If you pay taxes - buy index funds - II |
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Hi folks. The "buy index funds" thread was getting a little long (I have a slow modem) so I thought I'd try to start a new one with a question about mutual fund theory. On the last thread it was said that size of a fund doesn't matter. However, this is something I've often wondered about: How many truly good investment ideas can a manager have? 5? 10? 15? I think Buffett's approach is better - find the really good ones and throw more money into them, rather than putting that money into more (different) stocks. I remember getting the report of Altamira Equity's holdings and flipping through page after page of stocks, in small 6 pt. type. How can all of these stocks have merit? If a fund manager can rank their investment opportunities on a scale, it seems to me that 15 or 20 stocks would be the outside limit. If you've got 300 stocks, why are you buying the 300th instead of putting that money into your #1 idea? Sure you might be wrong, but that's the whole premise of active management, isn't it? Now, the bigger a fund gets, it has to hold more stocks because it can only hold a certain % of any one company's stock (see AIC). This forces "diworsification" by the fund, so even though a huge fund may be insignificant compared to the TSE's value, it can't hold enough of the "good" picks in significant amounts. I believe this is what happened to Altamira Equity - Frank can still pick stocks, but now he has to get 100 winners instead of 10. Hard to do, even for him. This is all a roundabout way of saying that I think one should go with index funds until a large position (say $100k) has been built up for security, and then start putting together a portfolio of 5-10 stocks that you think will outperform, for whatever reasons. Extra cash is used to buy more of your #1 pick, not some new stock. If you don't have time to stockpick, then I guess you should stick with the index. Any thoughts?
Great thread(s) - thanks Scooby for starting a continuation - perhaps someone could insert a link in here back to the original thread? You raise a few interesting issues - investors do cross the barrier eventually to a point where the use of Investment Counsellor "pooled funds" with the low MERs or a carefully segregated account makes sense. One issue with the "transition" to this higher level of investing is the cost factor of triggering the capital gains built up so far in a portfolio (assuming a non-RRSP position). Also, you are presumably making a move for the investor from a strategy that has been beneficial and comfortable (not to mention refined) over time - there is, in my experience, quite a resistance to changing to a different strategy (especially when it becomes evident that a great deal of tax will become payable). Finally, while many of the excellent conributors here are able to "select" Cdn stocks, what about US stocks and International stocks (not to mention consideration of country/currency issues). I would say that with even a fairly decent pool of $$$ (say $300kto $500k), selection of a "few good positions" in the various sectors would leave the overall mix under-diversified. OTOH, the ability to buy, and hold and control your "turn ratio" and therfore the tax hits in the future is quite appealing. Just my 2 cents (Cdn) worth, I have been out of town for the last week or so and away from the 'puter, but it sure is nice to read through an excellent thread like this right from the beginning. Thanks to all who have contributed here to date. Warren.
This thread is a continuation of...
Warren, Welcome back! Re the tax issues, you may want to review a recent thread Equity Funds - Better Off Outside RRSP? that challenges the "conventional wisdom" of holding fixed income assets inside one's RRSP and equities outside. We look forward to your comments on this.
Warren, your point is well taken but I was a little unclear. What I envisioned was maintaining that original $100k in the index funds, but putting any extra cash above that point into individual stocks. That way you're still diversified and have the portfolio you're comfortable with, but the new money goes straight into stocks. Point taken about foreign stocks being hard to pick, but I think the U.S. market would offer ample opportunities for finding great stocks and I think it's close enough that getting enough info wouldn't be a problem.
Thanks Bylo, for the link(s).... Scooby, I see your point, this I think actually would gradually keep some sense of diversification in the portfolio, but does it then not go against the Warren (hmmmm, nice name
Warren.
Sorry I did not notice that a new thread had been started. I posted a site which is relevant to Managed Funds. sorry I do not know how to hot spot
go to: www.moneydaily.com
My problem with buying index funds is the feeling I get that being average is best. It goes against human nature.
