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  • 8 Wellington Street East
    3rd Floor
  • Toronto, Ontario M5E 1C5
June-12-12

Asset class investing versus index investing

There has been a lot of discussion about passive versus active investing. Our investment philosophy is on the passive side, but that doesn’t mean we sit and do nothing!

Our investment philosophy embraces asset class investing – we want to achieve very broad diversification among a number of asset classes. This represents one factor in managing the investment risk in our portfolios. We look for investment vehicles which achieve this objective. Traditional ETF’s or index mutual funds follow defined indices. While there is a trend towards the development of more focussed rather than broad-based funds, the narrowing of objectives does not accomplish our purpose. We stick with the broadly based funds that satisfy our asset class requirements at the most reasonable cost.

Having said that, we also look to add tilts to our equity allocations (Canada, US and International) towards small companies and value companies – factors that have proven to provide compensation to investors for the extra risk associated with them. Yes, there are index ETFs to accomplish this allocation, but we also are fortunate to have access to Dimensional Fund Advisors (DFA) mutual funds.

Index based ETFs are forced to buy and sell securities at the same time that the index changes. Their mandate is to track the index as closely as possible. Consequently when an index is “reconstituted”, the ETF must sell the securities that are leaving the index and buy those that are entering. Trading volumes in these securities increases and prices can fluctuate dramatically.

On the other hand, DFA operates their funds on the basis of a ranking of the universe of securities in each asset class according to book to market ratios. Without making active stock picks, they determine where a security becomes a “value” or “small” stock and therefore eligible for inclusion in that portion of a fund. There is no prescribed time in which trading must happen and often DFA’s traders, who have time on their side, can benefit when indices are being reconstituted. Smart trading can have an impact on overall returns.

By combining traditional ETFs based on broad-based indices along with small and value tilts provided by DFAs mutual funds, we can construct the equity portion of our portfolios in a cost-effective manner while exposing clients to risk factors that have compensated investors over the long term.

By: Kathleen Clough | 0 comments