Index investing or “Indexing” is a passive investment strategy (also commonly known as “buy and hold”), where an investment is made in a security like an ETF that tracks a stock index such as the S&P/TSX Composite. On the other hand, an active investment strategy aims to provide investors with superior risk-adjusted returns above their benchmark index by actively researching, buying and selling individual securities.
Indexing was first made available to U.S. investors in 1976, and since then has seen incredible growth. These days, portfolio managers highlight several advantages Indexing has over active management, helping explain the strategy’s appeal.
Lower Costs
A passive index strategy trades stocks less frequently and is not required to employ the various professional’s necessary to generate stock-picking ideas. Less trading and fewer salaries leads to lower fund expenses.
A popular way to represent the fee to operate and manage a fund is the Management Expense Ratio (MER), which appears in percentage form and is charged annually. A study released in 2015 by Morningstar Canada1 calculated the average MER for Domestic Core Equity in Commission-Based accounts to be 2.1%. Comparatively, the current MER for the S&P/TSX Composite Index ETF managed by iShares Canada is 0.08%.
Performance
Over the long-term, actively managed funds have a tough time outperforming their benchmark. The principle reasons being the higher fees they charge, portfolio manager turnover and the human emotions of investing. The following graph illustrates this point very well, showing the % of actively managed funds in four categories that under-performed their benchmarks over a 10-Year time period.
Diversification
The S&P/TSX Composite Index contained 250 separate companies as of October 31st, 2017. So, an investment in a security that tracks this index, will grant broad diversification into a similar number of companies.
An active manager who is trying to outperform the S&P/TSX will tend to hold significantly less securities in their portfolios so that, if they are successful in picking the “right” securities, the impact on the fund they manage is more pronounced. LINK looked at the ten largest actively managed Canadian equity funds during Q42017 and found they held an average of 85 companies2.
Buying a larger number of companies in an Equity investment such as an Index-tracking ETF does not protect you from broad-market declines. It can, however, reduce what is called “single company risk”, a risk that a specific company declines due to events affecting only that company.
Simplicity
Index funds are for the most part “what you see is what you get”. So, if you own a security that tracks the S&P/TSX Composite Index chances are you know your investment is very close to 100% invested in Canadian Equities.
On the contrary, while actively managed Canadian Equity funds invest a majority of their assets in Canadian Equities, they have the ability to invest outside of Canada as well. Many investors don’t realize that a Canadian Equity fund may have 10-20% of that fund invested elsewhere.
Indexing has become an undeniable force in the investment world. Consider: In the United States alone, USD 1.4 trillion (CAD 1.7 trillion) in net new cash flow and reinvested dividends went into domestic equity index funds and ETFs from 2006 to 2016, which is astonishing when compared with the USD 1.1 trillion (CAD 1.4 trillion) that came out of domestic equity active funds in the same period3.
Notes on risk: All investing is subject to risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or protect against losses in a declining market. There is no guarantee that any given asset allocation or mix of securities will meet your investment objectives or provide you with a given level of income.
1. Morningstar Canada, 2015. What Canadians Pay for Mutual Funds: Part 2: http://cawidgets.morningstar.ca/ArticleTemplate/ArticleGL.aspx?culture=en-CA&id=685965
2. Data provided by Morningstar Canada. Fund companies report their portfolio holdings at various times, the funds being analyzed have portfolio reporting dates between June 28th, 2017 and October 31st, 2017.
3. The truth behind indexing, Vanguard Investments Canada https://www.vanguardcanada.ca/individual/articles/education-commentary/indexing/truth-behind-indexing.htm
