Cap-Weight vs Fundamental Portfolio after 3 Years (July 2013) - Tight Race Continues

Three years after launching in June 2010 a realistic portfolio simulation (which includes trading commissions, actual prices, distributions, foreign exchange fees for converting CAD vs USD) of traditional cap-weighted ETFs pitted against fundamental factor-weighted ETFs, the race continues to be very close.

Neck and neck contest - tiny differences in total portfolio value
2010 Year-end - dead heat: 0.1% difference
2011 August - cap-weight slight lead by 0.6%
2012 March - dead heat, 0.07% difference
2013 August 7 - fundamental slight lead by 0.6%

There isn't a huge divergence in any asset class either, the largest gap being the 10% ($500) advantage of PDN over EFV in the small- to mid-cap developed markets holding.

First ever portfolio rebalancing
For the first time in three years, some of the asset classes finally exceeded the policy limit set at portfolio creation that rebalancing should occur when any asset class strays more than a quarter from its allocation. The strong performance of the US equity market and the weakness of emerging markets and bond market caused a big enough imbalance to exceed the threshold in both portfolios. It was a good time in any case to invest the accumulating cash balances.

Perhaps counter-intuitively to some, the portfolio rebalance policy is obliging sale of recent winners US equities (PRF & PRFZ and VV & VBR) and purchase of losers bonds (XBB and ZRR), emerging markets (PDN and EFV) and commodities (UCI).

Solid performance by both - up about 26% in total over the three years, or 8% per year compounded. That may be the biggest lesson of this exercise - a diversified portfolio works well.

The current market value of holdings in the two portfolios is shown in the spreadsheet at the bottom of this blog page. Between updates like this one, which I do every six months or so, the monthly distributions are not reflected in the portfolio cash holdings so the total portfolio value may be slightly under-stated for both. The spreadsheet is still a pretty good reflection of the current status of the contest since the distributions of the two portfolios are quite similar i.e. the current market price of the ETFs creates most of the difference.

Fundamental vs Cap-Weight Portfolio: Still Very Close after 2 and a Half Years

Early in 2010 I became convinced that indices based on fundamental accounting numbers made more sense as an ETF investment strategy than the traditional indices based on market capitalization. The research seemed convincing but would real world investing see the same results I asked myself. To try answering the question, in June 2010 I created two parallel portfolios with the same initial pretend capital of $100,000 and the same asset class breakdown to pit ETFs based on each type of index in a head to head battle.

Past updates on the contest:

• June 2010 - initial post with all the portfolio rules
• August 2011 - Cap-weight portfolio ahead by 0.4%; both portfolios up about 10%
• March 2012 - Cap-weight portfolio ahead by 0.07%; both are up 16% in total

Today (see bottom of this blog page for the Google spreadsheet with details of the current portfolio):

• Cap-weight still ahead in total by a slight 0.5% 
• Both have gained over 22% since inception
• Every asset class / ETF holding has made gains
• Asset class gains are unequal as expected but none has yet gone beyond the automatic rebalancing rule of a quarter deviation over/under its initial share (e.g. a 5% holding going above 6.25% or below 3.75% of the total portfolio)
• In some classes the cap-weight ETF is ahead, while in others it is the fundamental index ETF

Recent Substitution trades

• In May 2012, the fundamental ETF PowerShares FTSE RAFI Canadian Fundamental Index ETF (TSX: PXC) replaced the iShares Canadian Fundamental Index Fund (TSX symbol: CRQ) since it tracks the identical Canadian equity index but has a much lower MER (see post discussing the two)
• In January 2013, the commodity ETN UBS Bloomberg Constant Maturity Commodity Index Total Return ETN (UCI) replaced iPath DJ-AIG Commodity Index Total Return (DJP) because of what I found out in this post on my other blog, basically that UCI employs a much superior futures rolling method)

Bottom line

• The jury is still out with such a tiny total cumulative difference, though I am a bit surprised the fundamental side isn't pulling ahead. 
• Having a portfolio with a mix of asset classes really works well - note how the total portfolio is up 22+%. By comparison, the TSX Composite Capped index is up almost the same at 21%, almost the same but the ride has been a lot smoother with both our portfolios

Hooray! MER Cuts on US Powershares RAFI ETFs

IndexUniverse posted details today of US-based Invesco Powershares cuts on several RAFI fundamental index ETFs. The cuts in MERs are quite significant - almost half. The reductions in MER vary from 0.30% to 0.36% e.g. for PowerShares FTSE RAFI Emerging Markets Portfolio (NYSEArca: PXH), which goes from 0.85% MER to 0.49%. This is excellent news since the difference will go straight to the bottom line and boost investor returns, mine included, as these ETFs are a core part of my holdings.

(In)efficient markets, indices and investors - Martellini explains - brilliant!

Highly recommended: Lionel Martellini's Inefficient Benchmarks in Efficient Markets at the EDHEC Research Institute. Martellini is precise and brief in his explanation of a couple of the slipperiest and most important ideas in finance and investing. Quotes: 

• " ... cap-weighted indices are inefficient benchmarks, regardless of whether or not markets are efficient (keeping in mind that they probably are efficient, at least to a first-order approximation)... " i.e. the implication is that indices like the S&P 500 and the S&P/TSX 60 aren't very good
• " ... When the word “efficient” is used in reference to a market, as in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, it suggests that at any given time, prices in the market fully reflect all available information on all stocks in the market. ... " and "... there is a consensus regarding the fact that markets can still be regarded as somewhat efficient ... " i.e. it's not impossible but it's hard to outperform the market, considering fees and costs
• " ... even if markets are efficient, at least up to a first order approximation, investors can still be holding highly inefficient portfolios. The word “efficient”, now applied to a portfolio as opposed to a market, means that the portfolio performance can be improved without any increase in risk through an improvement in the portfolio diversification ..." i.e. it isn't a great idea to invest only in Royal Bank shares even if the price is correct
• " ... empirical evidence also suggests that the average investor holds a severely inefficient portfolio. In other words, the finding here is that the portfolio held by the average investor, which by definition is a cap-weighted index, tends to be poorly diversified. This result is hardly a new finding, ..." i.e. buying SPY (S&P 500 tracker ETF) or even VTI (Vanguard Total US Market ETF) or XIC (S&P/TSX Total Market ETF) is NOT the ideal thing to do.
• "... various alternative weighting schemes have been proposed to improve upon cap-weighting (see Amenc et al. (2011), Arnott, Hsu and Moore (2005), Choueifaty and Coignard (2008), Maillard, Roncalli and Teiletche (2008) to name but a few), and it is now commonly accepted that moving away from cap-weighting tends to enhance diversification and increase risk-adjusted performance over long horizons. ..." i.e. consider dumping SPY and XIC. I think the best practical answer is an empirical matter - if another non-cap-weighted (like equal-weighted, or fundamental weighted) index ETF exists for the asset class with reasonable costs that do not eat up the performance gain (e.g. perhaps PRF, EWI, RSP, PXC, CRQ;

