The Problem With Market Capitalization-Weighted Index ETF's
Introduction
Investing in Canada has been made easy thanks to Exchange-Traded Funds, or ETF’s for short. With a single purchase you can gain access to an entire index or sector and essentially replicate it. When choosing an ETF, many people focus on the Management Expense Ratio, or MER, which is basically the amount you pay to the portfolio manager as well as all the day-to-day operating expenses, legal fees, accounting fees, etc., of the fund. Of course everyone hates paying fees, but by focusing primarily on this, you may be making a huge mistake.
Types of Indexing
Portfolio managers can generally choose one of three indexing methods. They can:
replicate the index itself by buying the shares of companies and mirroring the weights.
track the index by buying most of the large-cap stocks and taking a small but representative sample of small cap stocks.
weight the stocks of an index not by their market-capitalization, but by various fundamental metrics - a process known as fundamental indexing.
Replicating is easy to do, but costly for the average investor so it simply isn’t done. However with ETF’s, through a process called creation and redemption, a basket of securities (i.e. the securities in the underlying index) is exchanged for cash. This process ensures that the cash exchanged represents the value of the securities. As ETF investors, we pay for this, though it’s usually for a lot less than if we tried to do it ourselves (hence their popularity).
Tracking an index takes a bit more work but a well-created portfolio should mimic the index and have a low tracking error relative to the index itself. Since it’s more work though, the MER is a bit higher.
The last is fundamental indexing, which takes the most work out of the three. It’s also the most costly, but it has huge benefits you’re likely not going to get with the other two. Allow me to explain:
The Problem With Market Capitalization-Weighted Indexes
Unless you believe in total market efficiency, it’s fair to say that most, if not all stocks, are either overvalued or undervalued. If you think about what it took for certain stocks to get to the top of that market-capitalization list, there are probably at least a few of them who don’t deserve to be there - in short, they are overvalued. The result is an index which is fundamentally flawed for investing in - overvalued stocks are getting the most weight. Now the opposite is true of course as well - undervalued stocks should eventually revert to their truer, higher values, but since their weights aren’t high enough to begin with, it is not enough to offset the losses.
Fundamental indexing is a way around this market-capitalization flaw. This approach ignores market capitalization’s and instead focuses on four fundamental metrics:
five-year sales
five-year cash flows
five-year dividends
book value
After making adjustments for companies which do not pay dividends, each company in the index is ranked by the above metrics and the results are averaged out. Then a weight is assigned based on the average ranking. Robert D. Arnott wrote a book about it actually, which you can find on Amazon here, and his findings were quite remarkable. In his research paper, linked here, he found that these alternative indexing methods vastly outperformed the S&P 500 from the period of 1962 to 2005 and did so primarily by outperforming during recessionary periods, while only marginally outperforming during periods of economic expansion. Again, I believe is even more proof that investors should have protection of principle as their primary investment goal rather than investing in high risk stocks looking for big gains. If you have some spare time, I highly suggest reading his studies, as it may change your view about investing!
Options For Canadian Investors
So as investors in the Canadian stock market, what options do we have? Most people I speak to are either involved in some ETF tracking the broad S&P/TSX Composite or TSX 60 Large Cap stocks. Their management fees are so small you probably don’t even notice them. But there’s also fundamental index ETF’s which offer the benefits described above. Below is a sample of BlackRock’s ETF offerings for your consideration.
Summary
In my judgment, despite the higher MER, the Canadian Fundamental Index ETF offers more value for investors and they are likely to offset the higher fees with higher returns over the long-run. While we have been in a stock market boom for over a decade now, investors should not expect this ETF to significantly outperform the other two low-MER ETF’s above; however, if the author’s research proves to be correct for the next recessionary period, investors should be able to look forward to better protection of capital. And at the end of the day, that should be the number one goal for any investor.
Good luck!