Index investing: Easy street

Part three of our “Six Winning Strategies to Build Your Wealth” series:
Want a low-cost investing strategy that beats most professional managers? Harness the humble power of the Couch Potato.

48

by Dan Bortolotti
October 25th, 2010

Online only.

48

invest_120
What I learned as an index investor

Steve Petras, 27
Registered Nurse; Hay River, N.W.T.

I read a lot of books before I started investing three years ago, and the data clearly show that indexing usually leads to higher returns than typical mutual funds. One book that I read recently is William Bernstein’s The Investor’s Manifesto. It really pulls together everything about the indexing approach and argues that picking individual stocks may not be the best strategy either. Bernstein says diversifying using ETFs or index funds is a better solution for the long haul, and I agree.

I decided to use one of the Couch Potato portfolios suggested by MoneySense. It was an easy process to set up the account and purchase the TD e-Series funds. Because I’m relatively young, I’ve taken a more aggressive approach. I’ve allocated 25% each to four funds: Canadian equities, U.S. equities, international equities, and Canadian bonds.

I chose the index approach because of its simplicity as well as the low fees. Behaviour has a big influence on an investor’s returns, and I think indexing reduces the number of decisions you make: I just let the market
do its thing.

That said, the crash of 2008-09 was a real eye opener. My emotions got in the way: I froze, and for six months I stopped adding to my funds. I didn’t sell anything, and I’ve since recovered all of my losses, but I would have done better if I had just continued with my plan and kept contributing every month.

…..

If you want to succeed in your career, get better at golf, or become a master gardener, you need to spend countless hours improving your knowledge and skills. When it comes to investing, however, it’s possible to succeed with a strategy that requires minimal financial savvy and no more than an hour or two a year. In fact, if you’re an index investor, the best thing you can do to your portfolio is neglect it.

Indexing investing makes no attempt to pick market-beating stocks, identify brilliant fund managers, or predict where the economy is headed. Instead, it attempts to capture the returns of the overall market at the lowest possible cost by using index funds and exchange-traded funds (ETFs) that track entire asset classes, such as the entire Canadian or U.S. stock markets, or the whole universe of Canadian bonds.

Despite its simplicity, indexing has proven highly successful over the medium to long term. The MoneySense Global Couch Potato portfolio (see “Indexing the world” to the right) has outperformed most global mutual funds for years. In fact, over most five-year periods, less than 10% of actively managed funds exceed their index benchmarks.

Still the strategy isn’t a magic formula, and it’s not suited to everyone. Here’s how to make the power of indexing work for you:

Choose the right vehicle. Couch Potato investors can build their portfolios using either index mutual funds or exchange-traded funds. ETFs typically have lower annual fees, but they’re not always the best choice. You have to pay a brokerage commission (usually $10 to $29) every time you buy and sell ETFs, and these fees can take a big bite out of a small portfolio. With index mutual funds, on the other hand, you can add money with no fees, which makes them suitable for small accounts and those who contribute every month. ETFs are a better fit for investors with six-figure portfolios who make only a few contributions per year.

Stay passive, my friends. There was a time when all ETFs passively tracked major asset class. But the market has exploded to include dozens of new products that have nothing to do with Couch Potato investing: some add leverage (which doubles your potential returns, but also your potential losses), promise inverse returns (they go up when the assets they track go down), while others are actively managed. If your goal is to earn market returns at the lowest possible cost, then stick to the basics: use index funds or ETFs that track broad-based markets.

Diversify globally. The Canadian stock market is dominated by banks and natural resources. Adding exposure to U.S. and international stocks offers far more diversification. “What I have learned over the years is that you have to be more diversified than we originally thought,” says Tony De Thomasis, president of De Thomas Financial in Thornhill, Ont. The index portfolios that De Thomasis builds for his clients include bonds, equities and real estate investment trusts (REITs) from around the world.

Resist the urge to tinker. There is no such thing as a perfect portfolio, so stop searching for it. Just choose a balance of stocks and bonds that suits your risk tolerance and time horizon: for example, a recent university grad who is comfortable with volatility might allocate 80% to stocks, while a risk-averse grandfather might go for 80% bonds.

“Whatever portfolio you choose in the beginning, make sure it’s one you’re comfortable with,” says De Thomasis. It’s fine to change your asset allocation if your appetite for risk or your investment goals change, he says, but don’t make adjustments based on where you think the market is going. “During the volatility in Europe this year, some of my indexing clients were saying maybe we should change. But once you have made a decision, it has to be left alone. If you’re just guessing, then you’re almost certainly going to make changes at the wrong time.”

How has the Couch Potato fared? The graph above shows the performance of a portfolio of 40% Canadian bonds and 60% equities, with the equities divided equally between Canada, the U.S., and international markets. Over the past 30 years, that strategy garnered impressive average annual returns of 9.7%. It’s important to note that for comparison purposes, the graphs for all strategies in this report show the returns before fees are subtracted, so the light blue line shows the performance of the underlying indexes only. However, to give you an idea of what impact fees would have, we also include after-fee performance for both the Couch Potato and balanced mutual funds (see page 42 for the funds). In this case, you’ll notice that the fees make all the difference: it’s only after fees that the Couch Potato comes out on top.

What can go wrong? Index funds do not offer protection from market declines: when stock markets around the world plunged during the tech wreck and again in 2008, active mangers could move into cash and avoid further losses. (Of course, many also missed the recoveries that followed.) Passively managed index funds and ETFs don’t have that option.

The strategy also requires patience. You’ll likely be tempted to abandon the strategy whenever the market crashes or your brother-in-law boasts about his huge stock-picking returns. “For most investors, even three years seems like an enormous amount of time,” admits De Thomasis. “We’ve had clients with great portfolios, but they were always thinking there was something better out there.”

Indexing the world

The MoneySense Global Couch Potato is an easy and low-cost way to build a broadly diversified portfolio. Here are two versions, one using ETFs and the other using TD’s e-Series index mutual funds. Portfolios under about $30,000 are generally better off with the latter option.

Allocation ETF option Index mutual fund option
20% Canadian equity iShares S&P/TSX Capped Composite (XIC) TD Canadian Index
20% U.S. equity iShares S&P 500 CAD-hedged (XSP) TD U.S. Index
20% International equity iShares MSCI EAFE CAD-hedged (XIN) TD International Index
40% Canadian bond iShares DEX Universe Bond (XBB) TD Canadian Bond Index
Total management expense ratio (MER): 0.35% 0.45%

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