Fundamental vs Cap-Weight Portfolio: Still Neck and Neck after 20 Months

No Clear Winner Yet - Last time I reported on the contest in August 2011, the cap-weight portfolio had jumped into an inconclusive lead. The contest between portfolios made up of either fundamentally-weighted or cap-weighted ETFs continues without a clear winner. The portfolios, shown in detail in the Google Docs spreadsheet at the bottom of this blog page, have been updated with all distributions up to and including February 2012. The $85 separating the two portfolios' values is a miniscule 0.07% difference. Three of the fundamental ETFs are in the lead against their cap-weight rivals while four of the cap-weighted ETFs are ahead, but by lesser amounts.

Every Asset Class is Up - Our contest start date of June 2010 must have been a good time to get into the market since every ETF is above its initial start value. The portfolio as a whole has gained 16%, a very satisfactory result for less than two years in the market.

No Rebalancing Yet Required - None of the ETFs has deviated beyond the limit (more than 25% away from its target allocation e.g. a 4% holding can go up to 5% or down to 3% before our rule kicks in) we set for forced rebalancing. That has been the case since the start. Both portfolios are quite maintenance-free. There is cash building up however, and come the June anniversary date, it will be time to invest that cash into the ETFs that lag their target the most.

Lack of Automatic Reinvestment Warps the Comparisons - One of the difficulties with making head to head fundamental vs cap-weight comparisons between ETFs within an asset class is that the cash distributions do not get reinvested within the ETF. The market hype of the ETF providers use total return calculations which assume that the distributions do get reinvested when received. Our growing cash pile includes an important part of the ETFs' returns but the cash doesn't show in the current market value of the ETF shares that we use to do the Red vs Green who-is-ahead comparison. Since the ETFs do not distribute the same amount of cash, the total returns can be a fair amount out of whack with the Red vs Green indicator on my spreadsheet e.g. PXF distributed USD$404.82 in 2011 while its counterpart VEU paid out USD$644.80; VEU is much further ahead at the moment than the $124 showing in the spreadsheet. The truest comparison of my test is at the total portfolio level.

The best direct head to head matchup is between Canadian equity ETFs CRQ and HXT since in those cases, the dividends do get reinvested. In HXT's case, the construction of the ETF itself as a total return swap ensures that HXT's value reflects reinvested distributions. In CRQ's case, Claymore's free DRIP program buys new shares for the investor so all but a few dollars each quarter gets reinvested. Right now CRQ, despite its much higher MER, is winning the race by 2.6%.

Risk-Efficient Indices - Evidence from Live Results

One of the biggest problems with any financial research is that patterns and strategies that worked in the past may not work in the future. The folks at the EDHEC Research Institute who created supposedly "new, improved" Risk-Efficient Indices about which I wrote a year ago, have now come out with data in the Live Results article that tests their theory. It uses actual results from the last two years, data that comes from the time after the new index method was worked out and thus could not merely be suited to the method simply because it was part of the data set used to create it.

The "new, improved" indices are put up against the traditional cap-weighted index method which is taken as the benchmark or representation for all major markets like the S&P 500, the TSX 60 or Composite, the FTSE 100 and which underpins all the biggest ETFs around. EDHEC also compares results of other alternative indexing methods (which die-hard cap-weight believers refuse to call indices at all) like Equal-weighting, RAFI Fundamental and Minimum volatility. Here's one of the EDHEC charts for the US market.



1) The good ole cap-weight S&P 500 loses to every other method, not only in terms of raw return but also in various measures to adjust for risk (Sharpe ratio, Sortino ratio, Information ratio, Treynor ratio), just as it did in the model-building time period.
2) The FTSE EDHEC Risk-Efficient Index wins by the most and by a huge amount over the S&P 500.
3) Minimum Volatility is a close second, perhaps even first, given the risk adjustment ratios. Perhaps the new ETFs launched on this basis, which I wrote about in my other blog in Low Volatility ETFs - Promising Safety and Reward, are worthwhile.
4) The Risk-Efficient out-performance is repeated separately in the UK, Eurobloc, Japan and Developed Asia ex Japan. RAFI fares indifferently (oh-oh, for my portfolio!). The other two couldn't be tested.
5) The Risk-Efficient performance is primarily NOT due to exposure to small cap and value factors. It comes from better stock weighting.
6) "... provide some evidence that the performance advantages of efficient indices largely stem from the improved diversification."

So far, I've only been able to find one actual live fund that applies the new Risk Efficient index method, the Parworld Track FTSE EDHEC-Risk Efficient Eurobloc traded in Luxembourg. Expect more to come from the ETF industry.

Is this a real improvement over cap-weighting, or an artifact of data that doesn't go far enough back (only to 1959 for the S&P 500)? Of course, by the time there is enough data to satisfy everyone, we will all be dead.

Passive Indexing Trend Leading to Increased Investment Risk

Too much of a good thing for individuals can be bad for everyone collectively when it comes to passive index investing. James Xiong and Rodney Sullivan explain how this has come about in How Passive Investing Increases Market Vulnerability, available for download here at Top100Funds.com and here at SSRN.

Through a series of statistical tests on US equity data back to 1979, they show how the take-off of passive index investing since 1997 is strongly associated with their disquieting stock effects:

• "... the rise in passive investing meaningfully corresponds to a decrease in the ability of investors to diversify risk in recent decades" and
• "... the diversification benefits of equity investing have decreased for all styles of stock portfolios (small, large, growth, or value). The decline in diversification benefits can couple with increased market volatility and firm-specific volatility."

Passive index investments in mutual funds and ETFs by late 2010 reached about a 1/3 share, or $1.2 trillion, of the total in such funds of $3.5 trillion - active investment funds makes up only 2/3 of the total. (The paper also tells us that institutional investors now hold 70% of US equity stock vs 44% in 2000 and only 24% in 1980.)

The chart below from the paper shows the vertiginous rise in correlations between pairs of stocks. Note how the more passively indexed segment, the SP500 large caps, has higher correlations than smaller caps, the non SP500 stocks in the chart.

