Not All Index Funds Are Created Equal

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.

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 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. 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.

I’d also love to read your thoughts and questions about this video in the comments.