Not All Indexes Are Created Equal

In yesterday’s post I looked at the recently launched BMO Equal Weight REITs Index ETF (ZRE), which invests in Canadian real estate investment trusts. The new ETF is going head-to-head with the  iShares S&P/TSX Capped REIT Index Fund (XRE), which until now had no competition in this space. The big difference between the two funds is that ZRE is equal-weighted, while XRE uses traditional cap-weighting. So, which strategy is superior?

There’s no question that cap-weighted indexes have a flaw: because they are heavily influenced by each stock’s current share price, they give greater weight to overvalued companies and less to undervalued ones. That makes them prone to bubbles: for example, when the price of Internet stocks rose to absurd heights in the 1990s, technology companies dominated the S&P 500, even though some of these had never actually made any money. Meanwhile, fundamentally sound but undervalued companies made up a smaller and smaller portion of the index. We all know what happened next.

In recent years, a number of index providers have looked for ways to avoid this Achilles heel of cap-weighting. Perhaps the best-known “price-neutral” strategy is fundamental weighting, which is based on a company’s dividends, free cash flow, total sales and book value. This is the strategy Claymore uses in its most popular equity ETFs.

Another alternative strategy is equal weighting, or assigning the same fixed allocation to every stock in the index. A number of BMO’s new ETFs use this strategy, including ZRE, which includes 17 real estate investment trusts, each of which makes up about 6% of the fund’s holdings. In contrast, the cap-weighted iShares fund assigns 25% to its largest holding (RioCan) and less than 4% to its smallest.

Many commentators seem to take it for granted that XRE’s top-heavy index is a problem. But my first reaction is that we don’t apply that logic to other indexes. If you buy a cap-weighted Canadian equity index fund, you’re investing 30% of your money in the financial sector and just 3% in consumer staples. A European index fund has about 32% of its holdings in the United Kingdom and 2% in Finland. That simply reflects the economic reality, and few people would argue that we should weight sectors or countries equally.

By the same logic, if RioCan represents 25% of the REIT economy in Canada, why should it not represent a similar amount of the index? RioCan’s market cap is almost $4.8 billion, compared with Artis REIT’s $480 million. Why is it a sound strategy to invest equal amounts in both companies (as BMO’s REIT fund does) when one is ten times larger?

In some ways, criticizing an index for overweighting large companies is like suggesting that Canadian democracy is problematic because Ontario’s voters have more influence than Prince Edward Island’s. In fact, I’d make the opposite argument: by giving all the premiers an “equal weighted” position at First Ministers’ conferences, the 140,000 residents of PEI have a representation that is way out of proportion. This kind of distortion occurs in the Rydex S&P Equal Weight ETF (RSP), which holds all the companies in the S&P 500 and assigns each one a weight of 0.2%. In this index, Exxon Mobil has the same influence as Office Depot, even though the former is a hundred times larger.

If traditional indexes give too much weight to large or overvalued companies, equal-weight indexes are biased toward small-cap stocks, sometimes dramatically. They also overweight sectors that are made up of many small companies (like consumer discretionary) and underweight those dominated by a few large players (like utilities and energy). If you believe in efficient markets — and if you don’t, you’re not an index investor — then equal weighting is hard to justify as an investment strategy.

There are practical considerations that work against equal weighting, too, at least in theory. Daily price changes constantly cause the stocks in the index to deviate from their target weights. That can mean either large tracking errors or frequent rebalancing, leading to higher expenses and capital gains taxes.

When equal weighting makes sense

Despite its flaws, I don’t think the equal weighting strategy is nearly as problematic in ZRE as it is in more broadly based funds. First, an index fund dominated by one or two sectors, or by one or two countries, is not as vulnerable as a fund dominated by a single company. Barring Armageddon, an entire sector or country can’t go to zero. But a company sure can. Nortel once made up more than 30% of the S&P/TSX Composite and is now a penny stock—that’s the reason the iShares S&P/TSX Capped Composite Index Fund (XIC) no longer allows any stock to make up more than 10% of the index. If RioCan were to implode, holders of XRE would be dramatically affected, while investors in ZRE would have much more protection.

Second, there’s a big difference between a fund with 11 stocks (like XRE) and one with 500. The academic literature suggests that a portfolio needs to contain at least 30 names or so before company-specific risk is minimized. I don’t think equal weighting makes sense for the S&P 500, where no single company represents more than 3% by cap weight. But when an index has fewer than a dozen stocks and one of them is hugely dominant, that’s a different story.

The potentially higher cost of equal weighting isn’t likely to be a problem for BMO’s REIT fund either. According to its prospectus, ZRE will be rebalanced just twice a year, and with 17 stocks, that’s not going to be expensive. Its management fee (0.55%) is also the same as its iShares competitor. By contrast, Rydex charges 0.40% for RSP, about four times more than cap-weighted S&P 500 ETFs.

So, what’s my verdict on ZRE? I’m warming up to it. While I am always suspicious of new products that claim to improve on cap-weighting (most have more to do with marketing than sound investment principles), I think equal weighting may well be a superior way to invest in a sector with a small number of companies. I haven’t switched from XRE yet, but I may do so the next time I rebalance my portfolio.

[Congratulations to reader Len, who won the draw for a copy of Keith Matthews’ book, The Empowered Investor. Thanks to everyone who commented on last week’s series of posts, and to Keith for donating the book.]