They checked that the effects were not only manifest during the recent periods of extreme market crisis - the dot com crash in 2001/02 and the credit crisis crash in 2008/09 - when all asset class correlations rose significantly. The same pattern of rising correlations continued through the other more normal years of the study period.

There may still be value for individual investors to buy those passive index funds but the free lunch of passive diversification now appears to be merely selling at a discount. One thing for sure, as I tried to suggest in the thought experiment post What Would Happen if Everyone Did Passive Indexing? the success of passive indexing, when it becomes big enough, does have an effect on markets. In another post last year, Index Investing Becoming a Victim of Its Own Success, I noted research by Jeffrey Wurgler on the S&P 500 that reaches similar conclusions. No wonder the avant-garde of risk-aware, efficiency-aware institutional investors is moving away from cap-weight passive index investing, some to private equity direct investing, such as the big pension funds and others to alternative-weighting indices.

Fundamental vs Cap-Weight Portfolio: Surprise Performance Reversal after Year One

The first year has now passed in the head to head contest between the fundamentally-weighted portfolio and a parallel portfolio with the same asset allocation based on traditional cap-weighting. Both portfolios started out with $100k last June - see original post announcing the contest.

Both Portfolios Have Gained - up about 10% to $110,000 or so as of August 5th, though it was higher at the 1-year anniversary since the past few weeks have not been kind to market values. Every single asset class is higher than the value at inception. I note that our hypothetical investor is not panicking and is not / has not sold anything, unlike those mythical investors (why doesn't the press just call them speculators, anyway?) who have been obeying the chicken-little sky-is-falling market forecasting gurus.

Cap-weight Ahead Slightly! - Surprise, surprise, after being behind pretty well the whole year, sometimes by more than $1000, or 1%, the cap-weight portfolio spurted ahead in the last month or so and now leads by about 0.6%. I think the quick shift was the European banks getting hammered in the PXF vs VEU category but need to look further into this. Whatever the reason, this contest doesn't look very conclusive so far.

Rebalancing - After accumulating cash from most of the ETFs for the past year our policy called for review and reinvestment of the cash at each year anniversary. Note: Claymore CRQ ETF has automatic DRIP with distributions so I've tracked the reinvestment for CRQ. BMO also does auto DRIP but when BMO switched to monthly distributions with ZRR and ZRE it has not been worth my bother to do all the tracking of reinvestment for single share purchases, so I've simply tallied up the cash. Not one of the ETFs / asset classes had come near to the forced rebalancing point of 25% deviation from its target allocation in the portfolio. None are off even 10% from allocation target.

Nevertheless, to put the cash to work but not pay too much in commissions to rebalance small amounts, and to keep the asset class by asset class contest going, I've split the reinvestment cash to put another $1000 each into CRQ and it cap-weight rival HXT. The remainder has gone into XBB for each portfolio. These were the two asset classes with largest dollar amount divergence so it works out neatly as a quite realistic action.

More shares of XBB have been purchased (all purchases done at closing market prices of August 5th) because the cap-weight ETFs have paid out more than their fundamental weight counter-parts. That's interesting because the fundamental weight ETF holdings are supposed to be selected and weighted in part according to dividends. However, the higher MER's of the fundamental weight ETFs (about 0.5%) have to be paid. That's a cost performance drag of the real world for the fundamental ETFs that their superior index returns do not reflect. Our contest tests whether the stock performance is strong enough to overcome this impediment.

Fundamental DRW Replaces Cap-Weight RWX in the Fundamental Portfolio - Long ago reader Jordan suggested Wisdom Tree's Global ex-US Real Estate Index ETF (symbol DRW) as a fundamentally-weighted alternative to RWX. Now the switch is done it's done and there can be a contest in that asset class too.

As ever, the two portfolios can be seen side by side at the bottom of this blog page.

TSX Market Darlings & Dogs in March 2011

It is always worthwhile to compare the iShares TSX S&P 60 Index ETF (XIU) with Claymore Canada's Fundamental Index (CRQ). CRQ selects and weights its constituents according to historical accounting data while XIU does so based on the market value of companies. As such, the comparison tells us which sectors are popular and where the market expects future excess profitability and growth will come from - i.e. when XIU has more weight in a company or sector than CRQ.

Here's what my comparison table below tells me:

• Dogs (in Red on the table): Financials are still unpopular (less weight in XIU than CRQ) as a sector and across the board company by company with one exception, the Royal Bank, whose weight in XIU is slightly more than in CRQ. CRQ's 13.5% greater weighting than XIU in Financials and its overall weighting of 45% in that sector makes it extremely dependent on it. Incredibly, CRQ's Financial weighting has even increased since my last comparison. Inklings of popularity amongst banks and insurance companies are beginning to glimmer as most of them have gone up slightly in their weight within XIU from last August to today. Even Manulife and Sunlife, though still way less weighted in XIU than CRQ, have become less doggy i.e. have gained a little ground within XIU.
• Darlings (in Green, naturally): Energy (as in petroleum) has not only maintained its popularity, it is continuing to rise in XIU, both relative to CRQ, where it was already a heftier component, and to past August within XIU. The biggies are Suncor, Canadian Natural Resources and Cenovus and they have all gotten bigger. They must be making more money than other sectors since they have gone up within CRQ too.
• Waning Darlings: The Materials sector is still a grossly over-weight in XIU compared to CRQ but some slimming has occurred. Gold companies Barrick Gold and Goldcorp both lost ground as did Potash Corp of Saskatechewan. By the end of the day, uranium producer Cameco (CCO) (not shown on the table as it is too low down the list) might be considerably less as a proportion of XIU (it is down c. 6% as of 11:30am). CRQ has less to lose that way as Cameco is only have the size within CRQ as it is within XIU.
• CRQ's sector weightings have evolved much more slowly than in XIU. None of CRQ's sectors has changed as much as the 1.5% increase in Energy's weight, or Materials' 1.2% drop, in XIU. Accounting profits, sales and the like do not change as rapidly as market expectations, or should I say, today, market panic.

Book Review: The Power of Passive Investing by Richard Ferri

If ever there was any question or hope that a person could succeed in beating market returns (or their fund equivalent, market-cap weighted low-fee index funds) through investing in actively managed mutual funds, this book utterly destroys the notion. In The Power of Passive Investing author Richard Ferri presents piles of research results that slice and dice the data backwards and forwards, inside and out, upside and down. Whether it is high- or low-fee funds, past-winners, before- or after-tax, bond or equity funds, foreign or domestic investments, large funds or small, portfolios of funds, manager qualifications, Morningstar ratings, risk-adjustment that is used to select a mutual fund, none of it works better than cap-weighted index funds.