It's like going to a baseball tryout just to make the team. As long as your on the bench you can't personally fail but you can collectively share in the sucess of others.
If the index is best, then we have too many fund managers with too little knowledge. We should be rewarding the winners (Bisset etc.)
How many funds would the index have beat if the MER's were 1.5%, the 20% foreign content rule was eliminated, and every fund was capped at $500 million?
Accepting average can't be right but its built into our culture. Education (produce robots for Henry Ford's assembly line), marketing boards, welfare, etc.
Sorry for the preaching! Sunday mass is not necessry this week.
Scooby asked on another thread if I would comment on Colt's previous point. Subject to my understanding, Colt argued that even if one allows that a US index strategy is good, it does not necessarily follow that a Canadian index strategy is good. The reason being that the Canadian index is heavily weighted with resource and other cyclical issues. Colt has raised the point on a number of threads (and never been seriously challenged) that cyclical sectors do not make good buy-and-holds.
I have not had the time to fully consider his point, but can offer this objection to get some discussion going: If cyclicals are such bad long term holds, how did they make it into the index (which represents the largest Canadian companies)?
I suppose one could argue simply longevity, but that doesn't make them a bad investment, does it?
Have others considered this issue?
Randy.
Randy,
: "If cyclicals are such bad long term holds, how did they make it into the index (which represents the largest Canadian companies)?"
Stocks are not selected for the index based on their historical or likely future returns to investors as buy and hold investments.
Warren,
Why is underdiversity a problem ? Concentrated positions in a few quality companies may make a portfolio more volatile, but this does not equate to business risk and therefore greater risk of principle loss. For some investors diversification serves a purpose, to others it is simply a retardent to making money.
P.S. On another thread "da bull" claimed to be the best looking person in this forum. Having seen your mug in the paper I told da bull it was unlikely. Welcome back oh worthy sparring partner.
Matador,
I agree here. Setting aside the issue of whether or not index funds have indeed out-performed managed funds, there is something intellectually insultng about a strategy that says you can't win so why try.
But then isn't that what a buy and hold strategy is ?
Perhaps one approach to addressing this is to look at historical data on the TSE indexes.
Unfortunately PALTrak only reports TSE35 data going back 5 years. During this limited period the TSE35 index was consistently 1st quartile. They report 10-year data on the TSE sub-indexes (inception Jan86). Over periods up to 10 years the only sub-indexes that were consistently 1stQ performers were the (surprise!) Utilities, Pipelines and Financial.
I wonder how a made-to-measure DRIP portfolio consisting of just the largest phone companies, banks and pipelines would have fared if backtested? IOW, if the TSE35's high weighting in resource-based is cause for concern, then why not custom-build a "sub-index" out of the non-resource half of the TSE35? If that's too many stocks for an individual to manage, then how about just the top 2 from each of the 3 sectors? Perhaps the proponents of buying, holding and DRIPing conservative Canadian high-yield, large-caps have it right after all?
PALTrak does go back 15 years on the TSE300. That index has been in the 1stQ in all periods but 10-year, where it was 3rdQ. Since inception in Jan56 the TSE300 has returned 10.2% on an annual basis. No quartile ranking is given. One problem with indexing the TSE300 (and even the TSE100?) is that it includes a plethora of small-caps -- as many pension plan beneficiaries discovered when Bre-X went kaput.
The TSE website says they offer historical data, but evidently they charge for it. Does anyone have a source for historical data on the TSE indexes that goes back a few decades?
Just a quick comment - resource companies can be huge (and therefore part of the index) simply because there is so much money in extracting resources. That is, they didn't get big by growing the business, but merely because there are so many resources to extract. Thus their size may not be because of internal growth but merely thanks to nature. (Hope this is clear)
Re L. Sandell's reference to the article in Money Daily, here's the link Stuck in the middle of the road.
"And now for something completely different"... here's a link to Mutual Funds Interactive's thread on this topic DE-WORSE-I-FICATION.
