In defense of index funds

Intersting stuff Bylo;

Some comments:

I agree that a mer of 0.9% for an index fund is high. Royal and altamira offer them at 0.5%.

Under the median managed funds: Does Can Equity mean a fund 100% in Canadian Equities at all times, or could it have some foreign component or bonds? If yes, it would explain why its number of 9.1% looks so good.

Under the "Median Managed", the nex-idx varies from +0.2 to -4.3%. This seems to me to be a sign that there may be is something "wrong" with the data. If it was all treated in the same consistent fashion, there should not be variations in differences to this degree.

George,

1. True about the 0.5% MERs but Royal's and Altamira's fund selections are very limited compared to CIBC. For example they don't offer bond funds and they only offer 2 foreign funds (S&P500 and EAFE), both of which are RRSP (derivative) versions. Still one could build an RRSP out of some of them with a lower MER. [BTW still no word from CIBC re my laundry list of questions. Maybe they don't want me as a customer :-) ]

2. Excellent point! I hadn't considered it at all. I'm using FP's data for "Canadian Diversified Equity" funds. That category includes both the "pure" PH&N Canadian Equity fund and the "spiked" Canadian Equity Plus so I assume other "Canadian" equity funds with up 20% foreign content are also represented. FWIW over 15 years the former PH&N fund returned 10.8% and the latter 10.9%. Nevertheless, in general the "impurities" ought to boost results.

3. If you exclude the extremes -- 0.2% for Can Eq (which may be explained by your second point anyway), and also -4.2% US Eq and -2.8% Global Eq -- then the numbers are much more closely clusterd. The size of the US Eq index advantage actually seems to confirm the unprecedented out-performance of the S&P 500 since the start of the 1982 bull. Nevertheless, if I have time tonight I'll recheck the numbers. Spreadsheet programs have made a liar out of me before!

Am I alone in observing that over the last fifteen years one could have invested in just bonds and beat the returns on Canadian equities?

If one could take past performance as an indicator of future returns (I know, I know...) your numbers seem to point to: 1) invest only in bonds and get a good night sleep and get reasonably richer, 2) invest in a balanced fund like PH&N and get a good night sleep and also get richer, 3) invest about 50% in bonds and 50% in S&P equities, get a good night sleep and wake up a lot richer, 4) invest everything in S&P, forget about sleeping and if you survive you will be fabulously wealthy.

Hmm..mm, typical of a thinking addict to try and push more thinking...:)

George,

I found an error. The US Equity active vs. index should be -1.4%, not 4.3 (I subtracted the wrong cell.) [now corrected in table...Bylo] Interestingly that means that EAFE index funds beat their active counterparts by a wider margin than S&P 500 index funds beat their active counterparts. I wonder what John Bogle would have to say about that!

A-J,

Bonds beat equities in Canada because of the dramatic decline in interest rates during most of the past 15 years. Most of those results were accounted for by capital gains not interest income. With interest rates now at near record lows I wouldn't expect similar performance during the next 15 years.

Indexing is getting a lot of attention these days and I can see why, BTW great thread Bylo.

Would there be any disatvantages in using all index funds in a RRSP with no managed funds.

For example , CIBC Bond Index, US Index, International Index and a Canadian Index Fund.

"Interestingly that means that EAFE index funds beat their active counterparts by a wider margin than S&P 500 index funds beat their active counterparts."

This might have something to do with less information and less reliability of information provided for companies outside the NA. Reporting requirements and transparancy are very good in NA. This makes things easier for managed funds.

JFQ: You write: "Would there be any disatvantages in using all index funds in a RRSP with no managed funds. For example , CIBC Bond Index, US Index, International Index and a Canadian Index Fund."

These were exactly my thoughts back in November and I could see NO disadvantages. I have converted to an almost "total CIBC Index Fund" portfolio inside my RRSP.

Vanguard and Bogle have so many relevant points to make on this topic it is hard to know where to start.

I've linked to the article that contains the following table:

The Index Cost Advantage by Asset Class(basis points)

----------------Equity Funds------------------ -Bond Funds-

Large Cap Small Cap International U.S. Bond

Index Funds Index Funds Index Funds Index Funds

Expense Ratio 20 130 20 160 35 175 20 90

Transaction Costs* 2 60 70 288 8 248 24 78

Total 22 190 90 448 43 423 44 168

Index Advantage 168 358 380 124

Turnover Rate 5% 76% 25% 80% 4% 71% 40% 130%

Unit Trans. Cost (bp) 20 40 140 180 100 175 30 30

*Turnover rate x 2 x individual transaction cost

It looks like the table overlaps to two lines. Trust you can still make it out. To summarize: the Index Fund advantages are:

1.68% over large cap funds

3.58% over small cap funds

3.80% over International funds

1.24% over bond funds.

The first and last seem consistent with your numbers Bylo, given that the Vanguard mers are in the range of 0.20% instead of the 0.90% in your table.

Big "differences" for the other two classes!!

Bylo,

George$ would be proud of me, I bought Bogle's book - very interesting. In it, Bogle says that he prefers the broader indexes (eg the Wilshire and S&P versus the Dow Jones) as his market standards because they are a "much more reliable indicator of the actual experience of aggregate investors...".

My question is: in your performance comparison, you used the TSE 100 instead of the TSE 300. Why? Aren't most Canadian Index funds based on the broader index? Not a critique, just curious.

Steady, I'm proud of you too!

I fully agree with Bogle on the Wilshire 5000 vs S&P 500. Indeed my core US holding in Vanguard funds is VTSMX (Total Stock Market.) I only used the S&P 500 in my comparison because the FP data didn't have a figure for the Wilshire 5000.

Re TSE300 vs. TSE100: As Bre-X, YBM, et al have demonstrated, the inclusion requirements for the TSE300 are all to lax for my taste. That's why I prefer the TSE100 or even the TSE35. FWIW, over the past 15 years, the returns were TSE35 (9.7%), TSE100 (9.8%) and TSE300 (9.6%).

I'm proud too. It is now your duty to go out into the financial wilderness and persuade another poor despairing soul to become a Bogle convert. (:-))

The new "Vanguard Tax-Managed Small Cap Fund" is here.

Not sure one can buy into it just yet via Waterhouse. But I'm going to try and diversify some of our Vanguard S&P 500 Fund assets into this small-cap direction.

