Advocates of index investing were fighting off their critics yesterday, in the wake of a massive 26% haircut delivered in the collapse of the stock price of Nortel Networks Corp.

The twin problem of Canadian RRSP rules forcing 75% Canadian content and the 30% presence in the Toronto Stock Exchange 300 index of the gorilla known as Nortel has long made for a potentially explosive situation.

This prompted one financial advisor to comment yesterday on the merits of active funds sold by advisors: "In the last quarter, according to Bell Charts, most active managers in Canada are beating the index. Even those third quartile funds beat the TSE, after fees. The situation is similar in the U.S. And now with Nortel crushed the trend should continue. All that to avoid an advisor."

Unlike actively managed equity funds, which are constrained by the regulators to hold no more than 10% of any one stock issue, index funds and exchange-traded funds (ETFs) can hold as much of a particular stock as the market capitalization warrants.

Canadian index funds, sold chiefly by the banks, hold roughly the 30% weighting that Nortel makes up on the TSE 300 exposure. Thus, the CIBC Canadian Index fund had a 28% exposure to the stock. Harder hit was the Altamira Precision Canadian Index fund, which had a 38% weighting at the end of July.

Some ETFs are more concentrated than bank index funds because they focus on just 60 or 40 top stocks instead of 300. That makes their Nortel exposure that much more concentrated: as much as 42% in the case of the Barclays i60s and almost 50% for State Street’s recently launched DJ 40s.

Most value managers, such as Ivy Canadian’s Jerry Javasky, would have have weighted Nortel well below the market weight. Bissett Large Cap and Elliott & Page Equity, for example, had only an 8% exposure at the end of September.

But it’s unlikely that any properly structured portfolio of index funds would have been 100% invested in a fund like the i60s. Indexing believers like Eric Kirzner say that anyone who used proper portfolio construction -- diversifying by asset class, geography and even management style -- should not be hurting too much today.

Those who believe in portfolio rebalancing may even have been wading in yesterday to scoop up more Nortel or i60s, if they had been waiting for better valuations of both securities.

The anonymous indexing advocate and Web site commentator Bylo Selhi (www.bylo.org) agrees the TSE is "an unbalanced and extraordinarily volatile country index. Those who allowed it to dominate their asset allocation are now experiencing the consequences of that decision." [For the record: The previous part of this quote was actually posted by cbg1 on The Boomer thread "Nortel, down almost $30" on 25-Oct-2000 at 11:04 AM. What follows is mine...Bylo] "But that has nothing to do with the merits of indexing. This is a lesson in [lack of] balanced asset allocation, understanding one’s tolerance for risk, and all sorts of stuff that applies equally to stock-picking, active fund management and other investing disciplines."

A Nortel meltdown was the nightmare scenario many investment advisors have anticipated for the past year. Nortel was Canada’s major "Internet" infrastructure play and as such had developed a price-earnings ratio of 100 -- more in line with some Internet high flyers than most blue-chip stocks.

Earlier this year, value managers at Beutel Goodman and Opus 2 Direct.com calculated that Nortel was so overpriced that 22 of the TSE’s top stocks, including several banks, could be bought for the price of Nortel. Indeed, Nortel was "priced for perfection."

Any investor with a professional advisor should have been made aware of the risk and constructed a portfolio that minimized the exposure.

The investment industry had already begun to respond with products that dealt with Nortel’s dominant status in the domestic market. By year-end, Barclays Global Investors Canada Ltd. is unveiling a "capped" version of the i60s, which limits Nortel exposure to 10%. It is also unveiling a pair of bond funds and four sector index funds. An investor will be able to invest in three other sector funds with zero Nortel exposure: an energy fund, a financial services fund and a gold fund.

Other products have been developed, such as Fifty Nine Corp., which holds 59 of the largest issues in Canada but not Nortel.

Sophisticated investors and institutions might have hedged exposure to Nortel by buying put options that would rise in price should the drop in the stock materialize. In much of the rest of the world, indexing is generally a far more diversified affair.

Indexing works better in highly liquid markets such as the United States. In fact, some years ago, indexing advocate Ted Cadsby, CEO of CIBC Securities Inc., opted to scrap the bank’s actively managed U.S. equity fund in favour of an indexed fund.

One advisor says it’s time investors considered "North American" large-cap investing with U.S. indexes rather than cap-weighted TSE indexing. "You get a small but reasonable exposure to your important Canadian companies like Nortel, Seagram and JDS Uniphase with the U.S. indexes. That is all you need."

At the end of June, the biggest gorilla in the Standard & Poor’s 500 was GE, at 4.26%. Ironically, Nortel was 1.6% of the S&P 500 at that point.

While some critics have compared index funds to momentum funds, it’s not true that indexing is insensitive to fundamental valuation considerations. Some passive ETFs allow you to focus on either growth or value stocks. An example would be the Barra S&P 500 large-cap value fund.