Last week, Advisor.ca published a debate under the heading “Faceoff: Index, friend or foe?” The arguments against passive investing should be helpful to mutual fund salespeople trying desperately to defend their turf in the face of overwhelming evidence that they are failing investors. Here’s a summary of the arguments in the article, along with some handy tips:
1. Imply that large funds are more likely to outperform
Example: “The best-performing mutual funds are usually the ones with the most AUM, a fact glossed over by promoters of the passive option.”
Start by implying that investors who choose funds with more assets under management (AUM) have a greater probability of outperformance. This won’t be easy, because your client might notice you’ve got it backwards. He might explain how funds grow in assets after they have performed well, because advisors chase performance. He might explain the concept of survivorship bias. Finally, he might ask you for data showing a correlation between fund size and future performance, which will be awkward, because there are none.
2. Explain that your fund manager is smarter than the market
Example: “Passive investing presupposes that markets reflect all relevant knowledge. Yet that’s not true. Active managers dig deeper and find things out about companies through face-to-face interviews, for example.”
Tell your client the secret to beating the market is research. Your client might point out that thousands of analysts are doing this, and that their collective judgment (the market price of the stock) is the most reliable estimate of a company’s worth. You should deny this and explain that you can learn more in a face-to-face interview with management. After all, executives are always scrupulously honest about their company’s inner workings and have no vested interest in putting a rosy spin on their situation.
3. Invoke the name of Nortel
Example: “At its peak Nortel represented 31% of the index, so if you’re pinned to the index with a passive strategy you’ve just gone over the hump on a roller coaster — start screaming.”
Yes, we know this example is 13 years old (Nortel peaked in 2000), but it still has some legs. You just need to ignore that the S&P/TSX Capped Composite Index, widely tracked by Canadian index funds and ETFs, imposes a limit of 10% on any individual holding.
4. Name a couple of random people who made one good call
Example: “Alan Radlo (now at CI Investments) and Kim Shannon (who now markets Sionna funds through Brandes Investment Partners) both predicted the Nortel collapse when the price was north of $85.”
Index investors believe every active manager is always wrong, and there are no examples of individuals who made an accurate forecast about a company or the economy. You need to be ready with compelling anecdotes like this to prove them wrong. It helps to mention Nortel again (really, it never gets old), but you can also invoke Black Monday or the 2008 crash for variety.
5. Blame ETFs for investor stupidity
Example: “Many people are buying ETFs on speculation. They’re chasing performance by playing the market, and that’s a disaster waiting to happen. If you’re buying and selling intra-day, you’re trading, not investing.”
Passive investing doesn’t work because some speculators use ETFs recklessly. If your client doesn’t understand this, try a different analogy. For example, some people get drunk and drive their Honda Civics 180 kph, eventually crashing and dying fiery deaths. Therefore, Honda Civics are dangerous.
6. Reveal a staggering ignorance about how ETFs work
Example: “As a stock rises in market cap and is adjusted, the index adjusts the weighting up or down, and the ETF follows — it’s forced to react after the active managers have made their money. This knee-jerk action pushes or pulls the market for that stock up or down after the party is over. When the fall is precipitous, the pain is greater.”
This line of reasoning will be particularly influential with clients who have absolutely no clue how an ETF works, which is a common strategy. The important fact to ignore is that cap-weighted ETFs don’t “react” to anything: if an individual stock in the index rises or falls sharply, the fund’s value will simply go up or down accordingly. There is no buying or selling unless the company is added or removed from the benchmark, so an index fund cannot “push or pull the market for that stock up or down.” Make sure you include the part about active managers having already “made their money”: it’s a nice rhetorical flourish.
7. Argue that if something is popular, it must be good
Example: “Passive investments have been around for 30 years, yet account for only 10% of the industry. Wouldn’t more people be invested in them if they were so effective?”