It sure annoys a Canadian to read [in link below] that in the US "Net capital gains on securities held more than one year are taxed at 20% (10% for taxpayers in the lowest tax bracket)."

Not to annoy you further:

In Germany after 6 month 0% tax on capital gains.

George,

Like you, I'm looking at diversifying my core holding in Vanguard Total Stock Market (VTSMX.) This is about 70% (and rising daily!) large caps with the remainder mid and small caps.

According to Fama/French if one wants to improve returns one should emphasise the value and small cap segments of the market. I've already partly moved in that direction using VG Index 500 Value (VIVAX.)

Last year Vanguard introduced index funds that track the Growth and Value segments of the S&P 600 small cap index. I'm tempted to buy some of the Value segment (VISVX.) I realise (a) this is not a tax-managed fund and (b) small cap indexes have higher turnover rates.

1. Any comments on this strategy?

2. What ratio of large cap to small cap are you considering?

Hi Bylo:I'm not sure what to really make of the big cap vs small cap debate. My own views keep shifting and so it is hard to "trust" them.

I know you are not a fan of Business Week but I read it because I subscribe to it. The link below gives some more grist about big caps in the current[?] issue.

My guess is that you and I have different motivations for divesifying at this point. In our case we have most of our assets in the US large cap market. It did not use to be so but our luck with MSFT etc has tilted it way over in this direction. Now the main obstacle to diversifying is the tax hit on the substantial capital gains.

Thus I see that anything I can do to reduce our large cap exposure as a good thing. And I mean anything. That anything means I look at "equities" in our portfolio with minimal cap gains more favourably as candidates for diversification into something else. Vanguard 500 falls in that catagory. How much large cap goes to small cap is thus determined by how much tax we are willing to pay. Not by what might be an "optimum" number. [Not sure I like the sound of these admissions about myself.]

Some time ago I was dismayed to see turnovers in the 20-30% area in the older Vanguard small-cap fund and so did not bite. I'm hoping the new one will be better in this regard. And now, 1999, is a better tax-year to do this.

Some time ago Mikale advised that: "don't let the tax tail wag the investment dog". I wish it were that simple.

At the moment I am not attempting to deal with the Growth vs Value issue at all . [I probably should].

My sense is that you are on a more rational and better balanced investment plateau. Thus I doubt I can advise much, based on my situation.

oops above. I see that my link did not go to the B-W page I intended. To get there you must click on the prior issue, the "Pain" cover one , and then find the "Big Caps, Big Edge" article near the bottom of the table of contents.

It seems that the prior issues are "free" but the current issue is for "members" at Business Week.

double oops. I confused myself. Ignore above post. The first link does get you to the current issue of B-W [Pain} and has the correct contents page.

A ways down you will see:

"FINANCE

 Big Caps, Big Edge

 CHART: Small Cap vs. Large Cap: The Recent History

 A REIT Mogul in a Fine Mess"

A free link to Big Caps, Big Edge page IS available [I believe].

Sorry about this mess.

George,

That link is to this week's issue of BW whose cover story is titled "Conquering Pain." Is that a hint about what prophylactic measures to take before dabbling in small caps??? ;-)

Thank you for you candor. I'm not "on a more rational and better balanced investment plateau" as much as one might suppose. I'm considering small caps primarily because the experts tell me I should (see e.g. the data referenced by mikale.) Despite the roughly equal SD numbers in that data, small caps still make me somewhat queasy.

Also, I'm still in the "accumulation phase" of my investing career so this would be new money rather than a taxable shift from large to small.

I'm not convinced the adage "don't let the tax tail wag the investment dog" is always valid either. If one agrees with it then why take measures like putting the highest-taxed assets in RRSPs, etc.?

FWIW, I'm considering something like 1/2 VTSMX, 1/3 VIVAX and 1/6 VISCX which works out to about 1/3 LC, 1/3 LCV, 1/6 SC and 1/6 SCV.

Bylo,

Your allocation is FAMA precise, except that the DFA managers allocate 10% REITS.

Ya gotta start another thread in your series of debunking "conventional wisdom"..."In defence of the INVESTMENT DOG"... :-)

Well I might convert to all Index funds in my RSP too George$. Are all US Index funds the same, I read somewhere that your US fund should track the Willshire as well ,

JFQ: You ask: "Are all US Index funds the same, I read somewhere that your US fund should track the Willshire as well"

NO, not all US index funds are the same. In my own mind I distinguish between RRSP US index funds [derivative based] and non-RRSP US index funds [equity based].

The RRSP ones must buy futures options on Indexes and they are limited to the specific "index options" that exist in the marketplace.

The non-RRSP ones can follow any index, new or old, their managers have decided to use [a la prospectus]. They have a far wider range. I suppose they can also "deviate" from an index by buying more of one equity than the index prescribes. [This sort of latitude is not possible within an index option based index fund.]

The Wilshire 5000 represents the "whole US market" of about 50000 equities. It is the most basic US index of choice and thus should probably be your first US index fund. But given that the S&P 500 represents the 500 largest companies within the 5000, the S&P component within the 5000 usually dominates anyways.

Ooops. It should read

"The Wilshire 5000 represents the "whole US market" of about 5000 equities. [one to many 0's]

Anbd here is a link to information on Indexes.

George & Bylo,

Here is a link to more info on indexes.

Mikale: you ask, "What criteria do they use to screen for those names? " I don't know for sure but I always assumed it was some sort of "sampling technique". Some of the "missing 4000" must be rather small and inactive and so probably would have almost no effect should they go to zero or increase ten fold.

Q: "What criteria do they use to screen for those names?"

A: From the Vanguard prospectus:

The Total Stock Market, Extended Market, and Small Capitalization Stock Portfolios use a different selection process. Because it would be very expensive to buy and sell all of the stocks in each Portfolio's target index (the Total Stock Market Portfolio's target index, for example, includes nearly 7,000 stocks), these three Portfolios use a "sampling" technique. Using a sophisticated computer program, each Portfolio selects stocks that will recreate its target index in terms of industry, size, and other characteristics (such as pro-jected earnings, financial strength, and debt). For instance, if 10% of the Wilshire 4500 Index were made up of utility stocks, the Extended Market Portfolio would invest 10% of its assets in the utility stocks of the Wilshire 4500 Index with similar characteristics.