Worse, Ferri gives us the disquieting evidence that individual mutual fund investors get significantly poorer returns than even the average under-performing mutual fund because of bad trade timing.

It is thus difficult to dispute the practicality of his advice that individuals should buy passive index funds and focus their efforts instead on an asset allocation, matched with long term goals and personal circumstances (emotional strength aka risk aversion, age, wealth, job, health etc), that should change infrequently - only when the goals and circumstances do.

Ferri says it is not just individual investors who will be better off following that strategy. He makes an argument that charities, personal trusts, pension funds (especially small ones) and financial advisors should do the same to best carry out their responsibilities.

The referencing, presentation, writing style, grammar, diction and organization of the book is thankfully up to snuff (much better than another of his books that I reviewed).

That's the good stuff. Here is what I didn't like.

1) The big one:
Dismissal of active management and fundamental indexing - Showing that actively-managed mutual funds are, on average, losers, does not mean that active management, the seeking of "alpha", cannot ever work. Ferri indirectly and inadvertently (I think) recognizes such when he quotes (p.149) famed Yale University endowment manager David Swensen: "Low cost passive strategies suit the overwhelming number of individual and institutional investors without the time, resources, and ability to make high quality active management decisions". Or, on page 112, "Most of the great managers aren't for hire by the general public. The truly talented managers like to fly under the radar ... ". Or, again, on page 128 where he discusses where the dumb-money investors' money goes: "Much of it went to brokers, brokerage firms, and their trading desks. Another portion went to a handful of talented money managers who skillfully separate investors from their money". (my bolding)

He might admit that such managers really do exist (eg. Warren Buffett isn't just on a long lucky streak) but in effect says that we small-fry investors cannot tell them apart. Perhaps with active mutual funds that is so, but is it true with fundamental indexing, which he summarily dismisses on pages 75-76 with a stream of invective instead of looking at evidence? The historical performance evidence, along with the theoretical dissection of why fundamental indexing makes sense, presented most notably by Robert Arnott (whose book The Fundamental Index I reviewed here) deserves more attention than that from a smart guy like Ferri. The fact that some high-powered and neutral researchers like the EDHEC Risk Institute have effectively been trashing the value of market cap-weighted indexes for practical and theoretical reasons, suggests strongly that we, including Ferri, need to pay attention to this particular innovation, especially when it comes offered in reasonably low cost funds. The big question is whether the higher fees or tracking error of such funds (e.g. the US equity ETF from PowerShares PXF's 0.39% MER vs the classic S&P 500 ETF SPY's 0.0945%) offsets any alpha they might generate. That question is why I have the little practical side-by-side experiment going at the bottom of this blog (so far, fundamental is winning).

2) Minor annoyances:

• the mysterious 1:2 winner to loser ratio - all through the dismemberment of mutual fund performance, Ferri keeps emphasizing that the ratio of winners to losing funds in various studies settles around 1:2 (except even more mysteriously, that the bond fund ratio is even worse at 1:4), but he never explains why. There must be a Dan Brown novel in this!
• the big-5 lifetime financial liabilities in chapter 10 misses health costs - especially in the USA, and less so in Canada, health care costs, most likely in retirement, need to be a prime financial factor to be dealt with somehow
• the suggestion that it is too difficult to implement passive investing on one's own (page 191 chapter summary) - "The mechanics for prudent asset allocation and investment selection are more involved than how they are presented in this book. More reading is required to a portfolio is much easier said than done. Do-it-yourself investors often do not complete the process or maintain it well." Ok, here goes: US investor - 50% VTI (or PXF), 50% AGG; Canadian investor - 50% XIC (or CRQ), 50% XBB. Rebalance annually, or never, if you are really lazy. Add money by topping up the one below 50%. Withdraw money by selling off the one over 50%. Is that simple enough? It's only a good enough, not nearly optimal solution, but it should be possible for anyone to follow.
  

In short, this is a very good book with one significant flaw that is more of a missed opportunity than a damaging omission, as individual investors would not go wrong following the author's advice.

My rating: 4 out of 5 stars.

Disclosure: Thanks to the author's firm Portfolio Solutions for providing a free review copy.

Portfolio Cap-Weight vs Fundamental Test and Monthly ETF Distributions

The portfolio contest between traditional Cap-Weight and Fundamental Weight Index ETFs has become a little more tedious to track manually with the switch by both BMO and iShares to more frequent monthly instead of former quarterly distributions on more ETFs.

It also undermines one of BMO's advantages compared to iShares, namely the automatic, free DRIP program since now much smaller amounts are being distributed monthly, which in many cases won't be enough to buy whole shares. Even with a $100k portfolio, the January and February amounts for ZRE are not enough to buy even one share. Since for ZRR both portfolios have the same holding it won't any difference between them. Therefore, I will simply accumulate the cash for both portfolios until rebalancing at the annual anniversary date in mid July presents an opportunity to re-invest it. The spreadsheet at the bottom of the blog now includes the cash for both January and February distributions (which is anticipating a bit since BMO only distributes the cash March 7th but again it doesn't make any comparative difference).

Cash or no cash, it is quite interesting to see that the Fundamental portfolio has now opened up a significant lead of $1602 since the beginning of the year. It's easy to spot that it is because of the huge leap of the Developed Markets Fundamental fund PXF over its Cap-Weight rival VEU. Both portfolios have positive returns in every asset class! It's just that "some are more equal than others" with bigger gains. That includes Canadian Bonds where the price level of XBB is flat but the cash interest distribution would push its return into plus territory. Nothing is really close to the 1/4 share out-of-whack rebalancing trigger point though XBB is starting to get down there with 21.5% versus its target 25%. If interest rates start to rise then XBB is likely to start falling though equities might too.

The Next Step in Index ETFs: Risk Efficient Index ETFs

"The Moving Finger writes; and, having writ, Moves on"
The Rubaiyat of Omar Khayyam

Finance research fingers have written a lot on the various methods of indexing, poking holes in cap-weighting as being neither theoretically nor practically optimal for indexing, whether to use as a benchmark or an investment strategy. It's time to move on, apparently not to fundamental weighting or equal weighting, but to something called a Risk Efficient Index, which maximizes the reward/return to risk (Sharpe) ratio. The EDHEC Risk Institute came up with the new indexing method and provides a good FAQ here that explains the difference with the other indexing methods (and includes links to various papers with detailed comparison of the alternative indexing methods). The second-last question in the FAQ says the method could be used for an ETF. The new Index is where the institutional investors are or will be heading, so why not an ETF for individual investors?

