Traders work on the floor of the New York Stock Exchange, November 8, 2013.BRENDAN MCDERMID/Reuters
Investors using passive, index-based strategies get better performance than those choosing their own stocks over a full market cycle. There's not a single, reputable study that concludes otherwise. But this powerful, irrefutable piece of advice can often create more problems than it solves, particularly for Canadians.
An investor who fully subscribes to the research on indexing would hold two investments – an ETF tracking a broad equity benchmark and another following a composite bond index. And yet, I've seen thousands of investor portfolios and never once encountered one like this.
The tendency is for investors to extend the premise of passive investing beyond the broader index – into REIT, high yield bond, or precious metals ETFs for example – which means they've missed the point.
The advantages of passive investing arise from diversification and making the fewest investment decisions possible. The second an investor buys an index in a specific sector, the chances of outperforming the broader index decline. Buyers of the Horizons Enhanced Income Gold Producers ETF, for instance, likely did better than they would have done by choosing their own gold stocks, but this was little consolation when the ETF fell 43 per cent over the past 12 months.
There's another big problem in the current market environment. Knowing that index investing is the best strategy does not help investors make decisions like how much U.S. equity exposure to hold. What's more, the recent underperformance of the TSX versus the S&P 500 is forcing Canadians to make an asset allocation decision – the exact type of determination that indexing is designed to save us from.
Between 2002 and 2012 Canadians had it easy – they could ignore U.S. markets entirely. The S&P/TSX Composite's average annual return of 9.75 per cent trounced the S&P 500's 2.24 per cent in Canadian dollar terms. Cumulatively, the difference is even more stark – the Canadian benchmark climbed 154 per cent for the decade, leaving the U.S. market's 25 per cent return in the dust.
The past 12 months have seen an abrupt reversal in that trend. The S&P 500 has made up a ton of ground by outperforming the TSX by more than 20 per cent.
The premise behind the historical outperformance of passive investing dictates that domestic investors should move assets into funds or ETFs tracking the S&P 500. If broad diversification is the secret to the outperformance of passive investing, Canadians need to recognize that the U.S. market is more diversified (in terms of industry sectors) by orders of magnitude.
The S&P/TSX composite will lag the S&P 500 badly if global market leadership moves to any of the following sectors: health care, technology, autos, chemicals, retail, consumer staples or telecommunications hardware. The TSX just wouldn't have enough companies to benefit from those trends. And that's just a partial list.
Canadians pay the vast majority of their bills in loonies, so it doesn't make sense to move completely into U.S. dollar assets. A big fall in the greenback would hurt too much. But investors who believe in index-based investing – and there's no reason not to – should begin shifting portfolio assets into the S&P 500.