Digression: Garry Kasparov, the best (human) chess player (who lost to IBM's Deep Blue), says this about his preparation for the historic match: "Unfortunately, I based my preparation ... on the [ahem] conventional wisdom of what would constitute good anti-computer strategy. Conventional wisdom is -- or was until the end of this match -- to avoid early confrontations, play a slow game, try to out-maneuver the machine, force positional mistakes, and then, when the climax comes, not lose your concentration and not make any tactical mistakes."
Observation: Fund managers whose investment strategy is to follow "conventional wisdom" aren't the only "experts" to suffer humiliating defeats by computers.

Thanks George$, if I remember correctly CIBC(RRSP)is the only one that tracks the Willshire 5000 but it has a higher mer than Altamira and Royal.

JFQ,

I wrote a fax today to PHN , Tom Bradley, and suggested to create several funds that would simply invest in a Vanguard index fund.

Vanguards normal MER is some .2% but for institutional investors with over $10M it is .1% . They could offer any of the Vanguard funds this way with a .2% MER in Canada which would be great.

active,

That was a great idea. Keep us posted on the response. Thanks for taking the initiative.

BTW I suspect there would be regulatory hurdles to jump in order for a Canadian MF company to sell units of a US MF company's fund offerings. Both Royal and Altamira engaged State Street of Boston to set up and run US index funds on their behalf. State Street is one of the top institutional index fund managers.

Thanks for the CIBC link Bylo, sure wish Vanguard would come to Canada,

Here is a link that Steve Dunn suggested at another site. He does not give it much credence. Caution: read it with a grain of salt.

from Undiscovered Managers

"Mutual Funds and Taxes: Myths, Life Cycles and Strategies"

Here is an article from the current [March 15] issue of Fortune. It seems the tide may be turning.

[start quote] Funds That Make Sense

Years of academic research say that the smartest way to buy funds is to forget about recent returns and focus on low expenses. What sort of funds do you get when you actually follow that advice?

Carol Vinzant

Walk past any newsstand, and the path to financial security becomes immediately clear. All you have to do is buy the top mutual funds. Magazines offer cover stories like Seven Mutual Funds to Buy or The One Fund You Need to Buy Now as easily as Cosmopolitan serves up Ten Ways to Get Him to the Altar. There is one big difference, however. Cosmo girls know that what they're reading is folk wisdom, at best. Personal-finance consumers may think they're getting something more scientific. They're not, of course. The abundant research on mutual-fund returns offers scant hope that anyone--even financial reporters with the best mutual-fund screening software--can divine the top funds of the future. The best advice available from years of academic investigation is this: Avoid funds with excessive expenses and trading costs, and put little trust in great past returns.

This FORTUNE report takes the radical step of actually following that advice. In selecting the funds that appear in this story, we paid a lot of attention to expenses and none to recent returns. That led quickly to our core recommendation: There may indeed be just One Fund You Need Now for your equity portfolio, and it's a Wilshire 5000 index fund. We name a few funds that track that benchmark (which holds every regularly traded U.S.-based stock, currently around 7,200). We also include a handful of other funds to consider as a way to diversify your portfolio or simply to play a hunch. You decide whether you want those supplementary funds.

To be sure, the case for index funds has been made before. (Just for the record, index funds are portfolios that mimic the performance of a market benchmark like the Wilshire 5000 or Standard & Poor's 500.) But many people still cling to the impression that index investing guarantees mediocre performance. In fact, it should do considerably better. According to Lipper, the minority of funds that beat either index over the past 20 years offered only an average 1.5% bonus; the losers' penalty was 3%.

The reasons start with operating costs. Index funds run much leaner than their actively managed peers because the managers don't have to do such things as visit companies and employ analysts. Actively managed domestic funds take an average of 1.5% of your assets every year, while the expense ratio for the average index fund is just 0.6%--and many indexers charge less than half that.

By itself that gives index funds an enormous head start in the performance derby, but savings on transaction costs count for even more. According to Morningstar, active managers pay their brokers about 5.7 cents a share to execute trades, a rate that entitles them to stock research. Since indexers have no use for research, they pay an average of just 3 cents. Vanguard, the champion of cost-conscious indexing, pays about 1.7 cents.

And commissions are just the tip of the iceberg. Even more important is the market impact of the trade, says Wayne Wagner, chairman of the Plexus Group, an investing consulting firm. When a fund makes a big buy, it drives up the price of the stock simply by the law of supply and demand. If managers buy quickly, they push the price up rapidly. If they drag the trade out over a period of weeks or months, other buyers who independently decide to buy the same stock may drive its price so high that the fund never acquires all the shares it wanted. The combination of commission and price movement adds up to an average transaction cost of 2.3% per roundtrip trade, Wagner figures. He then multiplies that sum by the turnover rate of the average active fund (87%) and concludes that the average active fund loses 2% on transactions a year. (Trades by index funds also have a market impact, of course, but since indexers trade far less often, the cost is negligible as a percentage of assets.) That penalty comes on top of the 0.9% in extra fees that non-indexers charge. In short, just to keep up with an index fund, an active manager may have to earn as much as 2.9 percentage points a year before costs.

Every year some of them will succeed. Most funds will beat the index some of the time. But few will beat it over time, and there's no way of telling which ones they will be or how long they'll keep it up. A 1980 Financial Analysts Journal study speculated that perhaps 4% to 5% of managers were really talented, but the researcher determined it would take 70 years of data to prove beyond a statistical doubt that even those top guns really were skillful, not just lucky. "If you have 1,000 people flipping a coin, a certain number of them will flip heads ten times in a row," says Gus Sauter, who manages Vanguard's equity-index operation. "You don't ordain them at the end of the contest as superior coin flippers."

Once you buy into the indexing notion, you still have to decide which index fund to buy. Morningstar now counts 167 such funds on the market, 56 of which trace the S&P 500. As the previous story notes, years of bull-market performance by big growth companies have made the market-weighted S&P into a superstar with investors. But Sauter worries that S&P fund investors may have unrealistic expectations. In recent years the S&P 500 has been outperforming 80% or so of domestic equity funds. It's more reasonable, he says, to expect the index to beat 55% to 65% of equity funds annually.