This is a deep insight into humanity: if only a small number of people do something, it must be because it’s bad. The popular choice is always the best, and there are many other examples. You might point out that junk food is a better choice than vegetables: after all, if broccoli is so healthy, why are people more likely to eat potato chips?
These are a blast, and sure to be used, rest assured.
My personal favs: number 6, 7, and 5.
I have heard some of these arguments, particularly “Explain that your fund manager is smarter than the market”. The situation was a big bank wealth manager who showed a table of their analyst picks since the mid 80’s and an overall outperformance by the picks of the TSX over that time period. What stood out were periods of underperformance – whatever systems they were using worked until they stopped working. If one used the list in these periods you would have lost more capital than investing in the market index. The analysts who came up with the recommendations in the initial period would be long retired, and technology would have changed how the recommendations are generated.
Using such a list also assumes:
– the advisor/investor uses all the picks on the list at all times
– that one is always invested in the items on the list and that all dividends etc… are reinvested
– the time frame must be very long for the cycles of the strategies working and not working to result in overall positive results.
Finally the list did not include the effect of fees which in a ballpark measure would have negated the outperformance because it was so meagre. Tax accounting might also dramatically change the outcome.
I would bet that there would be much cherry picking from the list as it outperforms and under performs resulting in portfolio churn, more fees and tax implications.
Index investing is simpler, cheaper and more likely to mean staying invested in risk assets such as stocks because it is simpler and cheaper.
@Andrew: Did those lists include Nortel? :)
One point I always come back to is this: there will always be several investments and several strategies that outperform over any period you looked at. What you rarely see, however, is investors who outperformed over these periods. If you’re an adviser, don’t show me a list of analyst’s great picks, or even a fund with a good track record. Show me the personal rates of return for your clients.
Brilliant! What a great retort to advisors/salespeople who try to mislead the general public about ETF’s.
One thing investors need to remember is that the more people there are separating you and your money, the more money will be sucked off by these advisors or salesmen.
Excellent points Dan. You should become a marketing advisor to the mutual fund industry to help them earn greater profits. Maybe you could charge a fee equal to 3% of AUM? After all they are sure to outperform their peers thanks to your advice and they’ll have some great stories to tell at parties along the way. If they don’t want to pay for your advice they might be left to try earning a living after the indexers have already made their money – and no one wants that!
Here’s some questions to ask any advisor that is against indexing.
1. For the investment strategy you are recommending for me, show me the performance data for the last 10 years that shows you beat the comparable index?
2. How what percentage of funds have been closed in the last 10 years with the mutual fund company(s) you are recommending? What percentage were underperforming the index when they were closed?
3. Are your interests and the mutual fund companies aligned with mine? Do you make money when I make money and do you loose money when I loose money? Do you risk something when I risk something? I.E. Are they investing a significant portion of their wealth in the same things they are recommending.
If he or she doesn’t know the answers to these questions, then your advisor is throwing darts blindfolded and playing with your money. If on the other hand they are invested in the same investments, the fund companies they are recommending haven’t closed any funds and have outperformed a comparable index then I’d keep listening. (And please tell me the name of this advisor.)
It is futile to try to convince someone whose maximization of economic interest depends on the peddling of actively managed funds that passive indexing is the more profitable strategy long-term. Either deep down inside they know you are right but won’t admit it or they simply don’t have the intellectual capacity to understand. Both are compelling reasons for them not to be managing your money.
Brian “1. For the investment strategy you are recommending for me, show me the performance data for the last 10 years that shows you beat the comparable index?”
This still doesn’t show anything relevant – the strategy needs to have been thought up 10 years ago & the strategy needs to outperform the next 10 years. Anybody today can tell you the strategies that outperformed during the last 10 years.
Garth Turner has recommended preferred shares a lot. What do you think about CPD?
@Russell: I think prefs can be a reasonable alternative to corporate bonds in a non-registered account, because of their tax-efficiency. Other than that I don’t see a role for them.
In case anyone is interested, Vanguard Canada just introduced 5 new ETF’s. A lot sooner than expected. It’s going to be some good readings today!
