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

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 others,  

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 that has been designed to  

represent some part of the stock market.  Most of the indexes that you hear about  

day to day are market capitalization  weighted. Standard and 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 smaller companies, 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 the big name indexes like the S&P  

500 only track large cap stocks. Historically,  large cap stocks have had lower returns than  

small and mid cap stocks, so excluding them  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 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 markets  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 extra.

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.