This was also posted on the "A Foolish Consistacy...." thread
******Index funds force the investor to buy high and sell low!*****
That is, when a stock is dropped from an index it is because there is a problem of some sort with the stock/company, this problem is always reflected in the stocks price. Thus = sell low.
When a stock is added to an index it is always a stock that is strong. Thus = buy high.
In another vein, it might be interesting for someone to compare fully RRSP eligible foreign funds to foreign funds (in the same class) that are limited to the 20% foreign content rule. This should provide some idea as to whether or not being able to overweight some sectors and underweight others is of value.
An indexer would have participated to a limited degree in the performance of ----AIC Advantage, Dynamic Real Estate, Etc. An indexer would also have been forced to participate in the massive decline in gold and resource stocks that we have experienced over the past little while.
As usual, there is no perfect vehicle for all seasons. In a bear market the index/fund goes down, no defensive moves are possible. In a broadly based bull market an index/fund goes up, but so does everything else (that is all/most funds investing in the stocks that make up the index). In a narrowly focused bull market the funds investing in that narrow area will out perform the index/fund.
BWG
I’ve been spending some time recently shopping for a U.S. fund, and the Green Line U.S Index Fund is on my short list. Steven Kelman gives the fund a five-star rating. Ranga Chand puts it on his heavy-hitters list. Chevreau and Kangas deny it “Smart Fund” status, but put it on their “Noteworthy” list.
Gordon Pape, on the other hand, persists in giving Green Line U.S. Index a lowly $$ rating -- “Average. May produce only mediocre returns . . . .”
“I can’t give an index fund any better than a $$ rating because by definition it should alway be an average performer, “ Pape writes in his 1998 guide.
Now listen to Riley Moynes and Michael Nairne describing the AGF American Tactical Asset Allocation Fund: “The model may invest from 0% to 100% in any of the asset classes, which are made up of the S&P 500 index for stocks, the Lehman Brothers Long Bond Index for bonds, and 90-day T-bills for cash. No individual security selection is done.”
And Gordon Pape? He gives the AGF fund a $$$$ rating. It would be interesting to here Pape explain the consistency of his ratings here.
BWG,
Just a few comments. In a bear market an index fund will get hit harder, but you still have the choice to move some of your holdings into cash rather than paying a manager 2.5% MER to hold cash for you. Also, of course a narrowly focused equity fund may outperform when that sector does, but can you tell me which sector will outperform in the near future? Thought not. I also don't think the "drop/add" from the index has much influence - with the TSE there are 300 stocks and I imagine the great majority have been there quite a while. The whole point with index funds is that you save on all of the elements that are the investor's to control - MERs and (because of low turnover) taxes and trading costs (brokerage fees).
Buy TIPS to get exposure to the index. Then supplement your portfolio with a few situations that have appeal to you as an individual
I am probably going to get jumped on for this but here goes anyway.
Market timing and overweighing/underweighting, (i.e. strategic asset allocation for example) are two different things. Asset Allocation strategies can be divided into a number of different groups, fixed mix strategies, buy and hold strategies, dynamic asset allocation strategies, strategic asset allocation strategies, and possibly a few more. I would suggest that it is not market timing to be underweight in gold stocks at the present, nor is it market timing to begin to accumulate Asian stocks. Templeton (Sir John) is very negative about market timing, but he was not an indexer either. It would be incorrect to say that anyone who is not an indexer is a market timer as has been stated (I think) by Scooby. As for the drop/add issue I will try to dig up some documentation on that score as soon as I can. Time is in short supply just now so it may be a while.
What is the US equivalent to TIPs that would be RRSP eligible as foreign content?
Taylor. I do believe Standard & Poor's Depository Receipts are one such instrument (S&P500-derivative) and there was recently launched a DJIA-based derivative product as well. Cannot recall its name though.