Vanguard's senior chairman, John Bogle, has long pushed the Wilshire 5000 as a better benchmark. While the S&P makes up between 65% and 80% of the Wilshire, depending on the relative market moves of large and small stocks, the broader index offers more diversification and a chance to participate in any recovery by the long-suffering small-cap sector. A handful of fund companies offer Wilshire-based funds, including Vanguard, Fidelity, T. Rowe Price, and as of February even Wilshire (see table, Broad-Market Funds). All are low-cost funds that should serve you just fine. All else equal, however, Vanguard Total Stock Market Index is our first choice because of the company's proven record in managing index funds.

Arguably, that may well be the only fund you need for the equity portion of your portfolio. It spreads your money over the entire domestic market and gets you invested as efficiently as any fund can. In theory, you would be perfectly justified to buy the fund, turn off CNBC, and get on with your life.

We recognize, however, that not every investor would be comfortable with just one fund. While a broad market index fund should be the core of your equity portfolio, it makes sense to supplement it with investments that are underrepresented on the index. For example, the common wisdom is that you should keep some 20% of your assets in foreign stocks, and the Wilshire has none. In addition, any index that weights by market cap, including the Wilshire, will always tilt toward whatever stocks have been hot lately. If, say, Coke goes up, the index fund has to own more Coke. That means the Wilshire doesn't own much of what's out of favor, which could make you miss opportunities. But as "value" and small-cap managers have learned painfully in recent years, sometimes what's out of favor on Wall Street doesn't bounce back. It just falls further out of favor.

Geri Hom, who runs the index funds at Charles Schwab, is one who believes that foreign stocks belong in almost everyone's portfolio. Not surprisingly, she gets her international exposure through her own Schwab International Index fund. "In my personal portfolio I own only index funds," she says. "I invest it across the asset classes--large domestic, small domestic, international, cash, and bonds." The fund follows Schwab's own index of the 350 or so biggest companies in 14 developed foreign lands. Think of it as the S&P 500 of the world.

Like many other cap-weighted international indexes, Schwab International has most of its assets in Europe now. Europe's prospects are so bright that it may be worth raising your European stake even further. Companies there are restructuring like crazy, and the integration of the Continent's economies under a single currency broadens the opportunities for forward-looking companies. If you buy that argument, you should consider the funds we name in the Eurocentric Funds table. They include both Europe-specific index funds and actively managed funds with a heavy European stake--and all have low expenses and low turnover.

If you'd like to place similar side bets on the domestic front, Bear Stearns chief investment strategist Elizabeth Mackay likes the chances for small companies and value stocks. Academic research has noted that both sectors tend to have an edge in the long run, although their dismal recent record makes them seem like a contrarian play right now. Last year, for example, the Lipper Small Cap index lost 0.9%, compared with the S&P's 28.6% gain. The Vanguard Growth Index rose 42.2%, compared with 14.6% for the Value Index. But Mackay believes that the tide may soon turn in small companies' favor and is encouraged that many small companies are buying back their own shares. As for value stocks, she anticipates that earnings' unexpected strength may heighten interest in the cyclical stocks that value investors adore.

The table called Specialized Index Funds identifies several index funds that let you take a flier on small caps or value funds without the burden of an active manager's higher fees and transaction costs. The Vanguard Extended Market Index fund replicates the Wilshire 4500, which is the Wilshire 5000 minus the S&P 500. The Galaxy II Small Company Index tracks the S&P Small Cap 600 index. The Vanguard Value Index tracks the cheapest companies in the S&P 500 based on price/earnings ratios.

Another way to supplement your core index fund, of course, is with funds run by humans (see Actively Managed Funds). History shows that active managers' higher costs are a serious, probably insurmountable, drag on their performance. Still, judging from the continued strong sales of such funds, it seems that most investors find it difficult to trust their money entirely to index-investing robots.

If you must express this sentiment by investing in actively managed funds, do it intelligently. Stick with those that trade infrequently and charge comparatively modest fees. And make sure that your manager truly does offer a distinctive portfolio, rather than a quasi-index made up of hundreds of stocks.

Eric McKissack, who runs the socially conscious Ariel Appreciation fund, is one manager who gives you the benefit of his convictions. He normally owns no more than 45 companies and holds each one for about five years. "If you own 100 to 200 stocks," he notes, "it's hard to see how you can have any depth of knowledge." That's no problem for McKissack. He talks to competitors, customers, suppliers, managers' former colleagues--anyone who might have an insight not yet absorbed by the market. "For what we do, it would almost be useful to have a background as a private investigator," he jokes.

The Torray fund is willing to take a longer view than the typical fund, according to co-manager Douglas Eby. He and co-manager Robert Torray aim to buy quality companies on the cheap and hold on to them for five years or more, unlike many fund managers, who sell within months. Ron Muhlenkamp of the Muhlenkamp fund looks for broader trends. In the fall he bought construction stocks and other companies that had been pounded by recession fears. He has stayed away from the giants that dominate the S&P 500, which he considers dangerously overpriced. "We buy good companies when they're on sale," he says. "Right now Cadillacs aren't on sale." FAM Value co-manager Thomas Putnam seeks stocks selling for what would look like a sale price to an investor buying the whole company. His typical turnover of 9% or so a year minimizes transaction costs.

In the end, the most important reason to supplement a core index holding with other funds--actively managed or not--is that it's the best way to position your portfolio for whatever happens in the market. "If things start to go the other way--and we're not predicting that they will, because we don't know--people could be better off with a fund like ours," says John Lindenthal, manager of Preferred Value, which seeks undervalued companies with high return on capital. But predictions are chancy. History shows that fund investors are wrong more often than they're right. That's why you should keep the index at your core and play your hunches only on the edges. To put it in portfolio terms, you want to overweight the science and underweight the folk wisdom.

Issue date: March 15, 1999 Vol. 139, No. 5

Bylo; Will Fortune magazine "keep" that link alive and free into the future?

Some magazines drop older articles and others charge for archival retrieval. This uncertainty was on my mind when I copied it to FundLibrary.

I find it pretty amazing that at long last, lead stories in mainline magazines are finally debunking the "hot fund" chase that is so wasteful of investor assets.

This thread is truly Canadian!

1. We are passive and we love our passive investing.

Nobody can beat the index investing, we're told, so why bother trying? Surely there must be enough intelligence out there to effectively discriminate between the top half of the companies in the index and the bottom half. The S&P500 owes its performance this year to the top 25 companies. Without them, the return would have been negative this past year. The other 475 companies were dead weight.

