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Even passive investors may make an occasional stock pick - and this can throw their investment model out of whack. (Peter Blottman/iStockphoto)
Even passive investors may make an occasional stock pick - and this can throw their investment model out of whack. (Peter Blottman/iStockphoto)

WEALTH STEWARD

Why your index funds are smarter than you Add to ...

Many years ago an investor’s default investment strategy – in the absence of an advisor’s involvement – was to invest in GICs or Canada Savings Bonds. Today, the more affluent investor’s default strategy is – increasingly – indexing, inspired by the likes of John Bogle, Charles Ellis and William Sharpe. But I have often found that indexing advocates implement strategies that are quite a departure from the underlying theory they use to support their choices. I have seen this play out in three ways.

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Company risk

It’s hard to find an individual investor who doesn’t buy individual stocks at least occasionally. And so-called passive investors are no exception. They may dutifully sock money away into a portfolio of index funds or ETFs, but once in a while they cannot resist scratching their itch to pick stocks.

Bank stocks or virtually anything paying a dividend are popular picks. But tilting one’s risk exposure much more heavily toward a handful of companies is in sharp contrast to indexing’s simple tenets – i.e. obtain the broadest exposure possible at the lowest possible cost. And while few investors actually have any disciplined method of buying or selling stocks, that doesn’t stop most from playing ‘active manager’ with that part their portfolios.

Geographic tilts

Over the past ten years, upping exposure to geographic themes has become commonplace. The most subtle of such geographic tilts takes the form of investors buying separate funds for U.S., overseas and emerging markets stocks. The more speculative version of this involves buying narrow regional or country funds – i.e. frontier markets, Brazil, Russia, India, China, etc.

At best, this is akin individual investors deciding that the allocation across countries or regions based on market capitalization – the purest form of indexing – is somehow inferior to their own abilities to pick countries or regions. At worst, it’s all-out gambling.

Sector bets

Similarly, many investors feel compelled – often prompted by investment product sponsors – to buy baskets of stocks focusing on sectors or industries or individual commodities. But again, this slice-and-dice approach is in sharp contrast to the underlying theory behind indexing and it risks compromising indexing’s potential tax efficiency.

Advice for indexing hopefuls

It’s human nature to want to take advantage of whatever insights one might have about a particular industry, country or company. Even if an investor knows the full ‘story’ about a particular investment, that isn’t enough; few investors are able to translate the story they know into an estimate of value or upside potential. In the absence of this skill, what many call tilts are little more than conjecture.

And if such investors have so little confidence in professional portfolio managers’ abilities to make these calls, there seems little basis for assuming that so many individual investors possess this same skill. Those wanting to invest as closely as possible to the underlying theory may want to take another look at a piece I wrote more than four years ago – ETF Rule: Keep it simple.

Dan Hallett, CFA, CFP, is director of asset management for HighView Financial Group and a contributor to thewealthsteward.com.

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