BWG,
I don't recall saying that market timing and over/under weighting were the same thing, but now that I think about it that's not a bad analogy. If you move from oil to gold stocks, for example, are you not "timing" the market just as when you move between cash and shares?
With regards to Sir John Templeton, I agree he was neither an indexer nor a market timer. However, I don't think he was an "asset allocator" either. His stock picking style is the one I favour - "bottom-up" instead of "top-down". That is, search for excellent businesses no matter what industry they are in, rather than making bets on a number of companies solely because of the industry they are in (Frank Mersch?). With the latter strategy it does indeed seem to me like gambling. Of course, I think it is sometimes hard to find a manager that you are confident will not bet on a specific sector, which is why I like index funds and Templeton Growth.
I'll stick with my idea that you should index until you get $100k or so, then with all moneys from then on you should buy common stock in good solid business that are well managed, whatever the industry. If you think a company looks even stronger because of your expectations about the future of their industry, then of course this can be considered. I think this is consistent with everything I've said so far. Cheers.
And just so it's clear that I don't think indexing is perfect, there's a good new article on the Vanguard homepage entitled "Myths and Misconceptions about Indexing" at
http://www.vanguard.com/cgi-bin/NewsPrint/881351548
Sorry Scooby, I had the impression that you felt that anything that was not indexing was somehow timing. I equate timing with technical analysis as opposed to fundamental analysis. Timing tries to pinpoint entry and exit points, while the act of overweighting/underweighting is a result of the identifying (hopefully correctly) longer term fundamental factors that will affect the price of securities (i.e. value investing). Thus Templeton (for example) may overweight country/sector A, and underweight country/sector B. This action would of course be based on the judgement that A is fundamentally undervalued thus attractive and B is fundamentally overvalued and thus not attractive.
The only item that I have had time to locate re the effect of adding/dropping stocks from an index is an article in the April 7, 1997 issue of Forbes magazine. The title is 'What The Sales Brochure Didn't Tell You', page 90 to 96.
More about that latter, I have got to run now.
BWG
Scooby, thanks for the URL. This article shows that those who invest primarily in the S&P500 (and TSE300) index or large cap funds are probably going to see weaker returns than expected.
It's important to diversify.
I have been reading this thread with a great deal of interest. The idea that most managed fund’s cannot outperform an index (over the long term) is at first frightening. Why am I paying the MER ??. At first I thought this was just insane but as this thread continued I decided to do a little checking. The more comparisons I did between managed funds & index’s the more support I got for this horrible, insane & unbelievable idea that managers cannot beat the index. The last straw was a few minutes ago when I compared Templeton Growth, Trimark & the Dow for a 10 year period. - Dow won.
Go to www.Globefund & do it yourself (click on Chart Funds).
I guess I’ll be rethinking a few of my mutual fund picks.
Glad to see we've got you onside, Chris. However, I think it's important to say that the most crucial feature of any portfolio is balance.
For example, after this market run I suspect it will be highly unlikely that the DOW will produce stellar returns over the NEXT 10 years. That's why I'm willing to pay the MER on Templeton Growth - so that I'm adequately exposed to a number of different markets. S&P Index instruments are an important part of any portfolio, but if that's all someone owns they might be in for a shock.
Hi RSC, >Why is underdiversity a problem ? concentrated positions in a few quality companies may make a portfolio more volatile, but this does not equate to business risk and therefore greater risk of principle loss. For some investors diversification serves a purpose, to others it is simply a retardent to making money.<
Yes, but I have seen too many investors with only a handful of positions in their portfolio, and they think they have the market covered and are surprised to find they don't even come close to the index .....
A study we had done recently showed that if you invest in the cdn market, and say you don't want to exceed a position of more than 2% in any one position and you do not want any position to be more than 10% of a cos shares, then by the time you reach $7 Billion, you're limiting yourself to investing in about 105 stocks out of the 300 on the TSE ..... now Trimark has what (?) about $10 Billion in the Cdn market (Trimark Cdn, Trimark SELECT Cdn & Trimark RSP Equity) ..... performance here or underdiversification?