2. We are happy because we love average and have found our hero in the averages.

Is there anybody out there who tries to analyze what is going on and explain the current, passive, index investment phenomenon? Can a trend of the past few years be taken and extrapolated to infinity? Is there nothing beyond statistics and simple extrapolation of the past to guide our investment decisions?

3. We are happy because we're told the bigger the average, (WiItshire 5000 vs S&P500) the better.

This would really make for a Great Canadian celebration. We've discovered a big average is better than a little average. May we should include every single company in the country and invest in it. Wouldn't this be a bit like investing in the GDP of the country?

4. We are happy because non-Canadians have confirmed our belief in average.

We have an authority no less than Fortune magazine and the quotes of prominent indexers to reinforce our great belief in the average. So if Americans say it's true, who's to argue?

Folks, I just had to inject some alternative thoughts into this thread because all this fawning worship at the Idol of the Great Index is a bit much.

I wasn't able to find the online version of the article from Fortune quoted above, but I have the hard copy. It makes an interesting case for index investing.

Let's have a little fun with some of the numbers bandied about in this issue. From the article quoted above:

"If you have 1,000 people flipping a coin, a certain number of them will flip heads ten times in a row," says Gus Sauter, who manages Vanguard's equity-index operation. "You don't ordain them at the end of the contest as superior coin flippers."

True, that's no big deal. The odds of you or I doing that are 1 in 1024.

But let me give you a quote from the article just before the one quoted above ("the skeptic's guide to mutual funds"):

"Fewer than 20% of all equity fudns outperformed the unmanaged S&P500 index in the past year. The percentage drops to 11% over 10 years and to 4% over a 15-year stretch."

Now let's do a little probabiltiy with these.

These superior managers (or team) that beat the S&P500 are not the 1000 index fund managers flipping a coin with a 50% chance of getting a head. These guys are using superior intellect to flip a coin with about a 20% chance of winning and doing it 10 times and even 15 times in a row, on average.

The odds of 10 in a row, at 20%, according to my trusty spreadsheet, are a heroic 1 in 9,765,625. Imagine, 11% of the funds beat odds of 1 in 9,785,825. The odds of doing it 15 times? An astronomical 1 in 30,517,578,125. I think this amounts to a discovery of intelligence in the world of average.

Just because most people eat out at McDonald's, does this mean you should too, because you won't find consistently better food elsewhere?

Food for thought.

Who (other than you) ever said "Nobody can beat the index investing"?

What we are saying is that most managers can't match or beat the index most of the time.

"Surely there must be enough intelligence out there..."

There is. Lots of it. And that's why it's so difficult to beat the index. In a world where there are 1,000s of highly-skilled analysts on Wall Street and Bay Street, etc. and information travels at lightning speed, unless one is an inside trader, there's virtually no chance of knowing something about a company that isn't also known to everyone else almost instantaneously.

"The S&P500 owes its performance this year..."

Let me repeat the quote that you quoted out of Fortune "Fewer than 20% of all equity funds outperformed the unmanaged S&P500 index in the past year. The percentage drops to 11% over 10 years and to 4% over a 15-year stretch."

Oh, so you agree that this phenomenon isn't a one-year wonder. What's your point then? Do you know which funds will be among the ~4% or so that beat the index in the next 15 year stretch? (If you do, then why are you wasting your time here? You could make a real fortune by selling your wisdom.)

"Is there anybody out there who tries to analyze what is going on and explain the current, passive, index investment phenomenon?"

Lots of people. Many of them have even won Nobel prizes for their research. Some like Vanguard's John Bogle have seen their index funds grow from zero to hundreds of billions of dollars in the past 25 years. They've all concluded that indexing works. Even the managers who run traditionally conservative private pension plans have concluded that they can't beat the index and have decided to move massive amounts of money into index funds.

Gee...maybe these guys (and gals) are on to something.

"3. We are happy because we're told the bigger the average, (WiItshire 5000 vs S&P500) the better."

Perhaps you missed the posts that explain why. Bigger isn't necessarily better. But in this case it's definitely more diverse and far more tax efficient to boot.

"Folks, I just had to inject some alternative thoughts into this thread because all this fawning worship at the Idol of the Great Index is a bit much."

Thoughts are great and you're welcome to express them. Now how about some reasoned arguments? How do you determine which active-fund managers will outperform? What evidence do you have that past winners will repeat? (The preponderance of research has concluded just the opposite.)

"These superior managers (or team) that beat the S&P500 are not the 1000 index fund managers flipping a coin with a 50% chance of getting a head. These guys are using superior intellect to flip a coin with about a 20% chance of winning and doing it 10 times and even 15 times in a row, on average."

I think you misunderstand the point that Sauter's trying to make, but nevertheless, if their [non-index fund managers'] intellect is so superior then why do so many of them fail to match, let alone beat, a completely dumb index?

iconoclast, with all due respect, read a book or two on Modern Portfolio Theory, efficient markets, asset allocation, indexing, etc. Then come back and let's have a real debate.

Re: Count 2 in the Rebuttal. This is a rebuttal to the creation date bias.

For the most part, Norm Rothery confuses using a single index fund with an overall portfolio strategy. There well may be some naive investors who have heard the message concerning index fund advantages and then go on to implement poorly. I actually am worried about people who are tossing most or all of their investments into one index. But for those who understand the portfolio approach to investing, this is a non-issue.

I've said before that index funds are just a tool. Strategy comes first and foremost from an overall portfolio selection point of view. Within various classes of assets, index funds (or substitutes) provide a precise, low cost and tax efficient mechanism for implementation. The best examples are in the large cap classes of the worlds mature stock markets. These classes are areas that all thinking investors should have exposure to. But there are other classes less conducive to an indexing approach (more do to with availability than the validity of the approach). These classes should not be excluded from your portfolio just because an index implementation is unavailable or impractical.

The salient point is that it is your overall portfolio that counts. An investor should strive to build this portfolio using the three key criteria I mentioned earlier. Index funds can play an important role in sound, portfolio construction.

Re: Count 3 in the Rebuttal. This is a rebuttal to P/E Ratio.

Ex ante, an investor never knows whether growth or small cap will outperform value and large cap and vice versa. Why attempt to guess? Just tilt the portfolio along the expected risk-adjusted return curve.