I think Dan must be busy writing an other excellent article about it, looking forward to it :-)
Thanks for the funny article, Dan; and thanks for the great news, David L! The new vanguard funds look awesome — exactly what I’ve been waiting for: non-hedged broad equity ETFs. It looks like Christmas came early this year :)
“For example, some people get drunk and drive their Honda Civics 180 kph, eventually crashing and dying fiery deaths. Therefore, Honda Civics are dangerous”
“You might point out that junk food is a better choice than vegetables: after all, if broccoli is so healthy, why are people more likely to eat potato chips?”
This is funny but it also reveals how analogies can be manipulative and misleading. ETFs can be used as speculative instruments therefore ETFs users are speculators. Sport is popular therefore it’s a good thing, so are nice clothing, Justin Bieber and actively managed funds.
You can compare anything you want according to your biases and if you don’t pay attention, it seems to work.
I have been reading this fine blog and the Bogle heads forums but I still don’t find your arguments convincing. First there is the false dichotomy which proposes the only alternative to couch potato investing is to stick your money in a high MER mutual fund. That’s asinine! One can manage their account actively by buying put options to protect your investments when the stock market gets too frothy. Some have a great amount of success by buying dividend payer companies when their prices look attractive.
“But the markets are really efficient”, you shout?
Should I remind you of US/Canada stocks in 1999? Or Japanese in the late eighties? Or house prices in the US in 2006? Or house prices in Canada in 2013?
Efficient markets my wrinkled a$$!
I am a DIY investor but I’m never, ever going to stick my money in a market cap based index and let it ride.
First of all, you yourself admit the failure of your and Bogle’s dogma by citing Nortel. It is one of the finest examples of how silly market cap indexing can turn. And it is hardly a single example. Just until recently AAPL was responsible for a large fraction of NASDAQ 100. Same issue befell those who trusted that index. But I digress.
My main point is that the whole Efficient Market Hypothesis is obvious nonsense. If it had any merit we would never witness financial bubbles. Yet that is something we see with a remarkable frequency. The asset types change but the human psychology never does. Trusting an index and a market cap based one at that is ridiculous. It is the straight path to the poorhouse. Not only are you prone to catch a lot bubble pops you’re also likely to sell at the worst possible time due to your own psychology or simply because life happens to you like illness or job loss or some other urgent need for a large lump of cash. The sadly ironic part is that most people will need to tap their investments due to a job loss, probably during a severe downturn in stocks which means cashing out at the worst possible time.
But hey, keep preaching to the converted and showing charts of what they would have made if only they had been able to sit patiently through the mauling bears of 2008 or 2001 or 2011 or 1998 or 1987 or… you get my point. Just don’t show them a chart of a couch potato who invested in Japan in the late eighties. No need to mess with their pretty heads and introduce any stories that lack a happy ending.
Are you a fund manager that’s losing clients? Are you worry that they will switch to ETF’s and leave you looking for a second day job? Are you worry that you’ll have to compete with RE agents to find a new job once the gravy train stops?
First, to retort. Efficient market hypothesis doesn’t mean that it can eliminate all bubbles. Market is controlled by humans, and we are not rational beings; more like emotional animals with the capacity to rationalize. If you are interested in finance, you would have at least read the definition of EMH before spreading out non sense. In case you were too lazy (or ignorant) to read up on EMH, let’s definite it. There are three forms:
Weak: the weak form of the EMH states that you can’t use past prices to predict future stock performance and that technical analysis doesn’t work. It is possible to use fundamental analysis and insider information to gain an advantage.
Semi-strong: the semi-strong form of the EMH states that you can’t use any publicly known information to invest. It is possible, though, to use inside information to gain an advantage.
Strong: the strong form of the EMH states that you can’t use public or private knowledge to gain an advantage over other investors; therefore, it’s impossible to beat the market over the long run.
