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Portfolio Strategy

Beware the limitations of buying the index Add to ...

No one feels a stock market slump like an index investor.

The Canadian market is dominated by energy and metals, which are among the worst-performing sectors this year. Meanwhile, the micro-sectors of our market – health care, consumer staples and consumer discretionary – are the top performers. If you own the index, you own a lot of what’s not working and next to nothing of what is.

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I’m still a believer in index investing because it’s a low-cost way to generate returns that over the long term will beat most stock pickers, whether they be professional money managers or individual investors. But let’s not ignore the fact that there are times like today when indexing seems an approach that’s out of step with what’s happening in the financial world.

“When you look at the TSX, it’s half resource-geared and we live in a world where many people are arguing the Western world is going through a deleveraging process and everything is slowing down,” said Murray Leith, research director at Odlum Brown in Vancouver. “Do you want to be loaded up with cyclicals? There’s not a lot of common sense there.”

The drawbacks of indexing in the Canadian market are worth raising because they speak to the ability of investors to cope with stock market risk. Several indicators, including reduced stock market trading volumes and the dominance of conservative products in the mutual fund industry, suggest that people are uncomfortable with the kind of volatility they get when they buy the Canadian index directly through an exchange-traded fund or index mutual fund, or through a mutual fund that quietly holds pretty much what the index holds (that’s called closet indexing).

After losing 8.7 per cent last year, the S&P/TSX composite total return index (dividends included) started the year well and then gave it all back. With Europe’s economic problems once again in the headlines, it’s like we’re back in the scary market conditions that led to last summer’s market plunge.

David Baskin, president of Baskin Financial Services in Toronto, said investors can’t help linking today’s volatility to the big market plunge of 2008-09. “I see it in my clients all the time when I speak to them,” he said. “They tell me the market makes them nervous. It’s still a very visceral response.”

Mr. Baskin’s answer has been to design portfolios for clients with Canadian market exposure that departs significantly from the S&P/TSX composite index, which is just over 75-per-cent weighted to financials, energy and materials. By reducing exposure to this trio, he achieves two benefits. The first is being able to capitalize on smaller-size companies that have next to no weight in the major stock indexes, if they’re included at all.

“When you buy the index, you miss some really good little Canadian stories,” he said. “Like Cineplex, which has been just a whizz-bang of a stock. It’s doubled in the past three years and paid a terrific yield every year while doing it.” Cineplex is in the composite index, but with a weighting of about 0.13 per cent. In the balanced growth portfolio at Baskin Financial, it gets a weighting of about 4 per cent.

Another benefit, and one that will be of interest to nervous investors, is a smoother ride than the index. Mr. Baskin said that over the past 12 years, his firm’s portfolios have captured 72 per cent of the upside in the stock markets, and 42 per cent of the downside. “Our style here is to give up some of the upside to protect against the downside,” he said.

Last year, the firm’s balanced growth portfolio of stocks and bonds made 1.2 per cent while its benchmark indexes fell 3.8 per cent. For the first four months of 2012, the portfolio is up 4.5 per cent and the benchmark rose 1.8 per cent.

Odlum Brown’s Mr. Leith has for almost 18 years maintained a model portfolio of stocks that takes a different path than the index. For example, it has roughly half as much exposure to cyclical energy and metals stocks as the index, and twice as much in consumer discretionary and consumer staples.

The results have tried clients’ patience at times. In 2007, a big year for commodity investing, the model portfolio fell 3 per cent while the index made 10 per cent. In 2008, the portfolio fell 20 per cent while the index dropped 33 per cent. When the index roared back 35 per cent in 2009, the portfolio gained 20 per cent. Long-term investors would have done quite well. The model portfolio’s 10-year annualized gain is 8.9 per cent and the total return index made 7 per cent.

One of the implications of building a portfolio with different sector weightings than the Canadian market is that you’ll likely need to look at U.S. and possibly international stocks. Our market is very thin in consumer and health care stocks, but the U.S. market has plenty of them. In fact, Mr. Leith has given foreign stocks in categories like these a weighting of almost 47 per cent.

Decisions like this sometimes don’t work out, or they don’t pay off immediately. That’s one of the big risks of active management, which is what it’s called when a manager picks stocks and does not passively mirror a stock index. Mr. Leith said he moved into big U.S. stocks in 2005-06 and then had to endure a period a couple of years later when these companies were eclipsed by commodity stocks.

Managers such as Mr. Leith and Mr. Baskin have shown the ability to beat the index, but a committed index investor would be quick to say that there are billions of dollars rotting in mutual funds that lag the index badly because of high fees and/or lame stock picking.

So there’s definitely a challenge of finding a good manager if you want to get away from the index. And then there’s your own emotions to master. Portfolios that differ from the index will inevitably trail the index at times – can you accept that and resist the urge to sell?

One final point concerns the strong-performing dividend stocks that investors have been buying heavily in recent years. Many of them are not in the resource world, which means some people may have been taking an anti-index approach without even realizing it.



For more personal finance coverage, follow me on Twitter (rcarrick) and Facebook (Rob Carrick).

Follow on Twitter: @rcarrick

 
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