Book Review: All About Index Funds by Richard Ferri

Disappointing. After reading the excellent All About Asset Allocation by the same author (my review here), I expected more of the same quality from All About Index Funds, especially since this book is a second edition. Alas, too many small slip-ups and an inconsistent approach bring down the value of much useful information and sensible enough investment suggestions.

Slip-ups - Is it too much to ask for a proofreader to eliminate typos and for an editor to help with sentence construction? Yes, it is true that no book is perfect and we can usually fill in the blanks but such carelessness undermines credibility.

Unfortunately, I believe that loss of credibility is justified at times. Take this statement on page 160: "The sad part about modified-weight funds is that the issues claim to have found a new indexing nirvana when in fact all they have done is create more funds titled toward value stocks." Huh? "issues" find something? Would a better word not be something like "proponent" or "advocate"? As well, "titled" instead of "tilted"? We know what Ferri is trying to say but these trivial errors belie a too-casual, too-brief treatment of a critical issue in indexing. That issue is whether cap-weight funds are better than modified-weight funds such as equal-weight or fundamental-weight funds. Mere summary dismissal by Ferri does not help the reader make up his or her own mind. The absence of any footnotes or citations of research that he deems would answer any doubts about his position leaves the reader with a take-it or leave-it situation.

I happen to believe that fundamental weighting is better for the individual investor than cap weighting, my definition of better being a higher return to risk ratio. Whether I am right or wrong (and to find out I have a little experiment going in the form of the test portfolios at the bottom of this blog), the answer as to which is better is an empirical question that Ferri does not address. He should. Putting two and two together from information in the book, we can see that the supposed purist indices that underlie such index funds as the S&P 500 Spider (SPY) do not conform very well to purist cap-weighting conditions (e.g. violations like free-float adjustment, arbitrary stock selection by a committee, buffer zones to minimize trading and prevent front-running by hedge funds). All index funds can be seen to be merely trading strategies. The question is only which works best.

Ferri might answer that the book is only a beginner book, whose aim is to provide the "easy way to get started", as the sub-title says. Fair enough, but that raises the other problem I find with the book.

Inconsistent Approach - If the purpose of the book is to give advice, a basic how-to manual, then huge chunks of the material where the details and descriptions of various indices and myriad sector funds become irrelevant and distracting. In fact, Chapter 15 could do nicely for the investor who just wants to know what to do. The chapter lays out sensible sample portfolios with the names of specific funds and percentages to allocate across the funds.

On the other hand, if Ferri's objective is to give the investor the tools and rules to make up his/her own mind, then the pros and cons of his positions and of the alternatives need to be laid out. For example, there is lots of descriptive detail of commodities (with some errors, like saying on page 196 that cotton is an Industrial commodity! - see the S&P GSCI) and associated indices and funds but nowhere do we have an assessment of which are better, nor even a suggested method for deciding the matter.

Content - The book is divided into three parts. Part 1 puts forward the case for basing individual investing on low-cost index funds. Part 2 describes the many categories of index funds, their underlying indices and lists most of the available ETFs/mutual funds as they existed in 2007 (so inevitably this is out of date as ETF proliferate - is a book the right way to catalogue ETFs?). Part 3 says how to combine and manage index funds in portfolios. The portfolios suggested should do investors fine. The portfolios are based on mainstream cap-weighted funds and should perform well enough, even if fundamental- or equal-weight index funds do better over the long term. They offer the key feature of avoiding loss of money through high-fee funds and through the protection from diversification.

The content is at a beginner level, with no math, not even arithmetic. There are lots of illustrative tables and charts. The appendix includes a short reading list with classic books like those of John Bogle, William Bernstein and Burton Malkiel. A number of low-cost fund provider website addresses are given (I wish it included the handiest one for quickly finding all the ETFs by category, the completely mis-named Stock Encyclopedia).

The target audience is squarely people in the USA. Canadians will find it useful for their US ETF investing, but need to ignore all content to do with taxes, account types and mutual funds. No Canadian ETFs are even mentioned, nor is any pertinent history (Ferri could have acknowledged that the first successful ETF, the TIPS was created in Canada in 1990, predating the 1993 SPY - see Wikipedia).

Despite the beginner orientation, there is lots of interesting content for more advanced investors. I got many blog ideas, for questions that came into my mind during reading (but which Ferri does not answer), such as:

• what would happen if everyone indexed?
• book says there isn't an index ETF for high-yield bonds ... there is now, Powershares' PHB
• past correlations of asset classes have not been stable and tended to peak during crises - can we construct a model of correlation effects for various crisis types? e.g. asteroid strikes earth = all assets perfectly correlated at 1
• some indices are based on free-float, others on full cap for weighting, so does it matter and what is the effect?
• why have index providers all discarded the definition of Value stocks as those in the bottom half of price to book for more complicated multiple factors and what difference does it make?

My rating: 3 out of 5 stars.

Disclaimer: Thanks to McGraw Hill for providing me with a copy for review.

Fantastic Performance Results for RAFI Fundamental US Equity Index ETF

The RAFI US 1000 Portfolio ETF (Symbol: PRF) has outperformed its cap-weight rivals the S&P 500 and the Russell 1000 by a huge margin over the past five years since its inception according to a press release by PRF's manager Powershares. That's 23.1% for PRF vs 11.99% (S&P 500) / 13.8% (Russell 1000). Even better from a practical viewpoint, the PRF fund has outdone the indices i.e. the higher expenses of PRF have been more than offset. The cap-weight indices portray better results than an investor could actually achieve since the indices do not reflect the cost drag from the MERs of ETFs that invest in those indices.

Perhaps most telling for PRF fans, of which I am one (I own shares), PRF has outperformed by an even greater margin the Russell 1000 Value Index, which produced a measly 6.68% over the five years. If RAFI is only/merely value investing, it sure seems a better way to do it.

Cap-Weight vs Fundamental Portfolios: 2010 Year End Update

Last June I created two parallel test portfolios to determine whether Fundamental Weighting really does a better job than a Cap-Weighting as proponents like Robert Arnott say. The two portfolios have the same asset classes and proportions invested in each asset class. As much as possible, the portfolios mirror the investor experience, as I described in the initial post about this mini project.