Do any of these three says that EMH can eliminate bubble? I don’t think so. So your whole argument falls apart just because you aren’t even using the right definition. Stop confounding people with a definition that suits your need.
There is no dichotomy, studies have shown that index investing is the optimal strategy because it aims to take away the emotions that can cause a train wreck with your portfolio. In addition, there are tens of thousands analysts out there, crunching out numbers to determine the fair value of almost every companies listed on stock exchanges all over the world. All the analysis are combined and averaged out, forming the prices that we see in the market. By following an index investing approach, you are borrowing the brain powers of Goldman-Sachs, JP Morgan, and other big name firms. I’m not so smart, nor have the time, to do my own research, so I’ll concede to those smart people. The question you have to ask yourself is, are you smarter than all those highly paid analysts? If the answer is yes, that I congratulate you, and look forward to you becoming another Warren Buffett.
As for Nortel…there is a reason for the 10% cap for TSX. Diversification across asset classes and country is there to prevent over-weighing in a single stock, so again I have to ask, did you not read the operation manual about index investing?
Rebalancing is a fine art that’ll prevent you from selling low and buying high, because you are doing the absolute opposite of what your emotions are telling you, which is to hoard the high flyers and shunt the ones that are going nowhere. If you’re sufficiently well balanced, with stocks and bonds, you would’ve made a killing when the interest rate cratered, and with the proceeds, you would’ve bought more stocks (VTI, XIC, etc.) And now 5 years later, you’d be laughing to the bank with the S&P 500 up 170% since March of 2009.
Even yourself admitted that human emotion will wreck a portfolio, along with things such as accident or job loss. So how does buying individual stocks or index ETF’s change anything. If you’re desperate for cash, selling ETF’s or stocks is the same, there are no differences.
And again with the lack of knowledge (or is it just ignorance, I detect?), no one is suggesting that you invest only in Japan stocks, or any stocks of any one particular country. The whole point of index investing is diversification, by diversifying across country, you’ll always have something up, something down, but on average, the portfolio as a whole is up. Since none of us can tell the future, who is to say that Canadian market won’t go through the same funk as the Japanese ones? If you’re betting your entire retirement fund just on a few selected stocks on TSX or NYSE, you’d be a fool to do so.
One more thing about Nortel and bubbles. If you didn’t sell at the bottom, the loss is only on paper, but by selling, you realize the loss. If you look at the chart of TSX from 1999 to now, yes there were a few big drops, but if you have hanged on and rebalance mechanically, you would’ve sold high and bought low, and received dividends along the way.
Now the burning question, do YOU have the foresight to know when the next bubble happens? or the clairvoyance to buy the next Nortel, Blackberry, Apple or Nokia when it is cheap, and sell at the peak? Market timing is for people who are too ignorant to know their own follies. No need to mess with your pretty head and point out the flaws of your argument.
Here are a few specific responses to your assertions.
“One can manage their account actively by buying put options to protect your investments when the stock market gets too frothy.”
– Puts are not free. When markets get frothy the cost of put options goes up. Compare the performance of HUT.TO to XIU.TO to see what I mean.
“Some have a great amount of success by buying dividend payer companies when their prices look attractive.”
– Key word in this sentence is “Some”. I personally believe that dividend paying stocks are bid up right now but I won’t bet on it. Will you? Do you think you can guess this accurately today?
“I am a DIY investor but I’m never, ever going to stick my money in a market cap based index and let it ride.”
– Why not? Even if you had a portfolio of 50% TSX Index (XIU) and 50% Bond Index (XBB) and rebalanced annually, you would have made out well even through the Nortel debacle. Pick a couch potato portfolio and you would have done even better. Or maybe you’d like a Permanent Portfolio… it has consistently done well through all markets since the 1970’s.
– Second question? If not indexing, they what ARE you doing? So far you have not given a definitive, actionable plan. You mentioned a Black Swan put options strategy and that’s it… and that’s not even a complete plan… what stocks are you picking and how? Why not create a blog and document your investment plan and compare it’s performance to a Couch Potato portfolio? I’ll even wager that you cannot beat the index.
