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Fabrice Taylor

Index funds cost a lot more than you think Add to ...

Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.

Few things are certain in finance, but this is: There is nothing more self-serving than what the conventional financial industry tells you to do.

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Buy tech stocks? Rest assured it’s because they’re selling them. Income trusts? They’re bringing them public. Structured notes? Fat profit margins for banks.

Lately, the financial firms want you to buy the index because they’ve figured out that they can make a good buck selling index-linked products – funds and especially ETFs – if they can attract a critical mass of customers. ETFs are highly scalable, so each additional client increases the profit margins of the operator.

Sure, a broad index ETF only charges you a small management fee. That’s how they’re marketed. But the cost of holding this investment goes beyond the sliver of your wealth the ETF firm slices off for itself every year. The cost of owning a broad index, particularly the TSX’s, is well hidden but staggering.

No one knows this better than industry veterans. Just ask Stephen Takacsy of Montreal’s Lester Asset Management. Mr. Takacsy has been at it for 25 years, on all sides of the street. Few things rankle him more than investor obsession, fuelled by industry marketing, with big indexes and liquidity.

As Mr. Takacsy points out, there is little or no quality control over what companies are admitted into an index. It’s mostly a function of size and volume. That, in other words, is how your stocks are chosen. There’s scant attention paid to the company’s fundamentals, which could be poor or non-existent (think of Sino-Forest and Bre-X, both of which were in the big broad index).

Another issue the money manager points out is that the index is also full of companies that are always looking for new money. Banks, oil and gas, mining – all chronic issuers of capital.

And while he acknowledges that the banks are a little different – “they were a great investment for decades but they have headwinds now” – by and large a company that always needs more money is not a very good company. It is simply a very big and liquid company – liquid meaning that its trading volume, in both number of shares and the value of those shares, is very high.

Companies that raise money also introduce fresh risks because that money has to be deployed, and, as Mr. Takacsy says, “some do a good job, others are a disaster.”

Yet, because they’re big and liquid, they’re highly sought after by big funds, including ETFs. The trend in funds has been to bigger ones, as the mutual and pension fund industries consolidate and ETFs grow in size. The upshot of a big fund? It can only buy big, liquid companies.

So you’re buying an index not because the stocks in it are attractive, but because they’re big and liquid. But they’re also expensive because liquidity is expensive, and getting more so as funds get bigger and more and more money chases big stocks.

But why does everyone want liquidity? Mr. Takacsy’s firm has trounced the index since 2006, when he joined. It’s not because the firm avoids large caps. It’s because it also buys small and mid caps, and has a bias for them.

Why? “Because they can grow, and because they tend to be run by entrepreneurs who own stock and can make a difference,” he says.

They also trade for low valuations, because no one wants to buy them. Why is that? Because investors are convinced that liquidity, size and indexes are the place to be.

The truth is only large funds need the kind of liquidity offered by a large cap. Lester, at $200-million in assets, is in the sweet spot. It can invest heavily in Telus Corp. and BCE Inc., which it did a couple of years ago to earn outsized returns (these firms are a small fraction of the index, so if you owned a broad ETF you owned very little of either), and it can buy the smaller, entrepreneurial growth stories. It can invest for fundamental reasons instead of having its options dictated by size and liquidity. It doesn’t have to buy the index, which doesn’t reflect makeup of the economy given the weight of banks and commodities (which Lester has avoided).

It’s not that ETFs are all bad. Even Mr. Takacsy uses them for niche exposure, such as gold bullion and equities. But the big broad ones? They’re way more expensive than they appear.

 

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