BTW, to the comment about TDGL S & P 500 - good idea for an easy-to-access US index fund (mer of 0.77%)
Warren.
Is it just me or are Index funds the "flavor of the month"? Index funds are not new, yet all a sudden(last few yrs or so, longer in the USA)people out of the blue want index funds. Ever wonder why no one wanted to hear about index funds before the 1990's? Who wanted to own the TSE or the JDIA in the 60's, 70's or 80's? ( if you invested $1000 in the DJIA in 1968 you got your money back in 1982!!! 14 YEARS) That's almost 30 yrs of keeping up with inflation. We have a 8 yr bull and for some reason people expect it to go on forever. Is that realistic? History tells us it isn't.
Time to catch up on submitting my contributions to this mega-thread, Part II...hope everyone is well-rested.
First off, if the jist of 'Efficient Market Theory' (as I understand it) is that all available market information is rationally 'factored into' stock prices immediately (thus making the attempt to take advantage of market swings to 'beat the market' a futile effort), then I'd have to say I'm a non-believer in the theory, be it for US large caps, emerging market stocks, whatever.
Why? Two reasons:
1) I believe that investor emotion, not the rational processing of available information, has the biggest effect on stock prices in the short-term. While stock prices tend to settle in at their true value over the long term, I believe that this short-term 'buying/selling on fear, emotion, greed, etc.' does present opprtunities for rational, intelligent investors to seize, thus allowing them the opportunity to outperfrom the market/index over the long term (yes, even beating the mighty S&P 500 itself).
To give an illustration of what I mean, I refer you to an article by Nelson D. Schwartz entitled "Market Shock" which appeared in the November 24, 1997 issue of FORTUNE magazine.
On the morning of Gray Monday (October 27, 1997), an S&P 500 stock by the name of Intel (you may have heard of it) was "...deemed overvalued by the market at $85 a share, and at $80, and at $75". By Tuesday morning, it had fallen as low as $69. A day after that however, it was back up to $85, and "...suddenly, that price was considered eminently fair - maybe even a bargain". So, let me get this straight: one day, investors feel that the stock wasn't even worth $75 a share (even though it already lost about 13% of it's value in approximately 24 hours). Then, within another day or two, it's considered to be a bargain at $85, with all big-time players in the market rationally and accurately interpreting all market information as soon as it's avialable all the while, be it the Asian currency crisis, future chip demand, or any other tidbit of info that catches their eye. Sorry, I just don't buy it.
2)
Though they're a rare breed, there have been individuals who have shown that they can significantly beat the market/index over the long term. You know who they are: Warren Buffett, a man whose forte is investing in solid blue chip US companies (making him an ideal candidate to test the theory of being able to beat the big-boy S&P 500 index) has demonstrated that it can be done. Also, he's been doing it for such a long time now that I don't think anyone could rationally accuse him of being 'lucky' over all those years.
Let's take a look in our own backyard as well: Michael Quinn's Bissett Canadian Equity fund has beaten the TSE 300 (total return) in 7 of the last 9 calendar years (1988-1996). Given the huge lead of 15%+ he had on the TSE 300 for the one year return ended October 31, 1997, it looks like he's going to make it 8 out of 10.
Obviously, the trick is in trying to determine which fund managers / funds will be able to outperform the index over the next 10 - 20 years...all I'm saying here is that I believe the short-term emotional roller coaster that grips rookie and veteran managers alike provides opportunities for rational-thinking, knowledgeable investors to outperform over the long term.
