Why Not All Index Funds Are Created Equal | Common Sense Investing

Why Not All Index Funds Are Created Equal | Common Sense Investing


I talk a lot about index funds in this video series. I have told you that low-cost index funds
are the most sensible way to invest, and that you should do everything that you can to avoid
the typical high-fee mutual funds that most Canadians invest in. Great, well that’s easy then. Buy index funds. Where do I sign up? Unfortunately the financial industry does
not like making things easy for investors. With the increasing popularity of index funds,
index creation has become big business. There are sector index funds, smart beta index
funds, equal weighted index funds, and many other things, making it that much more challenging
for investors to make sensible investment decisions. I’m Ben Felix, Associate Portfolio Manager
at PWL Capital. In this episode of Common Sense Investing,
I’m going to tell you why not all index funds are good investments. Let’s start with the basics. An index is a grouping of stocks or bonds
that has been designed to represent some part of the stock or bond market. Most of the indexes that you hear about day
to day are market capitalization weighted. The S&P 500, an index representing the US
market is a cap weighted index. This just means that the weights of the stocks
included in the index reflect their relative size. A larger company, like Apple, holds more weight
in the S&P 500 than a smaller compay, like Under Armour. You can buy a fund that just
buys the stocks in the index. When the index changes, the
holdings in the fund change. This all sounds great so far. Low-cost index investing is what it’s all about. One problem for investors is that big
name indexes like the S&P 500 only track large cap stocks. Historically, large cap stocks have had lower
returns than small cap and mid cap stocks, so excluding those types of stocks from
your portfolio could be detrimental. The Center for Research in Security Prices,
or CRSP, is another index provider. The CRSP 1 – 10 index is a market cap weighted
index covering the total US market. While the S&P 500 offers exposure to 500 stocks
covering about 80% of the value of the US market, the CRSP 1 – 10 offers exposure to over 3,500
stocks, covering the vast majority of the value of the US market, including the smaller
stocks missed by the S&P 500. An index fund tracking the CRSP 1-10
is what you would call a cap weighted total market index fund. This is the building block for an excellent portfolio. There are total market indexes, and index
funds that track them, available for Canadian, US, International, and Emerging market stocks. The MSCI All Country World Index is.. What it sounds like. A total market index covering the whole world. An ETF tracking this index can be found in
the Canadian Couch Potato ETF model portfolios. Total market index funds are well-diversified
and extremely low-cost to own. That is exactly what you want as an investor. The Canadian Couch Potato ETF model portfolios,
which are globally diversified total market index fund portfolios, have a weighted average
MER of around 0.15%. That is exactly why fund companies have had
to come up with other index products to try and sell you. They need a reason to make you pay higher fees. One way that fund companies have been able
to increase the fees on their index funds is by focusing on indexes that track specific sectors. The Horizons MARIJUANA LIFE SCIENCES INDEX
ETF captures a sector that many people are interested in right now. It has an MER of 0.75%. There is no rational reason to buy this ETF
other than to speculate on a hot sector, but Horizons is cashing in. Another buzz word that fund companies have
been using to charge higher fees on index funds is smart beta. Smart beta funds attempt to find characteristics
of stocks that seem to have explained higher returns in the past. Some of these factors are extremely well-researched. A 1992 paper by Eugene Fama and Kenneth French,
“The Cross-Section of Expected Stock Returns,” pulled together past research to present the
idea that a large portion of stock returns could be explained by company size and relative
price. In 1997, Mark Carhart, in his study “On
Persistence in Mutual Fund Performance,” added to the Fama/French research to show
that momentum further explains stock returns. Finally, in 2012, Robert Novy-Marx’s June
2012 paper, “The Other Side of Value: The Gross Profitability Premium,” showed that
profitability further explains stocks returns. Together, those characteristics are responsible
for the majority of stock returns, so owning more stocks with those characteristics in
your portfolio might be a good idea. Fund companies have tried to build products
around this research, but the execution has not always been great. In a 2016 blog post, my PWL colleague Justin
Bender analyzed the iShares Mutifactor ETFs, ETFs tracking indexes that target some of
the well-researched factors. Justin found that they did not deliver on
their promise of factor exposure – disappointing considering their relatively high cost compared
to a total market ETF. There are other fund companies, like Dimensional
Fund Advisors, with a long history of capturing the well-researched factors. I recommend products from Dimensional
Fund Advisors in the portfolios that I oversee. I keep saying well-researched factors because
there are companies building indexes based on factors that are not as well-researched. They may be based on bad research, bad data,
or data mining. In their 2014 paper, “Long Term Capital
Budgeting,” authors Yaron Levi and Ivo Welch examined 600 factors from both the academic
and practitioner literature. Not all of these factors would be expected
to give you a better investment outcome, but they do give fund companies a reason to
charge you a higher fee. For most investors, a portfolio of market
cap weighted total market index funds is all that you need. Many of the other index fund products out
there claiming to track some special index are gimmicks designed to convince
you to pay an extra fee. Thanks for watching. My name is Ben Felix of PWL Capital and this
is Common Sense Investing. I’ll be talking about a lot more common
sense investing topics in this series, so subscribe, and click the bell for updates. I’d also love to read your thoughts and
questions about this video in the comments.