The 2010 year end has come and the cash distributions have been received by the portfolios in a mix of Canadian and US dollars. Where offered by the ETF vendor - BMO and Claymore only - the distribution has been reinvested in its ETF. Per the intention announced in the October update, in the Cap-Weight portfolio, I've now sold the iShares S&P TSX 60 Index ETF (symbol: XIU) and bought in its place Horizons BetaPro S&P TSX 60 Index (HXT), which cleverly uses swap derivatives to track the same index but with the key difference that it implicitly automatically reinvests distributions. That will make a fairer comparison against Claymore Canadian Large Cap ETF (CRQ) which has a DRIP.

The Competition Results:

• It is still more or less a dead heat overall between the two portfolios - only $128 dollars out of a portfolio total value of $113,400 or 0.1%;
• Fundamental Weighting leads in four asset classes and Cap-Weighting leads in two (I ignore RWX since it is the same ETF in both portfolios and the Cap-Weight portfolio has one more share so it will always be ahead by that one share)
• Cap-Weighting is ahead in Canadian large cap equity but Fundamental Weighting leads by a significant margin in the two small cap equity ETFs for the USA and for Developed Markets. It is curious that Fundamental Weighting leads by most in two of the asset classes which have had the biggest increases. Cap-Weighting is supposed to be the bubble follower I thought. Maybe it's a sign that the rise in those stocks is not a bubble at all, that in fact the previous weightings were out of whack - Cap was too high - and now Fundamental has been catching up.
  

General Investing Results:

• Both portfolios are up a healthy 13% since June, when we pretended to invest $100k
• Every asset class is up by double digits, except Bonds
• The rise of the Canadian dollar has reduced foreign returns but they were still much stronger than those of Canadian holdings after conversion
  
• None of the asset classes is anywhere near the threshold set for rebalancing (1/4 of its allocation percentage), which we said anyway we'd only do after a year.
• Cash inevitably has started to pile up unproductively in these accounts as in real life when distributions are not immediately reinvested. The Fundamental portfolio has $1767 in cash (1.6% of its total value) and the Cap portfolio a bit more at $2066 / 1.8% (since fewer of its ETFs offer a DRIP). This brings out the real-life no-perfect-answer dilemma of having idle cash vs paying too much in trading commissions to reinvest small amounts. At the year anniversary in July after two more quarterly distributions by the ETFs, there will be more cash and we'll reinvest & rebalance per our portfolio policy.
  

The details of the two portfolios are in a Google spreadsheet at the bottom of this blog page.

Cap-Weight vs Fundamental Portfolios: Q3 Update after DRIP

The live updated spreadsheet at the bottom of this blog, which shows the on-going contest between a cap-weight portfolio and its fundamental weight counterpart, has now been updated to include the automatic reinvestment of dividends where the ETFs offer that feature.

The DRIP purchases included the following:

Fundamental Portfolio

• CRQ - Claymore Canadian Fundamental Index Equity large cap - 6 extra shares
• ZRE - BMO Equal Weight REIT - 2 shares
• ZRR - BMO Real Return Bond - 6 shares

Cap-Weight Portfolio

• ZRR - BMO Real Return Bond - 6 shares

The leftover cash is now sitting in each account. The Cap-Weight portfolio is starting to pile up the extra idle cash while the Fundamental Weight portfolio is putting it to good use by reinvesting.

I'm going to substitute the new Horizons BetaPro TSX 60 tracker ETF (symbol HXT) in the cap-weight portfolio since its total return swap construction reflects implicit automatic DRIPing and I want to find out about the difference in weighting strategy not the effects of DRIP, which will always be beneficial to the ETFs that do it in rising market.

The net difference between the two strategies is pretty slim, with each one ahead in 3 holdings (I ignore the RWX since they both hold it and the Cap-weight is ahead merely and always because it holds one more share) and the Fundamental Weight portfolio is in the lead overall by only 0.1% or so ($171 on a $111,000 portfolio). It's a tie so far.

Cap-Weight vs Fundamental Portfolios: Q3 Update, Guess Who Leads

Regular readers may recall that a few months ago I started a contest to see whether a portfolio based on Fundamentally-weighted ETFs would do better than the traditional standard Cap-weighted index ETFs. This contest is meant to be as realistic as possible using actual funds, including trading commissions, currency effects, distributions, DRIPs etc.

The quarterly distributions have all been announced, though not all received as BMO only pays out on October 7th and Claymore on the 6th (so their DRIP calculation will have to wait till then).

However, the quarter end was yesterday so it's opportune to take a snapshot look at how the contest is going (in order to do the comparison I've assumed a bit precociously that the dividends owing by BMO and Claymore are in the cash account now until the DRIP happens, which skews the numbers by $111 in favour of the Fundamental portfolio). With or without that cash, the two portfolios are neck and neck - with the cash, the Fundamental leads and without it, Cap-weight would be ahead. It is less than $100 difference in total either way, or less than 0.1% of the $100,000+ portfolios.

Other observations:

• Strong portfolio gains: both portfolios up almost 10% since June!
• Correlated asset classes can be good: every single ETF / asset class in both portfolios has gone up since June. That's highly unusual and sure not to continue for very long. The value of having a diversified portfolio is still evident in the large disparity between the gains amongst the ETFs. If one had only been invested in Canadian large cap equity with a 4% gain and bonds with a 2% gain, the overall portfolio gain would have been somewhere in that low range. Emerging markets, Developed markets ex-US, international real estate, commodities and Canadian small cap and REITs all contributed percentage advances of triple or more Canadian large cap's. Another way to look at it is that not having a diversified portfolio means having to pick which asset class will go on a tear next in order to get good gains. Diversification = not as good as the best but better than the worst.
  
• Fundamental winning in most asset classes vs Cap-weight - leading by 5 to 2. It is still early days in our contest but this is going in the direction I would expect. ... However, where Cap-weight is winning (Canada large equity and Emerging markets equity), it is by enough to more or less balance things at the portfolio total. As I wrote about here, in the Canada equity case, I believe the difference is due to the ongoing Potash Corp takeover bid.
  
• No re-balancing required: in neither portfolio is the actual value of any asset class anywhere near to going beyond the 1/4 away from target that we said would be our rule for re-balancing; the Cap-weight percentages are slightly more out of whack compared to target, which is what we would expect from indices that rely on market prices - fundamental accounting weights should evolve more slowly. That will be interesting to watch as we go along. (in the updated spreadsheet that appears live at the bottom of this blog, I've inserted a new column in the individual portfolio spreadsheets that shows the ratio of each asset class' actual to target)
  
• Currency has reduced returns: the Canadian dollar has risen about 1.4% vs the USD since our launch, reducing our net returns on US denominated holdings and that is the same for both portfolios.
  

