Is the S&P 500 a passive index or an actively managed mutual fund?

I uncovered and interesting article, “The S&P 500 is a mutual fund – and a bad one,” written in 2002. As someone who has considered buying shares of SPY to make up the major part of his US portfolio, this article, claiming that the S&P 500 is a bad mutual fund was a must read. In it, Jon D. Markman says:

“Unlike most index publishers, such as the Nasdaq and Dow Jones, Standard & Poor’s adds and subtracts stocks from its three broad indexes — the largecap 500, the Midcap 400 ($MID.X) and the Smallcap 600 ($SML.X) frequently in accordance with a largely subjective list of criteria that includes market capitalization, liquidity and their representation of industrial sectors.” [emphasis mine]

The S&P 500 is supposed to be representative of “the market” (not the US economy which consists of 306 privately-owned US companies with revenues of at least $1 billion) and one of the ways they do this, is by matching the sector allocation of the entire US stock market (small-caps and all, almost 10,000 stocks as of 2005) to the index. In 2000, according to Mr. Markman, the S&P had a 14% weighting in technology stocks by market capitalization whereas the entire U.S. market had a weighting of 18% in technology stocks by market cap. The people at S&P proceeded to add the tech stocks with the next-largest market caps to its index, removing stocks in industries that had now become “over-weighted” compared to the entire US market sector allocations. Many of these technology-related stocks were at their peaks in 2000, and extremely over-valued. The S&P then held on to these stocks as they plummeted and lost sometimes greater than 80% of their peak values.

In their quest for ultimate sector diversification, they have performed one of the most banal rebalancing operations I have ever seen: buying tech stocks based on high momentum and high valuation. Standard portfolio rebalancing operations would normally involve selling stocks which have recently advanced to such a large degree so as to have overweight positions, compared to their original weightings. The tech stocks which were already in the S&P500 index had advanced significantly and the S&P500 was overweight in these positions compared to a few years ago, and probably should have sold off some shares in the technology sector; however, the broader market (including the large number of high tech companies barely post-IPO and with no earnings) just happened to have advanced even more (to make up 18% of the market vs. 14% for the S&P500), thereby triggering a technology stock buying spree for the S&P500 index managers.

This would be enough to put any holder of SPY in an uproar. Especially if SPY was a mutual fund with a mutual fund manager. Only the SPY (or S&P500 Composite) is in fact NOT a mutual fund, as the title of the above article claims, it is just an index. It was designed to be some representative figure of the value (as currently being traded) of the US stock market. This article, although it is misguided in laying blame on the people at S&P, highlights some key downsides of indexes, especially the ones based on market value, and sector allocation. There are also many other silly things which go into factoring how much of each stock is held, such as liquidity and available float. You get what you pay for I guess. ETFs which follow the major indexes are popular because of their low fees and the ability to beat the returns of a significant number of equity mutual funds. But the indexes are not mutual funds, and they are not supposed to be smart. They follow a passive strategy and stick to it.

There are other indexes out there which do not follow this type of methodology. Two of which I know of are the S&P Equal Weight Index (replicated by the Rydex S&P Equal Weight ETF), and also the Dow Jones Canada TopCap Value Index (replicated by TD Select Canadian Value Index Fund ETF). From Rydex’s website,

Equal weighting also offers increased diversification as compared to its cap-weighted counterpart. The composition of the securities of the S&P 500 Index combined with quarterly rebalancing avoids over concentration in popular (or momentum) sectors, such as the domination of the Information Technology sector that occurred in the S&P 500 in 1999 – 2000.

The S&P Equal Weight Index is just another alternative, and a good one if you want to avoid what happened to the S&500 in 1999-2000. I would not be surprised if the S&P Equal Weight Index was born out what happened in the late 1990s bull market, in the same way that the S&P TSX 60 capped index was created after Nortel became a huge percentage of the TSX 60 index during that same period.

See also: “The Hidden Risks of Index Investing” which I found out about from this article on the Investing Guide blog.

This article was first published on October 31, 2005

DRIPs for iUnits ETFs

As a follow-up to my previous post where I quoted a site that said ETF distributions could only be paid out in cash, I just found out from a comment on the canadiancapitalist.com that it is possible to have distributions from iUnits ETFs re-invested through a DRIP:

Dividend reinvestment plans let you take advantage of the power of compounding. Instead of receiving cash dividends from the company, you may purchase more of a company’s stock by having the dividends reinvested. Your brokerage firm may offer a dividend reinvestment plan that allows for the reinvestment of cash distributions on iUnits. Cash distributions, in the form of income, return of capital or dividends could then be reinvested in additional units of the same fund. You should check with your brokerage firm to see whether you will be charged for this service.

iUnits (Barclays) lists four companies which offer DRIPs for iUnits, three of which are Canadian big-bank brokerage affiliates. The one that wasn’t, Canadian ShareOwner Investments Inc. states “to enjoy complete dividend reinvestment and the lowest trading commissions in Canada, your iUnits need to be in an account at ShareOwner.”

The iUnits.com website goes on to say that “as demand increases, more firms will likely have DRIPS available on iUnits.”

I still can not see a huge advantage to DRIPs, except that using them would reduce the cash-drag in an investor’s account ever so slightly. I recently talked to my advisor about cash distributions the ETF I will be buying soon and our plan will be just to roll the cash into my regular monthly purchases within my RRSP.