11 Responses to Not All Indexes Are Created Equal

  1. Sean June 18, 2010 at 11:45 am #

    You seem pretty upbeat about the ZRE. I suppose you are looking for the pyramid effect because you own some? Actually the BMO fund has a higher MER than the iShares. No, they are not the same, read the prospectus. When choosing a new investment, it should meet 2 criteria:

    1) Dirvesification – most people already own or have equity in their home (probably their largest purchase). Thus, RE fails this test.
    2) Increase returns – except for the last year, XRE has done horrendously poorly. In fact, you have just been getting your own money back. So, RE fails again. Many REITs have payout ratios higher than their earnings and their individual management expenses are difficult to pin down.

    So, there! Just my piece!

  2. Sean June 18, 2010 at 11:50 am #

    Just one more addition to my comments above. The prices of the two ETFs is artificially high by what I call income trust refugees.

  3. Canadian Couch Potato June 18, 2010 at 12:04 pm #

    Sean: I think I was pretty clear that I own XRE. In any case, I don’t imagine my blog posts are very effective at moving the prices of billion-dollar funds.

    ZRE’s management fee is 0.55% and its total MER will be several basis points higher because of HST and some incidentals. We won’t know the true fee until the fund reports on it next year. I’m aware that management fees and MERs are not the same. I deal with this issue here.

    XRE’s management fee is also 0.55%. iShares used to list the total MER (including GST) on their website, but it recently announced that it will no longer be absorbing GST/HST, so its overall MERs will be going up in July. In the end, there may be a few basis points difference in the fees between the two ETFs, but it will likely be trivial.

    Most investment analysts disagree with the idea that owning a home is comparable to investing in REITs. That’s like saying you shouldn’t invest in stocks if you own your own business.

    According to XRE’s fact sheet, the fund has had an annualized return of 10.08% since its inception in 2002, including distributions.

  4. andrew June 18, 2010 at 4:57 pm #

    The complaint about XRE being a poorly diversified ETF is longstanding. My approach in the end was to buy three of the largest REIT components directly for the REIT portion of my portfolio. Why pay any management fee at all if you can get almost the same thing without any MER cost? Of course this approach assumes you can make relatively large (say >$5000) individual purchases to minimize the trading cost.

  5. Gaby June 18, 2010 at 5:13 pm #

    One more plus on equal weighting – if an entire index goes up, it’s possible the smaller caps will grow more. With rebalancing, won’t those gains be locked in before the inevitable drop where, once again, the smaller caps will lead the way typically with larger losses.

    I’d probably split the difference, and average out the market and equal weighted indexes together (e.g. Riocan would now be the average of 25% for price weighted and 6% equal, so about 15.5%)

  6. Think Dividends June 18, 2010 at 11:05 pm #

    If you buy Canadian REIT (retail, office, industrial) and Boardwalk REIT (apartments) you cover all the major real estate asset classes.

  7. Financial Cents June 20, 2010 at 7:59 pm #

    @Sean and Think Dividends – I’m with you. XRE is somewhat poorly diversified. So far, I’ve got REI.UN and HR.UN in my registered accounts.
    I may yet buy Boardwalk or Extendicare and that will be my three holds for this sector. The key here (REITs vs. RE ETFs), like others have said, you probably need a decent amount of cash (a few thousand) to make the purchase transaction worth your while.

    Do you guys keep your REITs in registered or unregisterd accounts?

  8. Dong September 13, 2010 at 5:27 pm #

    I am looking for a REIT ETF to put in my TFSA and i didn’t see the point of paying 0.55% MER for the XRE ETF… BMO ZRE might just be what i was looking for :)

  9. Dean H. November 4, 2011 at 7:13 pm #

    @Sean: “Many REITs have payout ratios higher than their earnings and their individual management expenses are difficult to pin down.”

    As soon as you start evaluating REIT’s like “normal” dividend paying equities, you’re in trouble. Because their assets (the properties) have such a long life span, depreciation write downs are not comparable to other businesses. Its more about cash flow with REITs. You probably don’t like utilities either because they also have high payout ratios, albeit for different reasons. Payout ratios need to be compared with companies in the same industry, rather than taken as an absolute number.

    “individual management expenses are difficult to pin down.”

    I’m not sure I’d agree with that statement. At any rate, barring a few notable smaller REITs in Canada, I don’t think management expense is a real issue. I’d be more concerned about the quality of the management you’re paying for and whether or not their interests are aligned with yours (ie. How large a position does management hold in the REIT).

    The real question regarding Canadian REITs in my opinion is not XRE vs. ZRE, but rather one vs. a basket of two or three individual stocks which will capture 80% of the market cap for the group. My inclination is to buy something like RioCan, Calloway, and Boardwalk and be done with it. But now we’re assuming company-specific risk. Choices choices…

  10. Jas April 6, 2013 at 9:12 am #

    @CCP:
    I’m curious to know what do you think of Horizon’s Canadian equity Equal Weight 60 ETF. One argument of active investors against passive investors (many financial advisors!) is the Canada’s index funds are not diversified enough…

    Horizon’s HEW seems like a good solution?

    http://www.horizonsetfs.com/pub/en/etfs/?etf=HEW&tab=overview
    http://www.hapetfs.com/pdfs/press_releases/201007_Equal_Weight_Launch.pdf

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