The contest continues ...

EDHEC Papers Burst Balloons on Cap-Weighted Indexing and SRI Funds

The EDHEC-Risk Institute, an academic institute with a practical orientation, has put out a couple of papers that knock down some investment wishful thinking.

In Does Finance Theory Make the Case for Capitalisation-Weighted Indexing?, authors Felix Goltz and Véronique Le Sourd, after reviewing the academic literature, answer that question quite categorically - "No, it does not". A cap-weighted index does not represent the market portfolio of finance theory and even if it could, it would not be efficient in a risk-return sense without making highly unrealistic assumptions. As they say, "... from a theoretical perspective, cap-weighted stock market indices seem to offer no particular advantage". It then becomes a practical problem to construct indices that offer higher return to risk trade-off (as expressed in higher Sharpe ratios). They offer their own Efficient Indices here and when they assess alternatives (Improved Beta? A Comparison of Index Weighting Schemes) like fundamental indexing, equal weight indexing, efficient indexing and minimum volatility indexing, the alternatives all beat Cap-Weighting (e.g. their US Efficient Index has outperformed the FTSE US Cap-weighted index by 2% annually since 2002 while lowering volatility). Of course, not all these better indices are investable for the average retail investor - so far only fundamental and equal-weight funds are available - and the costs of running the index fund could obviate the benefits (witness the sorry story of mutual funds in Canada) if too high (my assessment of US ETFs suggests they do preserve the benefit in real life and I've started a realistic portfolio experiment for a Canadian investor that includes Canadian ETFs).

The other foray into clarifying reality vs wishful thinking is The Performance of Socially Responsible Investment and Sustainable Development in France: An Update after the Financial Crisis by Noël Amenc and Véronique Le Sourd (again! does she like setting people straight or what?). Comparing the performance of SRI funds in France, they cannot really find any significant difference with ordinary funds in terms of risk-return efficiency. During the period of the financial crisis, SRI funds provided no better protection against the downturn. A subset of SRI, Green (environmental) funds, compared to best-in-class ordinary funds "... reveals, over the long term, higher alpha for green funds, with higher risks, including higher extreme risks." The paper's findings will give some comfort to the SRI-minded investor with its evidence that the investor need not lose out by going SRI. However, it does also remind us that SRI is no investing philosophy panacea either. I am currently reading Confessions of a Radical Industrialist by Ray Anderson and he leaves an over-the-top impression that going green is a sure-fire route to greater profitability. That may be so if you do it right but I daresay there are well run and badly run SRI and green companies, just as in any human activity (as an illustration of the principle for those with a reflective bent, I highly recommend the book Albert Speer: His Battle With Truth by Gita Sereny; it tells the story of a highly intelligent but amoral organizational genius who put his talents in the service of evil as the mastermind of Hitler's war production machine)

Investment Banks and Hedge Funds: the Bubble of the Past Quarter Century?

The Credit Bubble leading to the Crash of 2008. Who profited and where did all the money go? That's a question I have been asking myself since 2007 and the start of the credit / financial crisis. The answer I now believe is a) employees of investment banking; b) managers / employees of hedge funds; c) shareholders with stakes (i.e. whether as separate entities or whose profits flow up to a parent entity) in investment banking and hedge funds.

The Evidence: Read Baseline Scenario's Good for Goldman and Paper of the Year (hat tip to the Awl for the link) along with the April 15, 2010 speech by European Central Bank member of the Executive Board Lorenzo Bini Smaghi. The sources give stats and graphs showing that since around the mid 1980s employee compensation in these businesses has risen steadily far faster than any measure of education, risks or productivity would explain till it is around 40% more than it should be. This did not happen in the traditional banking side of things, only in investment banking and hedge funds. Smaghi says: "It is important to note that this is not due to rising compensation in “traditional” financial sectors like credit and insurance, but due to the large increase in compensation in non-traditional financial activities like investment banks, hedge funds and the like."

In addition, financial industry growth has taken an even larger share of GDP. Here is a fascinating graph showing US data from Research Affiliates LLC (reproduced with their permission - and thanks to blogger Preet Banerjee of WhereDoesAllMyMoneyGo.com for arranging this; the slide is also available as part of the Claymore-produced slide presentation Fundamental vs Traditional Index Investing on the Advisor.ca website - N.B. I have added to Research Affiliate's chart the red Bubble line)

The Fundamental Index Methodology used by Research Affiliates is built using four accounting measures of sector size to weight the index - sales, income, dividends and book value. It thus reflects the long term growth of the Financial Services sector in achieving actual results. Unlike the infamous Tech bubble of 2000, which was reflected in the brief spike of unrealistic share prices shown in the market cap weighted index on the left side of the slide, the Financial Services bubble has been building for decades. It has been made up of real sales, real profits and real dividends flowing to real companies and people.

When exactly did the Financial Services secular bubble start? That's a bit hard to tell, since as Smaghi discusses, the growth of Financial Services is a good thing up to a point since there is more efficient allocation of savings to capital investment and faster economic growth. But beyond a certain point, which he says the financial sector certainly surpassed, the excessive risk-taking and unproductive allocation cause bubbles and crashes, like the Tech bubble itself. "... excessive rents reaped by the financial industry lead to increased risk-taking which can endogenously generate boom and bust episodes..." Thus the expansion of financial services since the 1960s has not been all bubble, some of it has been beneficial.

I've drawn my Bubble line at the point in the late 1980s when salaries began their vertiginous ascent (see Fig.2 of Smaghi's attachments in this pdf), a point at which there is also a sudden higher rate of increase in the share of financial services in the Fundamental Index (i.e. when they started to make gobs of money) in the above chart.