ETFs vs. Index Mutual Funds

I found an informative Comparison of ETFs and Index Mutual Funds. It has some great information about the internals of ETFs and how they compare to index mutual funds. Notably, that “overall, there are few pros and many cons to using ETFs.” This came as a bit of a surprise to me. Much of what the article says is true, although told in a way that is biased towards index mutual funds. Some of the information is out of date such as: “ETFs have poor coverage of foreign style/size indexes. If you wanted to buy a foreign value ETF, for example, you would not be able to do so at present” and “there are few bond ETF options available at present.” I think these two points are no longer true.

One big difference between ETFs and mutual funds is that “they [ETFs] pay out distributions as cash. If you want to then reinvest that cash, you need to take some action to do so (and incur whatever transaction costs apply).” Although I initially found this annoying, it is really no big deal because the distributions can easily be re-invested into no-load mutual funds on a monthly basis along with other cash. Since you SHOULD be dollar-cost averaging on at least a monthly basis this should not be a problem for most people.

With many low-MER index mutual funds out there (and I expect to see even more, with possibly even lower MERs), the low-MER advantage of ETF is not a huge deal. I still think that the best option is to buy index mutual funds (with as low an MER as possible) on a monthly basis and switch them into index ETFs when the cost of making the ETF purchase (from commissions) becomes a small percentage of the total amount to be invested.

iUnits conversions approved

The iUnits unitholders of the ETFs (Exchange-traded funds) XIC, XGV, XSP, and XIN have approved changes to the underlying investment objectives (ie. they have changed the underlying index being tracked by these ETFs).

  • The new investment objectives of XIC and XGV are to replicate the S&P/TSX Capped Composite Index and the Scotia Capital Short Term Bond Index, respectively. The Funds’ new names are the “iUnits Composite Cdn Eq Capped Index Fund” and the “iUnits Short Bond Index Fund,” respectively. As of November 16, 2005, the ticker symbol for the iUnits Short Bond Index Fund will change to “XSB” on the Toronto Stock Exchange.
  • The new investment objectives of XSP and XIN are to replicate the S&P 500 Hedged to Canadian Dollars Index and the MSCI EAFE 100% Hedged to CAD Dollars Index, respectively. These are the same indexes these funds previously replicated, except the currency exposure is now hedged to reduce the risk of exchange rate fluctuations affecting the returns of XSP and XIN.

Information regarding the increase in the MER (Management Expense Ratio) for XIC is curiously absent from this press release. Not only that, but links to the original press release announcing the unitholders meeting (which mentioned the commission increase) and the information circular outlining the changes to the iUnits ETFs are now absent from the iUnits home page.

Owning Too Many Mutual Funds a Bad Idea

I used to own many mutual funds in my account at TD Canada Trust. A glance at an old statement shows that at one time, I owned the following funds in the Canadian portion of my portfolio:

TD Canadian Equity Fund
TD Canadian Index Fund
TD Dividend Growth Fund
TD Blue Chip Equity Fund
TD Canadian Small Cap Equity

What is wrong with being invested in so many funds at once? The problem is that with 4 funds, primarily large-cap funds, I was over-diversifying and basically forming an index for myself. I was owning the entire market, which is what indexes do anyways, and diluting the active management within each of the funds. But I was not paying what I should have been paying for an index (MER <= 0.25%). These funds have MERs of at least 2%, except for the index fund. So basically I was buying the equivalent of an index, but paying through the nose for it. The effect of a high MER eating into your returns every year can be huge. Don't make the same mistake I made. Get an index for the large-caps, and no more than one other large cap fund. Perhaps owning an actively-managed small-cap fund as well. If I had to do it again at TD, I would have bought TD Canadian Index Fund and TD Canadian Small Cap Equity. The other large-cap funds (TD Canadian Equity, TD Canadian Dividend, and TD Blue Chip Equity) are not significantly better than the indexes themselves, so I would rather take the low-cost index fund. The small-cap fund gives me some exposure to smaller companies which are not owned by the index.

Selling ETFs to buy index funds a bad idea

A friend recently asked me:

I’m just about to switch my ETF‘s to mutual index funds so I can contribute monthly without the transaction fees associated with ETF’s. I found a few funds from Altamira that have MER fees of 0.54. That seems pretty good to me…not quite as good as the 0.17% that you get for the iShares S&P TSX 60 ETF’s, but I think the ability to automatically contribute monthly makes up for the additional 0.36% in MER fees.

They wanted my opinion on this before they went ahead and did it. My reply was:

I wouldn’t switch if I were you because you’ll pay commission on the sale. If you are already invested in an ETF I would just hold it and let it grow. . . Definitely if you want to contribute monthly you should put your money into a mutual fund. Obviously no one would recommend buying ETFs monthly with the kind of monthly amounts you’re probably putting in, so really you have no choice. Just don’t sell the ETFs you already own.

The only reason I could see for you wanting to sell your ETF is if the mutual funds you are interested in required some sort of initial minimum. That would have surprised me though, because all of TD‘s funds for example, only require a minimum RSP investment of $100, and minimum subsequent investment of $100.

Basically if you are putting in small amounts per month, use mutual funds, that’s what they are for, if you have large amounts, get stocks or ETF indexes. When the amounts in mutual funds are large enough, it might make sense to transfer them into an ETF. But it’s up to the individual, especially if the difference in MER is so small, you might as well just leave it in mutual funds.

The MER on those mutual funds are really low which is great, so I would say buy them every month, but just don’t sell the ETFs you already own.