If you subscribe to the Fama/French 3-factor model that small cap and value equities outperform in the long run then you adjust the portfolio to correspondingly overweight those asset classes.

Iconocast writes:

Let's have a little fun with some of the numbers bandied about in this issue. From the article quoted above:

"If you have 1,000 people flipping a coin, a certain number of them will flip heads ten times in a row," says Gus Sauter, who manages Vanguard's equity-index operation. "You don't ordain them at the end of the contest as superior coin flippers."

True, that's no big deal. The odds of you or I doing that are 1 in 1024.

But let me give you a quote from the article just before the one quoted above ("the skeptic's guide to mutual funds"):

"Fewer than 20% of all equity fudns outperformed the unmanaged S&P500 index in the past year. The percentage drops to 11% over 10 years and to 4% over a 15-year stretch."

Now let's do a little probabiltiy with these. These superior managers (or team) that beat the S&P500 are not the 1000 index fund managers flipping a coin with a 50% chance of getting a head. These guys are using superior intellect to flip a coin with about a 20% chance of winning and doing it 10 times and even 15 times in a row, on average.

The odds of 10 in a row, at 20%, according to my trusty spreadsheet, are a heroic 1 in 9,765,625. Imagine, 11% of the funds beat odds of 1 in 9,785,825. The odds of doing it 15 times? An astronomical 1 in 30,517,578,125. I think this amounts to a discovery of intelligence in the world of average.

----- end of quote----

Iconocast's calculations are incorrect because 1) it assumes that the S&P 500 had beaten 80% of managed funds in each of the past 10 year or 15 years but such high relative performance has only occurred in the last 3 or 4 years and 2) it is a calculation of the probability that the index fund beats the managed fund in every year rather than beating it on average over the 10 years. Clearly, the chances of the S&P beating a managed fund in every one of the past 10 years is very small but to beat it over a 10 year period only requires the S&P to beat the managed fund half of the years (if the amount it beats or loses by is the same each year.)

The formula for determining the probability that an the S&P beats a given managed fund, say, 7 years out of 10 is 10!/(7!*3!) * p^7* (1-p)^3 where p is the probability that the S&P beats the managed fund in a single year. To determine if the S&P beats a managed funds over a ten year period, we need to add up the probability that it beats the managed fund for 10, 9, 8, 7, 6, and 5 years. In the case of 5 years, we can assume that half the time the S&P beats the managed funds over the entire 10 years and half the time, it's the reverse.

I have some data from a Vanguard pamphlet about the percentage of general equity fund that the Wilshire 5000 index beats for 1985-1994. (Note, 0.3% was subtracting from the Wilshire return to reflect the approximate index fund cost.)

Yearly percentage 1985-94, Wilshire 500 beats general equity fund: 77, 61, 54, 65, 73, 41, 56, 53, 44, 59

For the entire 1985-94 period, the Wilshire 5000 beat 66% of general equity funds

The average of the yearly percentage was 58.3%. Plugging in .583 for p in the above formula gives 70% for the fraction of funds the Wilshire should beat over 10 years, which is a somewhat higher than the actual 66%. If there was perfect persistence in performance, then the same 58.3% of funds would underperform the benchmark every year so the 10 year percentage would also be exactly 58.3%. If there was no persistence in performance, the 10 year percentage would match the formula. So the actual data shows a little persistence in performance. However, this may be due to survivor bias. (The sample only includes funds that survive the whole 10 years, which are likely to be persistently better performing funds.)

The very high relative performance of the S&P (beating 80%+ of growth funds) in recent years is, I believe, mostly due to the fact that large caps stocks have been doing very well rather than the inherent superiority of indexing. This is describe as "Dunn's Law" in the Efficient Frontier article list below. Basically, index funds must stick to their benchmarks while managed funds tend to drift. This means that managed funds does relatively better than index funds in sectors that are doing poorly (like US small caps), since their holdings include stock outside the sector, but they also don't do as well in sectors that are doing well (like US large caps), also because their holdings includes stocks outside the sector. The very first post by bylo in this thread supports this view. The difference in index and managed fund returns in each asset class is perfectly correlated with the total returns of that asset class.

The recent relative performance is much too high. I think that, in the long run, index funds will beat 60 to 65% of managed funds in a given year. Using the 60% figure and plugging it into the formula above, indexes should beat 73% of managed funds over 10 years, 81% over 20 years and 86% over 30 years.

Mabey I missed it, but what would be a good US small cap fund to go along with my US index fund in my RSP.I looked up a few on Globefund and they all seemed to have high mer's and didn't come close to tracking the index they were compared to.

A couple of observations here:

1) S&P index may have done so well the past few years because more people are buying the index funds, in addition to "regular" demand. Limited supply, increased demand = higher prices.

2) Whilshire 5000 Index funds can, and commonly do, exceed the Wilshire index. (I'm sorry I can't recall where the article I read was but here goes, from memory...). Why? The reason is that most Whilshire 5000 index funds do not hold every company in the index, as Bylo alluded to earlier. There's simply too many illiquid companies and the index buying would have too great of a distorting effect on prices of these companies.

What these funds seek to do is, however, own a *representative* sample of the index. That means for most funds, somewhere between 700 to 2,500 of the approximately *7,500* stocks in the Whilshire *5000* index. Anywhere from one-tenth to one-third of the actual stocks in the index.

Now because some of these stocks are so illiquid, and an index fund does not have to buy any one particular company, these gives the fund enormous discretionary buying power. Just as them demanding to buy a large quantity of one illiquid stock *could* have a price elevating effect, a seller *having* to sell a large portion of a stock into that same illiquid market could have a very punishing effect on the price.

So, how the Whilshire index funds use this to their advantage is that they say to some potential large volume sellers is "Hey, you want to sell, we *want to* buy. But we won't buy, unless we can get it at a discount to the current price."

If the seller says "OK", then they've got an index beating deal. If the seller says "Hey, no way", then the indexer says "I don't *need to* own *your* stock. All I need is a *representative* sample. See you later. - Oh, and good luck with the sale. And gee, I hope the volume you're peddling doesn't push the price down below what I've offered you."

And of course the buyer either reconsiders and sells, or the index fund moves on to another representative company, with whom it consumates a deal. And so the *index* fund outperforms the index. Interesting, no?

