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Investment Ideas Why global exposure is key for Canadian portfolios, the Trump volatility index, and is there really a bubble in index investing?

Michael Burry’s successful trades ahead of the financial crisis reached legendary status thanks to Michael Lewis’ book The Big Short and Mr. Burry was played by Christian Bale in the movie version of the story. Recently, Mr. Burry was back in the news after predicting a bubble in passive index funds that ‘will be ugly’ when it unwinds.

Mr. Burry’s pessimism is focused on the potential for index fund investment to distort stock prices. In simple terms, when an investor buys an index exchange traded fund or open-ended mutual fund, the funds are distributed to underlying stocks according to market capitalization. The largest stocks make up the largest portion of the index, and they get a larger portion of the investment.

The mechanical allocation of index fund assets can result in a ‘big gets bigger’ situation in which the largest companies receive the most new investment even if they are prohibitively expensive or their respective profit outlooks deteriorate.

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Liquidity – whether there will be enough buyers to step in when passive funds endure heavy selling - is another major issue for Mr. Burry. Roughly half of U.S. fund assets – over US$4-trillion – are invested in index strategies. The manager noted that daily trading volume for most S&P 500 companies is below US$150-million and that mass selling of index products could swamp any potential buying interest. This would result in a ‘disorderly’ sell-off where stock prices quickly gap lower.

The first point I’d make is that index investing has been a huge success for investors so far. The inability of expensive actively managed funds to generate performance equal to the index means passive funds have generated a big improvement in wealth creation for the average investor.

I also believe that passive investing will cause a significant increase in volatility at some point, although the degree of damage is impossible to predict.

The rise of indexing is the type of large-scale change in market structure that has been accompanied by bouts of market volatility in the past. Experts blame the rise of portfolio insurance, for example, as the main cause of the brief but incredibly painful crash of 1987. In addition, I remain adamant that credit default swaps were primarily responsible for the excesses that led to the 2007-2009 financial crisis.

That said, I do not share Mr. Burry’s concerns about equity markets to the same degree. He has a point about blind allocation to large-cap stocks but so far, valuations do not appear overly excessive.

The largest S&P 500 stocks now are Microsoft Corp., Apple Inc., Amazon.com Inc., Alphabet Inc. and Facebook Inc. Amazon looks expensive at 76.4 times trailing earnings, but the average price earnings ratio for the other four is 25 times – reasonable in light of strong growth.

Passive investing wasn’t a big deal in the late 1990s but large-cap valuations were much more ridiculous. At that point Cisco Systems traded at 214 time earnings, Microsoft 78 times, and Oracle was 102 times earnings.

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There are other market sectors – U.S. high yield debt is a good example - where I think Mr. Burry’s view represents an important warning. In general, however, I think the benefits of index-based investing far outweigh the risks.

-- Scott Barlow, Globe and Mail market strategist

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Stocks to ponder

Extendicare Inc. The stock has a current yield of 5.8 per cent and with a payout ratio of 77 per cent in the first half of 2019. Looking out to 2020, the company’s profitability is anticipated to ramp up due to two key drivers. Jennifer Dowty reports. Meanwhile, the Contra Guys also see potential in the stock.

The Rundown

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The glitter appears to be coming off the rally in all things gold

After a stellar three-month stretch for gold bullion and the stocks of companies that dig it out of the ground, the glitter appears to be coming off the rally in all things gold. An easing of global recession fears and a nascent rebound in long-term bond yields have taken back some of the gains in gold and gold equities through an otherwise ascendant summer. Tim Shufelt reports

Sorry Canadians, but your stay-at-home approach to investing isn’t as logical as you may think

A stay-at-home approach seems logical for many Canadians. It isn’t, though. For all the apparent risks involved with international investing, it tends to pay off over time. Over the past few years, people who have refused to venture outside Canada’s borders have cost themselves significant money. Ian McGugan reports

‘Volfefe’: A volatility index for the Trump era

Traders know that when President Donald Trump tweets he can rock financial markets, often in unpredictable ways, but analysts at JP Morgan have now quantified the impact of his tweets, at least on the U.S. interest rates market. Read more from Reuters.

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Others (for subscribers)

Monday’s Insider Report: Director invests over $900,000 in this Canadian bank stock

Monday’s analyst upgrades and downgrades

Insiders still banking on Bank of Nova Scotia despite downbeat outside investors

Others (for everyone)

‘Volfefe’: A volatility index for the Trump era

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Four-per-cent rule still a great starter for retirement planning

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Ask Globe Investor

Question: We receive dividend income primarily from Canadian preferred shares, which benefit from the dividend tax credit (DTC). We are thinking of gravitating toward ETFs and two we are considering are ZDH and ZPW. Do these ETF qualify for the DTC?

Answer: No. The BMO International Dividend Hedged to CAD ETF (ZDH) invests in dividend stocks domiciled outside North America, while the BMO US Put Write ETF (ZPW) generates income by writing put options on a portfolio of U.S. large-cap stocks. Because these ETFs do not invest in Canadian dividend-paying stocks, they do not qualify for the DTC.

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A quick way to determine whether a particular ETF benefits from the DTC is to look up the annual tax treatment of its distributions. With BMO ETFs, for example, this information is provided under the “Tax and Distributions” tab on the web page for each ETF. For both ZDH and ZPW, the amount listed under “eligible dividends” for 2018 is zero. (Note: You must choose a year in the drop-down box and then scroll down to see the annual summary and eligible dividend amount, if any.)

--John Heinzl

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What’s up in the days ahead

Is the S&P/TSX Composite Index the best index for investing in Canadian stocks? Rob Carrick will take a look at other Canadian market indexes you can invest in via ETFs and index funds.

Click here to see the Globe Investor earnings and economic news calendar.

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Compiled by Globe Investor Staff

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