might not necessarily be a great investment at that time. In theory, a smart beta index ETF would be able to “see through” this rush of people that were investing for the wrong reasons and instead invest more of your money in companies that are likely smaller and better bets to grow.
9) There is a large body of academic evidence that shows many different types of fundamental indexing work. In fact, it’s a little scary how well many of them work when we see how they would have done in the past (known as back-testing). This way of looking at new investment products is controversial because it is easy to game and you don’t really care about what happened in 1940, you want to know what will happen over the next 20 years right? In the few short years since smart beta has been around it has an impressive track record against traditional indexing. Here are some great articles by Preet, Andrew, and Dan Bortolotti (aka The Canadian Couch Potato) that reference and explain primary studies that show this outperformance.
10) So case closed then right? Smart Beta wins. It slightly modifies the principles of traditional index investing, but it still remains faithful to the bedrock of not picking and choosing stocks. Does this allow it to outperform the cap-weighted stuff your grandpa’s generation came up with? Not so fast…
11) As with anything new – it costs more. Both Claymore and iShares have ETFs available to Canadians based on fundamental indexes. For Canadian content you’re looking at a MER of .72%. While this is still reasonable (FAR lower than most mutual funds!) it is more than 8x as expensive as some of the vanilla TSX 60 index ETFs out there. Also, if it is invested outside of a TFSA or RRSP there are some issues with tax treatment when compared to the simpler traditional index ETFs. These tax and fee considerations drag those outperformance numbers down a lot closer to our good old simple index ETFs.
12) It’s worth noting that other smart folks – such as index investing Godfather John Bogle – don’t think very much of these new strategies. Bogle is on the record as saying that you could plausibly say these new methods of indexing aren’t really indexing at all since they seek to outperform the market. He even labelled them “witchcraft” at one point. Of course Bogle has a lot to lose if a new method of indexing replaces the one he essentially pioneered.
Ultimately Is This for You?
This is an extremely difficult question for me to answer. Here’s what I feel confident in saying. For the vast majority of people reading this the answer is NO! There is just so much value in understanding what you are investing in and keeping it simple. If something gets too complicated you’re more likely to not invest consistently and will lose focus on the real things that matter much more than the fundamental index vs traditional index debate – stuff like earning more than you spend and how RRSPs and TFSAs work.
For the small percentage of people out there who are comfortable calling themselves investment geeks, this smart beta stuff is something to read about and explore. There is a lot of theory and semi-advanced terminology to sort through in understanding some of these things because not only is the basic theory a bit complex, but each of these smart beta or fundamental index ETFs operates under a different premise. Whereas all of the traditional ETFs have the same underlying principle – the bigger the market cap the more of it we have in our index.
Investment Geeks Only
If you think you’d rather move on to more important stuff than investing minutiae disregard this paragraph. For the money nerds out there, read on… Another consideration with all of these alternative indexes is that it is quite likely you can achieve close to the same results just by playing with the weightings and getting a little fancy with indexes that focus on small-cap stocks and value stocks. Check out Dan Bortolotti’s “Uber Tuber” model portfolio to see what I mean. The basic idea is that you overweight parts of your portfolio in order to take advantage of the fact that smaller cap stocks have outperformed the big boys by a considerable margin in the past. As well, stocks that fit “value criteria” as a group have also outperformed the rest of the field. Once again, you’re essentially betting that there are inefficiencies in the market. If you choose to enact a strategy like this I personally believe it will give you most of what you are getting from a fundamental index with much less of a fee drag (lower MERs).
At the End of the Day…
If you like reading about this stuff there is a chance some of these new strategies could add 1-3% to your overall investment results. That being said, many of these theories remain largely unproven in the modern context and I’m dubious as to if their outperformance will continue going forward (if something works, money flows to it – thus increasing value, and it all evens out again – then we’re right back at basic indexing being the king).
Personally, I will be sticking to basic bread-and-butter ETFs that I recommend. I love the simplicity, I love recommending simplicity, I love concentrating on the personal finance stuff that is more important than this debate. If these type of new-age index ETFs keep establishing a good track record and their fees continue to fall, they might be something to consider in the future.
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