Jay,

Good description. I don't think it applies to the W5K as much as to the small and micro cap indexes.

Hello Jay Walker -

As Bylo's links show, your comments are valid but probably apply more to small cap indexing.

Re SP500 gains in the last couple of years (or more), I don't think you can attribute the move to indexing to any dominant extent. Money going into an index fund is a demand component so it obviously has an impact. But, if I remember correctly, less than 20% of net new investments are indexed (in the US). Even more importantly, the SP500 has been largely driven by a few (about 25 or so) large stocks. Since indexing buys the entire SP500 in market cap proportion, it is difficult to see how indexing could account for relative changes in position of various stocks. For example (and Howard could probably provide better info here), Phizer has moved up about 10 positions in ranking the DOW stocks in terms of total market cap. A change in relative position has to come from the non-indexed part of demand. So, I don't think its accurate to attribute the responsibility for SP 500 gains at the feet of indexing.

I am still not sure as to why you need to bother witha mutual Fund as opposed to DIA, QQQ, and Spyders? The major problem with an Index style fund such as the NASDAQ QQQ is that one stock that has had tremendous market runups like .com can markedly increase the volatility? A fund manager can lighten his position, take profits, an Index just becomes more volatile AOL $10 movement down today, that has to over effect QQQ??? Today on CNBC, 10 % on the DOW and 15% on NASDAQ, was predicted, not good for index funds????

Hello Howard -

Re index funds vs trust units (SPDRS, etc) it depends on how much you have to invest. For larger lumpsums and relatively large balances, trust units are a better deal due to their lower MER. But if you are a smallish investor making regular contributions (say 1K/month) the brokerage costs add up and cause the breakeven timeframe for the two investments to be quite large. Also, if you are American or a Canadian with a US brokerage account, you have Vangaurd available as an option. The MERs between Vangaurd's SP500 fund and SPDRS are essentially the same. So, unless you want to trade there is no advantage (indeed there is extra cost to using SPDRS).

Regarding volatility, the volatility of an individual investment is not the big issue -- its the volatility of your overall portfolio that counts. Managed funds are like mini-portfolios -- they hold cash and other asset subclasses above and beyond their core mandate. An index investor controls overall portfolio risk by holding these investments as well. As to your point about active managers taking profits at key times, this implies they are making valid timing decisions and there is very little evidence that this works in a consistent way.

PK,

Some clarification on the tradeoffs between Vanguard and IPUs through US brokers.

When you buy Vanguard funds through a US broker there's a transaction fee (US$25 in the case of Waterhouse) which is the only remuneration the broker gets since VG pays no commissions or trailers. (This transaction fee BTW doesn't apply to reinvested distributions.) As a result, unless one has a very large portfolio, it's probably best to buy the most diversified VG funds, e.g. their Total Stock Market (W5K) fund and also to DCA quarterly rather than monthly. Unfortunately VG's Total International Index "fund-of-funds" isn't available through US discount brokers so one has to DIY an EFEA fund using VG Europe, Pacific and EM funds.

OTOH, Waterhouse charges only US$12 to trade IPUs. And that includes a "free" DRIP, something that isn't generally available from Canadian brokers despite their much higher brokerage fees.

That said, if your portfolio is in an RRSP it's probably best to use low-MER Canadian index funds from Royal or Altamira (or CIBC is you have at least $150K.)

hey does anyone feel like sexy chat on indunds

I am relatively uninformed in regard to index funds. I was wondering if anyone here has any recommendations in regard to choices of Index funds (S&P 500, S&P 100) in both no load and loads.

Thank you for your info.

In this era when the financial departments institutions of higher learning are referring to you as an anomaly, and efficient-market proponents are saying you can't outperform the market, where does one go to find a mentor, someone like you found in Ben Graham, whom you can ask questions to regarding value investing? Buffett: I think the efficient-market theory is actually less holy writ now than it was 15 or 20 years ago at universities. You know, if you have a merchant shipping business and all of your competitors believe the world is flat, then that's a huge edge, because they will not haul any cargo to places where they think they will fall off, so we should actually be encouraging the teaching of efficient-market theories at universities. Keynes said that most economists are most economical about ideas: They make the ones they came up with in grad school last a lifetime. Professors get a lot of themselves and their ego and their professional security invested in those ideas, and it gets very hard to back off of them after a given point. To some extent, this has contaminated the teaching of investing in universities.

Munger: I would argue that the contaminations massive, but it's waning. Good ideas eventually prevail.

Buffett: Now that word 'anomaly'--Columbus was an anomaly for a while, I suppose. What it means is something the academicians could not explain, and rather than reexamine their theories, they simply discarded any evidence of that sort as anomalous. I think when you find contradictions that challenge previously cherished beliefs, then you've got a special obligation to look at it and look at it quickly. I think Charlie told me that one of the things Darwin did, was that whenever he found something that contradicted some previous belief, he knew that he had to write it down almost immediately, because the human mind was so conditioned to reject contradictory evidence, that his mind would soon push it out of existence if he didn't get it down in black and white very quickly.

misterinvestor;

I thought somebody else might reply. You say "I am relatively uninformed in regard to index funds. "

There is much good material about index funds on the web. Try the Bylo Selhi site, or the Vanguard site or the link below.

Go "no load" in my opinion. Royal and Altamira have low mer index funds.

Is it for inside or outside an RRSP?

I noticed Businessweek places State Street in their top 50 companies from the S&P500. I believe this is the outfit in charge of managing the Altamira and Royal index funds. Just a little tidbit. Businessweek also suggests their top 50 outperforms the S&P 500.

The TSE is still 13% lower than it was a year ago. The 'average' Canadian Equity Fund lost 9.8% last year. A 'no-brainer' managed fund like Ivy Canadian or AIC Diversified actually made significantly more vs. the index. Clearly indexing in the Canada is not as lucrative as it is in the US.

Five Dots,

There are several problems with your analysis.
1. Creation and end date bias.
2. Foreign content analysis bias.
3. Style analysis bias.

mikale, surely you jest. The 2 managed funds mentioned outperformed the index over every trackable compounded time period, with the exception of the 6 months. Sounds like your 6 month time outlook was not picked out of a hat, was it ?