“First of all, you yourself admit the failure of your and Bogle’s dogma by citing Nortel. It is one of the finest examples of how silly market cap indexing can turn. And it is hardly a single example. Just until recently AAPL was responsible for a large fraction of NASDAQ 100.”
– This is a red herring. Fact is a 50/50 portfolio of stocks and bond indexes of either the broad Canadian market or the broad US market both did okay in the long run. You also fail to mention that Apple had huge returns from 2002 to 2012. As long as you rebalanced you did okay and better yet, you didn’t need to guess it was going to be Apple back in 2002 to still benefit.
– Also, truth be told if you only invest in one country, even indexers will tell you that’s dumb. As the saying goes, don’t put all your eggs in one basket. Best to avoid concentration risk but one can do this and still be an indexer (just see CP portfolios for examples.)
I’m not going to reply to each of you individually but here’s a one size fits all reply to all your brilliance. Make of it what you will.
First of all, I’m not a fund manager or a broker. Anyway, it is irrelevant to the argument and and ad hominem. You’re attacking the messenger as opposed to the message.
Alas, I digress. Now, back to you, “lazy portfolio” heads. I think Bogle and his ilk are leading you to get sheared one more time. And I suspect this time might be even more epic than the last few times. This bubble is built on the credit card of the sovereigns.
But hey, you have a plan for that… rebalance automatically and all will be right in this world.
The only flaw in it is the assumption that all price corrections are just temporary dips that eventually bounce back. And that’s often the case. Except for those cases when it’s not. Say your “safe” bonds which are nothing more than promises of western governments who are presently gorging on cheap debt to repay you your money at some point in the future. Often in the currency they themselves can print. It will only take a loss of confidence in those pieces fo paper by someone who matters for all hell to break loose. Hyperinflation will ensure that you will automatically and with great discipline rebalance into a black hole. Well done. Now you’re holding a tonne of paper most of which will be defaulted on or inflated away to approximately zero.
Another assumption is that you will have X decades to sit on paper losses and watch your nest egg recover 20, 30 or 40 years later. Awesome. I’ll believe that when I see it. I hope you have enough lifespan to wait it out. And enough guts. Ditto for your wife, parents who are aging, kids who want to go to school, etc.
Another way you might get snookered is counter party risk. Remember MF Global? Oh yeah, but that was those saveages in Amerika. It couldn’t happen here. We have stellar banks up here in Canuckistan. Nothing will ever topple them. Not possible, no way, no how. The Dear Leader has told us as much. Meanwhile he’s passing a law for just in case those stellar banks do topple you’ll have to chip in to help out…. Curl up your toes and sleep tight, honey.
One of you mentioned the Horizons “black swan” ETFs. Those will only work assuming the system doesn’t blow up all over the place with margin calls and your counter party honours the puts. Alas, if a whole bunch of them get margin called at once… fun times.
Someone mentioned the Permanent Portfolio which is a bit saner than the Boglehead crap but still suffers from the “rebalance into a black hole” scenario. I think that is probably the sanest portfolio if you don’t follow the silly advice of selling winners and buying losers with the proceeds.
Another one of you asked me what alternatives I suggest. I don’t have any great ones. I gave you some alternatives but none of them are bullet proof. But all of them, like buying puts for protection or buying distressed dividend payers are a whole lot better than your naive scheme. You can also try market timing. I iknow, I know, this is heresy here. The Church of Bogle will not tolerate such blasphemy. Yet, Mebane Faber and others have showed that even the crudest of market timing methods such as using the 200 day SMA as a buy/sell signals handily beat “buy and hold” on risk adjusted basis.
However, I won’t claim that they are perfect. And, just because the answer is “I don’t know” does not mean you can make stuff up and pretend that you have found some holy grail of investing nirvana. If all that was required for a 7-10% compound gain was to buy a bunch of ETFs or low cost funds everyone would be retiring as millionaires. Where are Jack Bogle’s clients’ yachts?