Well then, if I don't believe in efficient market theory, then where does indexing fit in? Well, even though I believe some mutual funds/fund managers will be able to outperfrom the index over the long term, logic suggests that the majority likely won't. To paraphrase John Bogle, in any equity market, be it US large cap, emerging markets, Euopean Small caps, etc., all investors own all of the publically-traded stocks. If someone makes money trading a stock, other player(s) somewhere in the market suffer a corresponding loss. If we consider a the given stock market index (be it the S&P 500, Russell 2000, a Morgan Stanley CI regional index, etc.) to be a reasonably accurate rtepresentative sample of that particular stock market, logic would suggest that the index, on average, will beat about half of the players in that market. Given that the index is assumed to be "MER-Free" while a given equity mutual fund has it's MER deducted before perforance figures are computed, one could expect the index to end up somewhere in the second quartile over the long-term, all other things being equal. However, we as unitholders assume that the manager managing our fund is not simply a 'typical player' in this area of equity investing, but one of the chosen few who can/will be able to outperform the market, even after one takes the MER into account. Consequently, factors such as management-style compatibility with your own investment beliefs, MERs, and other considerations should play a significant role in determining whether you choose to invest in actively-managed funds, index funds, or a combination of both. As always, the choice is yours.
Colt,
While investor emotion does seemingly contradict EMT this affliction tends to be temporary. BTW, as I recall the Intel hysteria you cite came about when they announced earnings that were a penny or two shy of market analysts' expectations. (Cheeky analysts!) This investor emotion ought to be of little concern for the long term buy-and-hold investor. There may be some fund managers who can exploit these opportunities (Frank Mersch claims to be one) but how many can do so consistently?
Another oft-cited contradiction of EMT is that often closed-end funds sell at a substantial discount to NAV. After Burton Malkiel pointed this out in an early edition of "Random Walk Down Wall Street" many US C-E funds rose in price to be closer to NAV. Still if you look in today's papers there are still many C-E funds selling at a greater than 10% discount to NAV. Go figure...
Re indexing, the relatively high MER of the typical actively-managed fund imposes an approx 2% handicap on the fund's manager compared to an index fund. Over time the performance of most funds regresses to the mean. If you look at long term (15+ years) stats you'll see a very narrow range between 1st and 4th quartile performance. Sure there will be a few ace managers who have beaten the index over the long run. The problem is to guess today who they will turn out to have been over the next 20+ years. Would you have invested your wad in Bershire Hathaway stock or Fidelity Magellan 20 years ago when Buffett and Lynch were unknown?
I've come to the conclusion that the best course of action for a long term buy-and-hold investor (e.g. me) is to make new investments in a combination of low-MER index and psuedo-index funds (e.g. TIPS, PH&N, Bissett and Vanguard.) This may be dull and boring compared to chasing the flavour-of-the-month. But I consider it to be a bonus that I no longer have to worry about monitoring fund size (Trimark Can) or manager style (hello Frank Mersch.)
BTW, I'm not selling out of any high-MER funds just yet. I don't want to have to deal with the tax hit. I also want to hedge my bets! :-)
The idea of efficient market theory meaning that the price of a security always must be rational is wrong according to contempory versions of this idea. Many of the academics who have devoted their lives to the study of markets and prices are now focusing on what is known as "behavioral finance". They are focusing on the emotional side of investor behavior in pricing stocks, recognizing perception of the future leads to "irrational exuberance" both on on the upside and downside.
Do all index funds (Canadian equity for example) have the same performance, if you don't take into account the MERs? Gracias.
Segovia: Yes they do , but likely random fractional differences based on rounding,deploying cash etc.
Colt, Bylo, Keith:
IMHO, I think your messages, taken together, describe an appropriated and balanced understanding of this issue. For my own portfolio, I have much the same mindset as Bylo described - I'll be shifting my focus from managed funds to indexes for the bulk of my investments. Although (with sufficient study) I will add a few selected individual stocks as long term holds and play with the odd foreign country fund when the time seems right (Japan anyone? How about that Friedburg Currency Fund for an Asian play?) - in tax sheltered accounts, of course.
Don't forget a manager must overcome the early payment of tax on distributions as well as the MER.
I've learned a lot from the threads on this topic. Thanks! It's still hard to accept that management usually doesn't win, but you gotta go with the facts!
Randy.
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