Hello 5 dots:

All of Mikale's points are completely valid. To consider just one, the foreign content issue, at the beginning of the year the National Post published their year end performance summaries. They itemize the percent of foreign content contained in Canadian Equity funds. Of all the Can Equity funds, about 100 or so had zero foreign content. If you look at this subset's performance, the index is a HIGH 2nd quartile performer. This, of course, doesn't factor in cash holdings which benefit managed funds in a down year. If you factor cash into the equation, the index would have been a low 1st quartile performer.

I'll decide on my own asset allocation and leave active manager risk alone.

mikale, who cares what the MER is, when the long term performance beats the index? Berkshire is a relatively new holding.

Dotty,

Since when did "long term performance" constitute 5 years or less?

Bylo, 5 years is more indicative than 6 months.

dots,

But not by much.

Find me a high MER fund that beats its respective l-r index and you will have shown me an extraordinarily risky fund. AIC Adv is a good example.

What makes IVY Canadian and AIC Diversified "no brainer's"? Their historical returns?

How would you have know these were the "no brainer's" five years ago? Couldn't have been their past 5 year return's at that time (1994) as these funds don't go back that far.

I wonder how the funds with the best 5 year returns back in 1994 (the "no brainer's" of the day) have done from 1994-99.

Which are the "no brainer's" for the next five years? The same two funds?

chuck, when makes the index agument so compelling.....past performance. These funds no-brainers because the managers have excellent down-side risk. Review the Sortino ratios on each. Ivy Canadian has never been the best performing Canadian Equity fund, however, Javasky has shown prudence in his investment style throughout his career. The reversion to the mean argument will eventually come into play and, God-forbid, the managers holding cash equivalents may be your only liferaft.

P.S. I never said the funds with the 'best 5 yr returns' were the no-brainers since there are much better 5 year performers than the 2 I've mentioned. The next 5 years? who knows.....but in Canada, managers like Degeer, Javasky, Radlo and Fortuna (to name a few) may not be all that bad.

Dots, true it is the past performance of indexing that makes its so compelling. Key though is the likelihood of this performance being persistent into the future.

I was only speculating that you were basing your "no brainer" assessment on past returns, I see now you based it on the past records and style of the manager(s).

At least you have a larger view of the picture than many people with the "who cares about MER as long as there is superior return" opinion.

Protection from downside risk is a matter of taste I guess. I would rather protect against downside risk by reducing my exposure to equities through asset allocation. You would rather let professional managers do it for you. My way is definitely cheaper. Am I as good at assessing market conditions as professional money managers? Probably not. On the other hand, fear of short term underperformance does not influence me to "follow the herd". Personnally, I'd be nervous about counting on the cash holdings of most equity funds to be my life raft in a serious down market.

Chuck: re "Am I as good at assessing market conditions as professional money managers? Probably not."

Don't be so kind to these ridiculously overpaid dice-rollers. What do they know that any reasonably intelligent, well-informed, experienced investor doesn't? They make their bets, some win, some lose in what is always a zero-sum game.

As PK pointed out in Reg's thread about TAA, there is no evidence that managers as a group add value to a portfolio with their market-timing decisions-- in fact they generally underperform passive strategies. Of course a few will always outperform their benchmarks, but we have no way of knowing in advance which managers will. That is why prudent investors, use low-cost, passive portfolio strategies.

5Dots,

Bonjour mikale:

For an article that reviews both sides of the Sortino check out the link below. Fans of Ibbotson will be pleased to know that Paul Kaplan is featured in the article.

There is agreement that downside risk is a better measure of risk than sd when the asset returns are skewed. The hot point of contention is which assets have skewed returns.

Sortino believes that downside risk is only one of several measurements of risk that should be used

Lado

Indexing & Assett Allocation : Portfolio Considerations (for those who care to share)

I have been influenced by Larry Swedroe's book on Assett Allocation - (The Only Guide To A winning Investment Strategy You'll Ever Need - 1998) and I find his views on indexing and on assett allocation to be compelling. One of the advantages that US investors have is the relatively low mers that will determine the rate of return. Since I do not have access to American funds with low mers, it seems to me that I can not follow all of the recommendations of people such as Swedroe.

With that understanding, I would be interested if anyone would like to comment on the indexing/assett allocation issue that I am faced with in my portfolio. (Time frame - about ten years - am ok with volatility)

I had planned on Intl small caps value of 15%, as per Larry Swedroe, but I am concerned about mers and performance and choice of a good small cap value Intl funds. Instead, I may take that 15% and split it between a Japanese index fund (i.e.7.5% of portfolio) to offset N.A. exposure and the other 7.5% could be put into spyders mid cap(7.5%). Portfolio could look like this:

CAN 15% 6% Tips 35 9% Can Small cap value(Bissett, Saxon, Scudder, others?) (btw,Saxon turnover is aprx 30%)

US 41.5% 9 % Spyders 7.5 % spyders mid cap (OR buy Europe index??) 25% small cap value (Franklin, 2.5 mer)

INTL 43.5 36 % MS EAFE (CIBC) .3% mer 7.5% Japan Index (T.D.1.5 mer)

Note I have tried to balance small and large, to some extent. here are some of the issues: 1. I am more overweight in US than I had planned, 2. I may be a little high in the mid-big caps growth and weak on small cap value - esp Intl(because of expense and availability). 3.I could tweak this with more MSEAFEor a Europe index fund 4. I could reduce Spyders mid cap, I suppose. 5. Japan Index? 6 Reduce Can holdings for Intl?

If you would like to share a quick comment on how you might tweak this in order to improve performance over ten years, please let me know. I'd be plesed to return the favour. Thanks! david David_Kuracina@ocdsb.edu.on.ca

Here are John Bogle's views on "active market timing"

"What happened to the vaunted ability of fund managers to raise cash before market drops (and to reinvest that cash after the drop is over)? It simply wasn't there. In mid-1998, just before the steepest stock market decline since 1987, reserves represented less than 5% of equity fund assets, close to the all-time lows, compared to 13% at the market low in 1990, close to the all-time highs. This pattern is all too typical. Funds have consistently tended to hold large amounts of cash at market lows and small amounts at market highs. For example, cash equaled only 4% of assets immediately before the 1973-74 market crash, but increased to about 12% at the ensuing low; at the beginning of the bull market in 1982, equity funds held cash equal to 12% of assets. Managers, in short, have been bearish when they should have been bullish and bullish when they should have been bearish. It is not a formula for success. "