What is the right size for Financial Services and where will the sector settle out?
It is more or less universally agreed that the Financial services sector is too big. The shrinkage has already started. The Fundamentals show it - note the shrinkage in sector size from 2007 onwards in the above chart. Markets expect it too - note a much bigger change in share in the above chart. This difference between the trailing results-influenced Fundamental Index and Market Cap Indices shows up in popular ETFs:

• USA - in Vanguard's Market Cap VTI, Financial Services = 16.4% as of 31 July 2010 vs Powershares RAFI PRF = 20.9% as of 31 Aug 2010
• Canada - iShares TSX Composite XIC = 29.6% vs Claymore Canadian Fundamental Index CRQ = 45% as of 3 Sep 2010
• World - Vanguard All-World ex-US VEU = 25.8% as of 30 April vs PowerShares Developed RAFI ex-US PXF = 28.9% as of 3 Sep 2010
  

Regulators will impose new regulation to control and to deliberately reduce the size of Financial Services (as the Paper of the Year post reports, regulation is the only thing that effectively controls the size of the sector, not market forces). But the authorities don't know how much to reduce -
Lorenzo Bini Smaghi: "...we still run into practical problems if we try to establish the right “threshold”[size of the financial sector], and research in this field has been very limited".

And there is lots of expert debate and disagreement about how to go about it (e.g. William Buiter at FT.com, others at FT.com, Smaghi's review of options), never mind the sometimes politically-motivated actions of governments (e.g. punitive revenge-seeking laws, which though perfectly justified in my opinion, they don't necessarily help the individual investor make money / avoid losing more).

It looks as though one measure sure to come is higher capital requirements of banks per the Financial Post. How much that will constrain the size of the financial sector is very hard to predict.

Investing Implications
When Larry MacDonald says he would be leery of investing in the US financial sector except for Goldman Sachs, maybe he's right. But the US financial sector has the lowest share compared to any major world index so maybe the market has already anticipated and priced in the effect of regulation-imposed slimming. Maybe it has even over-reacted, as can happen in crashes after bubbles. If the market has over-reacted, the Fundamental Index may still be closer to the eventual settling point than the market-cap index.

Lately the Canadian banks, who on the face of it have the most out-of-line highest proportion of the total stock market amongst Fundamental indices anywhere, and thus might be the most likely candidates for regulatory reduction, seem only somewhat likely to be heading towards shrinkage. Finance Minister Flaherty has publicly resisted calls for additional bank taxes (see the Toronto Star back in April). All five major Canadian banks are ranked among the Top 50 Safest Banks in the World and all 5 in the Top 10 for North America by Global Finance. And the proposed capital ratios mentioned in the Financial Post report are well within existing levels at all the major Canadian banks. Some are even talking of re-instituting dividend increases (see speculation on MoneyEnergy and in the Financial Post's Dividend hikes expected from National Bank, then Scotia and TD) so maybe it is a case that strong Canadian banks, already getting a significant chunk of their business outside Canada, are ready to expand into a shrinking less competitive sector beyond Canada's borders.

Bottom line: as an index investor with holdings in the Fundamental-weighted Index Funds like PXF, CRQ and PRF, I may be at slightly higher risk than Cap-weight investors in North America if the share of financial services is destined to return to pre-bubble days of 1986. I believe there is an appreciably higher risk for the non-North American Rest-of-the-Developed World (PXF). For now, I am not changing my portfolio strategy away from Fundamental Indexing to Market-Cap Indexing. Time will tell.

The S&P TSX 60 Index vs Claymore Canadian Fundamental ETF and Active Stock Picking

Take a look at the holdings of the supposedly passive iShares S&P TSX 60 Index ETF (symbol: XIU) and you will not find a number of companies that I would expect to see based on the philosophy of not actively selecting stocks but simply mimicking the overall stock market according to relative market value or capitalisation. The description of XIU on the iShares website says "The Index is comprised of 60 of the largest (by market capitalization) and most liquid securities listed on the TSX ...". Go into GlobeInvestor, do a stock search of all common stocks, then sort by the handy Market Cap column heading, compare the top 60 there with the XIU holdings and you are in for a surprise.

Missing from XIU are no less than eight stocks listed on the TSX amongst the 60 largest by market cap according to GlobeInvestor as of close of business September 1st:

• Newmont Mining (symbol: NMC) in 13th spot by market cap
• Great West Lifeco (GWO) 18th,
• Power Financial (PWF) 28th
• Boliden AB (BLS) 29th
• Domtar Canada Paper (UFX - that's what GlobeInvestor says, though maybe it should be UFS) 32nd
• IGM Financial (IGM) 45th
• Ivanhoe Mines (IVN) 51st
• Fairfax Financial (FFH) 52nd

Why is this so? The main reason is found not on the iShares website but in the index provider Standard and Poors' Canadian Indices Index Methodology document which states this about the TSX 60 Index: "It has 60 constituents and represents Canadian large cap securities with a view to matching the sector balance of the S&P/TSX Composite Index." If S&P merely followed market cap for the top 60, there would be much heavier weight in the financial services sector stocks. The Composite Index is only 30% financial services so the 60 Index is artificially made to look like it.

That's why such small companies as Inmet Mining and Yellow Pages Income Fund, neither in even in the top 100 by market cap, show up in the 60 Index.

In contrast, another ETF which weights its stocks by size according to fundamental economic factors, the Claymore Canadian Fundamental Index ETF (symbol CRQ), has a substantially larger allocation to financial services - about 45% lately.

For an investor seeking to mirror the sector weighting of the overall Canadian economy, XIU comes closer than CRQ, since Financial services (including two other sectors - Real Estate and Management) make up only 20% of Canadian GDP (2008 figures - see Industry Canada data here).

The fact that CRQ's weighting scheme is based on actual historical accounting data, i.e. hard numbers, shows to what extent publicly-traded stocks in Canada are comprised of the financial industry. Private companies must thus make up a disproportionate share of other economic sectors. The Canadian public market is lop-sided.

For an investor seeking to go where the money is, or has been in the recent past, in terms of dividends, cash flow, sales and book equity, then CRQ comes closer than XIU since that is the basis on which CRQ picks stocks.

But to say that XIU is a totally passive fund, which therefore conforms best to an ideal, is not really true. XIU is not inherently superior to CRQ. Choosing XIU or CRQ comes down to which alternative investment strategy works best - XIU's strategy being based loosely on market cap (which in turn is based on the market's opinion of relative future value) and CRQ's based on past results being maintained in future. Which strategy works best is a matter of practical investigation.

Addendum
Just finished a chat with a very pleasant gentleman at S&P Canada who said that the financial companies in the above list were indeed excluded to keep the financial sector weight in line with the TSX Composite Index. Three others - Newmont, Boliden and Domtar - are not Canadian companies, a criteria which also forms part of the index composition. The last, Ivanhoe, has too small a float. iShares needs to improve its inaccurate summary description to include the fact that aligning to Composite sector weights is a criteria and that only Canadian registered companies, not merely TSX-listed companies, are included in the S&P TSX 60 / XIU.