36 comments

  1. Your videos are so helpful. Thanks Ben. Is it true that US small value stoxks/indexes have underperfomed the s&p in 2017?

  2. That video has so much value. My retirement thanks you Ben. Great Job mate. I look forward to your next installment!

  3. Great video. Great info. Could you change your intro music tho lol. Keep up the great work. Really appreciate it.

  4. Hey Ben, in your opinion are all iShares etf’s no good?
    For example:
    IShares Core S&P/TSX Capped Composite Index XIC

    Or

    iShares Core MSCI Emerging Markets
    IEMG

    Would these cover a wide enough share of the total markets?

    P.s. I just found your channel and I really enjoy your vids. Keep up the great work!

  5. Hi Ben, I am a young man, 22, just graduating from trades school, I currently have a TFSA in mutual funds through a local scotiabank which has an MER of 1.5%.(I invest 100$ per month since I was 18) I would like to move my investment into Index funds and pay lower MERs. How do i go about this? My main reason for having a TFSA is for retirement as I likely will not have a pension through work. http://www.scotiabank.com/funds/profiles/FP76270_74_ENG.pdf That is a link to the mutual fund I am currently investing in, what do you think? Could I be doing better?

  6. Great video Ben! I’m curious about the optimal mix of a US stock index fund vs. an international stock index fund when index investing. Specifically:

    Should you have equal allocations of the two in your portfolio? Or should I have more US stock fund than international stock fund?

    The Canadian Couch Potato site – and many others – say you should have equal allocations of US, Canadian, and international stock index funds. Eg. 20%, 20%, and 20% for the balanced portfolio. But I’ve read that John Boggle himself recommends no allocation (i.e. 0%) to an international stock index fund. Eg.
    https://www.cnbc.com/2017/10/17/vanguards-jack-bogle-eases-a-little-off-a-big-stock-market-bias.html

    Also, the balanced portfolio on Vanguard Canada’s site has a slightly higher allocation for US stocks (23%) than it does for international stocks (18%). Who’s right? Is there any definitive research that settles this debate by comparing the relative historical performances of each approach over a long period of time? Thanks!

  7. This video was worth my time, unlike most youtube videos which doesn't give me any useful information or anything at all that can be applied in real life.

  8. As a beginner to the topic, I've gone through a lot of your videos, when I returned to this video to rewatch it a second time I understood it a lot better. I wanna thank you for sharing your knowledge. The formats of your videos and the animations and text prompts are phenomenal. After searching endlessly for resources to learn, you've provided me with more than what I need. Look forward to learning more from you. Thank you brother!

  9. great video thank you. is there a difference between voo and vfv s&p 500 which of the two is better to invest?

  10. is it better to invest in index fund or its better if you just copy the company list in the index fund and invest on each of the companies?

  11. Hey Ben. Vanguard has a total international etf with epense ratio 0.11% and Schwab has theirs at 0.06%. even though it's a small difference, does it make to choose Schwab only because of the lower fee?

