Tuesday 13 November 2007

ETFs, Fundamental Indexing and Oysters

Fellow blogger Preet Banerjee over at WhereDoesAllMyMoneyGo was kind enough to send me a link showing an impressive-looking long-term out-performance graph of the RAFI Canadian Index over the S&P TSX 60 Index. The return is about 3.1% higher in the back-testing period of 1987-2006 with a lower volatility, as measured by standard deviation. Very impressive! Is it time to dump XIU (the iShares S&P TSX60 tracker ETF) and move over to one of (there appear to be a number of choices for the investor on these mutual funds - deferred sales charge, front-end, no-load) the ProFTSE RAFI Canadian Index Funds?

A bit of googling turned up a brief but instructive analysis titled Fundamental Indexing and the Three Factor Model by noted financial author William Bernstein (of Four Pillars fame). The article deals with the US but the principles remain the same for Canada and would for anywhere else. In it he finds that the approach of the RAFI index can be mostly accounted for by the value-equity tilt and, to a lesser extent, by the size tilt that fundamental indexing imparts and about one-third due to its own unique characteristics. And furthermore about the unique third, Bernstein concludes: "Unfortunately, this latter effect is not statistically significant, raising the issue of data mining. ... Differences in the expenses, fees, and transactional costs incurred in the design and execution of real-world portfolios can easily overwhelm the relatively small marginal benefits of any one value-oriented approach."

When one looks at the annual expense ratio of the Canadian Pro Index Funds at 1.85%, that latter warning becomes especially relevant considering that XIU's expense ratio is only 0.17%. So, if one takes the 3% out-performance of the RAFI index, which is not the fund and is before expenses, subtracts 2/3 for the value tilt, (which can be obtained with by buying the relatively new XCV iShares Canadian Value Index ETF, with the admittedly higher MER of 0.50%), one is left with only 1% out-performance, a gain that is completely lost with the higher expense ratio.

Fundamental indexing, as opposed to market capitalization weighted indexing, is an intriguing idea and has stirred a lot of debate since Rob Arnott launched the concept upon the financial world a few years ago.

But, for now I will follow the lead of the old wise oyster in Lewis Carroll's poem the Walrus and the Carpenter in Alice in Wonderland. The walrus and the carpenter invite the oysters for a pleasant walk along the beach, and this is the dubious oyster's reply:
"The eldest Oyster looked at him,
But never a word he said:
The eldest Oyster winked his eye,
And shook his heavy head--
Meaning to say he did not choose
To leave the oyster-bed."

If you don't know already, you can find out here what terrible fate awaited the oysters who succumbed to the ruse.


Anonymous said...

I am not sold on the benefits of FI either. I think John Bogle's opinion that FI is active investing by another name is true. Not sure if you read this criticism of FI by Bogle and Malkiel:


Anonymous said...

As soon as you put any thought into it, I think it becomes active.

The RAFI indices look impressive, but the thing that gets me is the fee attached to something that is supposed to be an "index". They are modeling their portfolio on a static screen and are charging a very high fee to do this really.

The reason ETF's are so cheap is due to the fact that you don't need a massive team of traders and analysts to create and manage the portfolio. The same would apply to these portfolios would it not? There is no active call involved.

Am I missing something?

Could this be the next generation of mutual funds? On one hand, it would be a step in the right direction - but not far enough. I think a long term realization is appearing that Canadians might not put up with exorbitant MER's forever, and a product like this is a bit backwards in a solution:

They've gone to indexing - but still charging a fee! :)

If the fees were in line with index funds - I would take a longer look.

Jean - a very well written and explained analysis!

Anonymous said...

Excellent post! I've been ignoring all the new ETFs and specialized products like FI (kind of a pretend index fund) since I think that you are better to focus on the big picture (ie your financial goals & asset allocation) and then get the basic tools to do the job.

Thanks for the link to the Lewis Carrol story. Not sure if I will read it to my son or not :)


CanadianInvestor said...

Preet, your comment made me think of another article I came across yesterday but did not include in the original post - a criticism on the Seeking Alpha website to the effect that the RAFI is not even an index since it does not represent the investment opportunity set because "an index serves to reflect the options that are available to an investor within any asset class". In my words, an index should be a reference point but the RAFI is not; it is rather, as Accidental Consultant says, an investment strategy. That doesn't necessarily make it bad or useless to the investor. The burden of proof does lie on the proponent of RAFI.

Another thought is that nowadays too often people assume ETF = index and index = good, but as we know, the labels often hide significant deviations, differences and obfuscations. Good material for posts and I invite you all distinguished bloggers to go at it.

CanadianInvestor said...

CC, just read the Bogle/Malkiel article - excellent, more wise oysters commenting! Thanks.

Anonymous said...

I believe you are right, there is much that we could write on those topics - both from a technical point of view and a philosophical one.

I forget who it was that came in for a presentation (average 2 a week) - I *think* it was powershares - they have some fundamental indexing products as well.

I think they will start to proliferate more and more. Most retail investors will have heard of the benefits of indexing and the marketing that is going into the FI products is getting bigger.

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