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Choose the index wisely

Compared to the investment performance of their passive benchmarks, 2011 was a difficult year for many active investment managers. The knee-jerk reaction for investors to avoid a repeat experience is to throw in the towel and invest in index funds, which at least assures them of getting the index return. However, investors should be careful what they wish for—an index fund, like any other investment strategy, has its own risks and rewards. Before you place your bet, you should be aware of the shortcomings.

Take for example the capitalization weighted indices such as the S&P/TSX Capped Composite Index. They are essentially a buy-and-hold strategy without any rebalancing. Bigger companies garner a bigger portion of your investment bet. Investors make their bet at the outset and let it ride. Winners in the portfolio are allowed to grow and compound. Invariably the performance of the fund becomes dominated by a few companies and/or a few sectors. Over 75% of the index is invested in three industry groups: financials, oil and gas, and materials. Is this a well-diversified portfolio?

Looking back three years from December 31, 2003, post the tech-bubble crash, had you placed an equal bet on each company in the S&P/TSX 60 (and rebalanced so that they remained equal), you would have enjoyed a return of 10.2%. The buy-and-hold strategy returned -2.8%.

When it comes to selecting an index, there are choices. Other types of market indices (and investable funds) include equal-weighted, risk-weighted, maximum diversification or indices determined based on fundamentals. Within a portfolio, strategies based on these other types of indices can significantly improve diversification and the risk/return profile of the portfolio. These indices can actually mimic active management strategies that have a contrarian or low volatility focus.

The right choice of benchmark indices is often overlooked in the process of constructing the target asset allocation. An inappropriate index assigned to an active manager may result in unwanted outcomes. The active manager wishing to minimize tracking error to a poor benchmark is unwittingly following a sub-optimal course. It is therefore important to fully understand the characteristics of the selected indices and to understand how these indices will behave in different market conditions.

The moral of this story is to assess the viability and suitability of an index (or index fund) with the same diligence as any other investment strategy for its relative strengths and weaknesses.