Mark Cuban has said this eloquently: “buy and hold is a crock of er… compost”. Most times you’re probably better off focusing on your career and keeping your money in cash and real assets that will withstand the ravages of inflation. However, if you do want to play with the Wall St sharks, at least wait until they start panicking and CNBC screams at you “Sell Everything!”.
Buy and hold, on the other hand, is just a nice way to part you from your hard earned money. Say you received a large cash inhertance yesterday. The likes of Bogle would have you plow half of it in US/EAFE stocks with the PE10 north of 24. Another half in bonds at yields of 2.5%. Splendid idea. Let’s see how this idea pans out after the “stimulating” orgy comes to a messy end (pun intended). When your bonds are down 50% and your stocks are down the same amount which way will you automatically rebalance?
If index investing is a straight path to the poorhouse, then I feel really bad for the half of all active investors (funds, individuals, institutions, or otherwise) who mathematically have to do worse than the index in spite of their goals to outperform. Doing worse than the worst must not be a pleasant experience.
Thanks for taking the time to present another side, Abraxas. I switched to index investing in early 2012 after years of holding underperforming mutual funds and I’m always looking to see counter-arguments to indexing. So far, I haven’t seen any that stand up to the mathematically sound and well-documented evidence of the virtues of index investing, so I’m going stay the course and keep telling my friends of this common-sense approach.
Abraxas, unfortunately, my takeaway from your argument is just that we’re in for a downturn and we’re all going to get financially obliterated unless we switch to some ill-defined and undocumented market timing approach. Not much I can do with that except hide under my bed. I think I’ll stick with the evidence of indexing.
Thanks for the article, Dan. I did learn a new anti-indexing argument. I’d never heard the “bigger funds outperform smaller funds” argument before. If true, that would help counter the evidence that index funds outperform a vast proportion of their counterparts since we usually see the comparisons on a fund by fund basis rather than taking into account the market capitalization of the respective funds. But again, that turns out to be just another red-herring that is unsupported by any evidence at all.
@Abraxas if the whole system collapses forever I don’t think any of us will fare any better than the others. If an entire asset class like bonds never never recover in spite of higher yields, and stocks lose 50% as you said we’ll all be slaughtered anyway (maybe gold will melt down also). But this is reasoning out of fear. I think investing in the market is always a kind of a bet. Couch potato is just an attempt to put the odds in your favour combining low fees and easy maintenance. You still have to bet on the fact that WW3 and eternal nuclear winter won’t come (well WW3 can trigger a recovery but that’s a bad joke).
One thing you’ll find interesting is that a volatile market going from 0 to -4 to -2 to -10 to -3 etc etc and back to 0 in 5 years or 10, can be profitable for an indexer who contributed regularly the same amount of money. Even if the chart gives you a market at no profit in 10 years. Buying more shares at low times and less at higher times can give you more profit than a market that slowly and steadily increased every year. So let’s say a Japanese investor stubbornly contributed during all those depressing times in a low fee index fund, he would eventually have fared better than many domestic stock pickers (some would beat him bad surely) and if our Japanese couch potato guy had diversified globally, we can expect him to have positive returns. That’s theory, I don’t even know if I could have done all I described were I Japanese because in the end it all depends on your behaviour. If you can’t believe in bonds, or in the survival of the whole system I wonder if you should invest at all because a lot of sleepless nights await you even if you put a lot of faith in your ability to dodge every market crashes.
Anyone opening claiming the markets are going to fall out and economies and banks will collapse shouldn’t be worried about investing. In that situation every strategy fails, save maybe hoarding up food, guns, and ammunition. If you have no faith in the market or economy in the future maybe you should get out of investing.
Also, where is your yacht?