  12. What do you think of this portfolio? I’m new to investing and felt safer buying into U.S hedged CAD ETFs then buying U.S individual stocks as a Canadian.
    – Nasdaq 100 ZQQ hedged
    – XSP S&P 500
    – Zud BMO US dividend
    – TD bank individual stock
    – Organigram holdings (speculative buy, seems the best valued stock in that category, time will tell).

  13. after watching your videos for a while now Ben ive decided to adopt the canadian couch potato model ETF portfolios. ive been shifting my money into the balanced model over the last few months. Heres hoping for long term success keep these great videos coming!

  14. Hi ben i would like to get your opinion on sp 500 index hedge on the cad dollar and unhedge is there one that is better than the other…and second question in term of allocation i see that 1/3 canada us international would make sense but for canada and international what would be example of total market etf for both of them i know you cant provide investment advise it would just give me a starting point to compare with vanguard ishare bmo etc thank in advance

  15. Regarding Horizons Marijuana ETF, did you factor in their dividend which they generate by lending shares to short sellers? I've been very impressed that the fund has generated this additional income which is far greater than their fees.

  16. Wouldn't an equal weighted index make more sense than a cap weighted index? It would equally spread the risk over all of those stocks and also smaller stocks are a factor for better outcome right? Unfortunately there are way more cap weighted indices

  17. While at university, I studied mathematics and electrical engineering. We had a finance requirement for engineers, which focused on how to budget and estimate costs for projects and such. As part of that we had to do a lot of standard financing (FV, ROI, etc). I never did well remembering the formulas because I would derive them as I needed them (to the protest of the professor). I say this, because I would love for you to do a video deriving some of the mathematics around some of the claims you are quoting from papers (Nobel Laureates, market "experts", etc).

    We all know economics can have some pretty heavy math. Let's see it. 🙂

  18. Hi Ben,
    can you explain why VUN and XUU have different dividend payout when they both tracking the same index? I know they are own by different company but I am scratching my head because the payout ratio gap is too wide. Which index would you pick out of these two?
    Thanks

  19. Hey Ben, thanks for another great video!

    What do you think about index funds offered by Fidelity? Currently most of the index funds that I own are as follows;

    FXAIX – Fidelity 500 Index fund (Majority of my Portfolio, although now I am buying less and focusing on the following)
    FSSNX – Fidelity Small Cap Index Fund
    FZROX – Fidelity Zero Total Market Index
    FKMCX – Fidelity Mid Cap Stock K

    I am a little uncomfortable with the fact that all of my investments are through Fidelity but once I have saved enough to start investing in Vanguard funds (Min investment of $3,000) I will certainly diversify who I am buying index funds through. I would love to read your thoughts. Thanks again for the great videos!

  20. Hello Ben! Could you do a video on psychology? For context, I'm 24 and I've been following Dan's 3 etf model. My portfolio rrsp + tfsa + margin is held in questrade. I have six figures worth of investment and it's scary seeing the market go down sometimes, but yet I have to keep up by contributing a healthy 2k chunk of my paycheck to my holdings every month. Is there a way I can justify this behavior to myself? Loving your videos!

  21. I wonder what you think about the currency risk of investing in foreign markets. I want to invest in US securities but cable $/£ is at a 10 year low, giving me a lot of potential currency risk if the pound strengthens or dollar falls which inevitably it will at some point. This is putting me off investing in some great companies with high ROCE.

    Would love to know your thoughts?

  22. Yahoo Finance chart comparison shows that VFV.TO is a much better performer in all time frames than XSP.TO. They are both ETFs for the S&P500 traded on the TSX. Why are their performances so different?

  23. The video is great and much appreciated along with all your videos. My only critique pertains to the production of your videos. The audio music for your intro and outro has such a drastic volume change that it becomes jarring and off putting. The audio quality for yourself is great. However, you yourself have a consistent tone. I often find myself raising the volume to hear and understand specifically what you are addressing (not a problem). Then comes the intro and I’m blasted with noise. It’s similar to watching a movie on broadcast television then being bombarded with commercials. I have nothing against the intro; I honestly believe it’s great; just think the volume could be slightly more consistent and that minor tweak would go a long way into making these videos even better than they are already. Love the info. Thanks again.

  24. If we can expect small and mid cap stocks to outperform large cap stocks over the long term, it’s then best to buy small and mid caps and leave out large caps as a long play, correct?

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