“I am a DIY investor but I’m never, ever going to stick my money in a market cap based index and let it ride. ”
You said you’re a DIY investor, yet you also come across is someone who thinks the whole system will collapse…so you’re also a doomsday believer now? By believing that the whole system will crash, rendering stocks and bonds worthless, you’re saying that you don’t have any faith in the system, so why do you bother with DIY investing then? You should stock up gold bullions, bullets, toilet paper and cans of spam, and build yourself a Doomsday Castle™. By contradicting yourself, you’re diminishing the strength and credibility of your whole argument.
Name dropping people such as Mark Cuban or Mabane Faber (whoever he is) doesn’t really strengthen your points. Yes, Mr. Cuban is a billionaire, not through index investing, but by being a businessman and investing in individual stocks/companies. You can spend your whole life following his teaching and not achieve anything close to what he has achieved, that’s because you are not Mr. Cuban. If you follow the workout and training of Kobe Bryant or Michale Jordan, does that mean that you’ll be a great as them? Not likely I presume. Naming one successful individual means you’ve ignored millions of failed investors who try to beat the market, the odd is definitely stacked against any one of us, so I’d rather be index investor; it’s better to be average than be in the poorhouse, I’m smart enough to know that I don’t have what it takes to be a superstar fund manager.
@abraxis: Yikes. Seems like some somewhat disjoint arguments here. But your thesis in the last post seems to center around the idea that passive investing won’t protect one from economic calamity. And you know what, I actually agree with you. The thing is, I don’t think any other investing strategy will help much either. So the world starts to end – best case, you do something like Faber’s technique and it gets you out of the market and into cash early. So where has that gotten you? To the points above, since the global economy is collapsing, never to return, and hyperinflating away, your pile of cash is just as useless. To use CCP’s analogy above, this is like us arguing whether a Honda Civic or a Ford Focus is the better car, and my declaring that the Ford is better because the Civic won’t save you from a meteor strike. ….And the Ford will?
Anyway I suspect we will not convince you. You may be enjoying great and continued success with your investing strategy – in fact I hope you are and wish you well. That does not change the overwhelming body of evidence, both historical, mathematical and especially behavioral which suggests that the vast majority of investors will be better served by a passive strategy.
And neither will be of much use to you if a meteor hits you.
This debate will never be resolved, so I am going to ask that readers stop dragging it on. Further comments that follow this thread will be deleted. Thanks for your understanding.
@Rhys: as far as I’ve seen, most managers of large funds struggle to keep up their performance as they run out of opportunities and/or luck. Someone who tries to say that larger funds have a better chance of outperformance would have about as much basis in facts as the rest of these arguments.
Although with large index funds there is a possibility of lower fees, lower tracking error, and other efficiencies so that is usually good to see.
thanks for another stimulating post and the lively comments that followed–I’m grinning from ear to ear. At least once a week I check in to read your latest. I guess that makes me a fan.
I’ve been looking at the new Vanguard Canada ETFs . . . am I reading it right that the new FTSE Canada All Cap Index ETF (VCN) is not capped? i.e. it would be more susceptible to another Nortel (since that seem to be the topic of the day) than say BMO’s ZCN?
@nbhms: I believe you’re right that there’s no cap on the FTSE index. (That’s also true of the S&P/TSX 60, by the way.) Right now that’s a non-issue: RBC is the largest company at 6%. If one company ever did come to dominate the index, it wouldn’t happen overnight, and you could always make a decision to switch to a capped fund if it ever became a concern in the future.
I think all this worry about capped or non-capped within the Canadian market is not the biggest issue. To me the biggest concern I have with the Canadian market is the strong sector concentration in financials, energy and materials. To really diversify I believe one needs to cap their Canadian holdings and add significant holdings outside of Canada to remove sector concentration. If you look at MSCI World Index for instance, Canada is only about 5% of the global market. I think too many people in Canada invest too much in the Canadian market and are therefore exposing themselves to more sector risk than they realize.
@Brian: investing outside the country is very important as you said. I look at my investments in Canada as exposure to natural resources and the Canadian dollar. It is nice to be able to get that without having to buy gold or oil. If we didn’t live in Canada we wouldn’t invest much here.
@Richard as long as you know the bet and the risks you are taking then that is fine. The concern I have is all the people in Canada holding the TSX/S&P 60 index (or a typical Canadian Stock ETF or mutual fund that often look like the index in terms of sectors) who think they are diversified. They aren’t. In my opinion, preferential dividend tax treatment in a taxable account is the only valid reason why one might want to slightly overweight their Canadian holdings above 5% of their overall stock holdings. Otherwise, I believe everyone should look to XWD first and understand it before they look at XIU, XIC or equivalents. Based on market capitalization of XWD, XIU and the worst offender XRE … it’s clearly not the case!
@Brian and Richard. I have the same feeling when I started DIY index investing. Sure, the enhanced dividend tax credit is nice because I can pay a lot less income tax on it, but on the other hand, I have great reservation about investing only in finance, energy and material stocks.
If you go to Vanguard’s benchmark statistics, you can see that Canadian stocks are less than 5% of the world market, so it boggles my mind when my financial planner suggest that I should load up on Canadian stocks because of the dividend tax credit and currency risk.
I currently have about 20% in two Canadian ETF’s and 5% in Canadian preferred, but I’m going to slowly pare it down by buying more VTI and VXUS over the come years. I’m thinking 10% is still double than what Canadian stock market represents in the world.
Currency exchange exposure is a risk for Canadian investors. You wouldn’t want to retire at the start of a decade-long slide in the wrong direction, with only 5% of your equities in Canada (although a large bond component might help with that).
I treat that as another factor to diversify. So 1/3 of my portfolio is tied to the CAD (most of it doubles as commodity exposure too) and the other 2/3 can vary based on exchange rates. Over a long period that mix will allow me to rebalance and take advantage of swings in the exchange rate. With only 5% in Canada, you would be trying 95% of your portfolio to the CAD exchange rate so you can’t do much when that exchange rate changes.
I see currency risk is actually a great way to diversify, along with sectors and countries. Since I don’t know where I’ll retire, I don’t want everything in CAD.
@Richard @David L As long as you are deliberately choosing for your situation, I think that’s what is important.
Keeping with the theme of the article… my beef is with advisors in Canada pumping only Canadian stocks when they know how concentrated and thin the Canadian market it. Even worse, many will often will chase sectors like we’ve seen over the past few years with gold miners, high dividend stocks, covered call products, REIT’s, financials. All have or will end badly and they’ve likely never get clients out until it’s too late. Most people won’t know or understand the risk they are needlessly taking.
Frankly, I think even the simple Global Couch Potato Option 1 is more diverse than most advisor constructed portfolios in Canada.
As you can probably guess from the makeup of my model portfolios, I come down somewhere in the middle here. Clearly the all-Canadian equity portfolio is impossible to justify, yet it’s still extremely common. But I would not go so far as to recommend that Canadians hold only 5% in domestic stocks because that’s the country’s share of the global market. There are some legitimate reasons to overweight Canada:
Respectfully, I believe the legitimate reasons you give are weak and not supported by evidence except for the beneficial tax treatment. Cost can be controlled and kept low now and my belief is that holding multiple currencies is a good thing… just ask anyone you has come from a country that saw their currency get devalued (which happens more often than you might believe.) The fact is, by overweighting Canada you believe you know better than the market. That makes you an active investor and not an indexer. I worry that investors in Japan used the same reasoning to invest in their home turf just before the lost two decades.
The advisor.ca article just shows you that their are just as many amateurs “in” the industry as well there are blogging nowadays. Great summary Dan. The most disturbing thing I keep coming across is this fundamental belief that one investing method is “better” than any other. Scary. People (especially advisors) have a fundamental lack of knowledge of soooo many things and they are afraid to admit to it. I hear so many people talk about index investings but freak out when we have a dip in the market. People like the idea of low cost equaling higher returns but get frustrated when their managed solution at the bank underperforms year after year.