Index offers little diversification: Morningstar

Client education can be an uphill battle, but after many lectures on the evils of chasing last year’s winners, you’ve convinced your clients that diversification is the proper approach. But how well do you know the funds in their portfolio? Are they really as diversified as they should be?

“In order for diversification to be effective, you have to do it on a number of levels, and that’s particularly true of the Canadian market,” says Scott Mackenzie, president and CEO of Morningstar Canada. “Following the benchmark is not a practical means of avoiding sector concentration.”

While everyone knows that the overall market tanked in 2001, many clients might be surprised to know that half of the TSX sub-indices posted positive returns. In fact, Mackenzie says an investor who equal weighted the sectors in their portfolio in 2000, would have enjoyed an annual return of about 8% through the downturn.

While the flaw that allowed Nortel to dominate the TSX has been rectified by the capping of individual securities’ weightings on the index, there remains the problem of excessive sector weighting.

Currently the S&P/TSX Composite Index has a 72% weighting in just three sectors: financials, energy and materials. Granted, these are the industries that make up the bulk of the Canadian market at present, but a correction in commodity prices would soon change that.

“Does it make any sense to create a portfolio that is so heavily concentrated in two or three sectors, if you’re building a balanced and diversified portfolio?” he asked at Morningstar’s annual investment conference in Toronto on Thursday. “Of course not, but that’s exactly what you get if you purchase an index fund or a core equity fund — in fact, hundreds of Canadian equity funds are closely linked to the index.”

Mackenzie asks if the next prudent move might be to cap the sectoral weightings in the index. Of course, with all that capping going on, one might question whether indexing was still a passive strategy.

“Why don’t we take it one step further and actively manage our passive benchmarks? That’s basically what we’re doing,” he says. “When we capped those indexes, that was an active decision.”

Mackenzie says there is nothing wrong with tracking the market, if that’s what the investor actually wants to do, but since there are low cost ways of achieving this, they should not pay the same fees as they would for active management.

But, tracking the index too closely leaves an investor with a dramatic underweighting in utilities, for example, which make up only about 1.6% of the index, but represent one of the most defensive sectors.

“The point I’m trying to make here is that we just don’t know which sectors are going to fare better than others, so we turn to that tried and true method of diversifying in order to mitigate that risk that we’re taking on.”

Consider the various sub-indices as if they were individual stocks. Just because a company is large, does this mean a prudent investor should automatically overweight it? The obvious problem with this as an investment strategy is that it leads the investor to overweight the sectors which have already posted the largest returns, rather than seeking undervalued sectors in the market.

“As indexers and ETF proponents often remind us, the number of managers who outperform the index are few and far between,” says Mackenzie, but he challenges this assertion, pointing out that the data supporting it includes closet indexers as active managers.

Due to the nature of the Canadian market, with its relatively low liquidity and small number of true large cap stocks, there are many Canadian equity funds which offer little variation from the index.

These funds are able to beat the index when the market sours, because their managers are able to sell off holdings in favour of cash holdings, limiting losses. In an up market, however, the only way to beat the index is to differ from it. Tracking the index precisely leads to underperformance, once fees are deducted. In fact, during bull markets, an average of 70% of low-correlation funds manage to beat the market.

He also challenges the claim that identifying these few managers is difficult. “Whether [indexing] is intentional or unintentional, there are ways to identify those fund managers who are truly active or not,” he says, referring to Morningstar’s Industry Sector Concentration (ISC) tool.

To arrive at this measure, a given mutual fund’s sectoral weighting is compared to the benchmark index. The percentage difference between the fund’s exposure and the index weighting for each sector is tallied.

For example, if a fun has an identical weighting as the index in eight sectors, but a 10% overweighting in energy and a 10% underweighting in healthcare, these 10% variations are added together for a similarity score of 20.

The closer a fund mirrors the sector weighting of the index, the lower the score. If a fund scores below 10, Mackenzie says it should be considered an index fund. Between 10 and 15, it is “not materially different.” A score of 40 or higher indicates a sector fund, but 94% of funds will rank lower than that.

“I’m not discouraging people from buying low-cost index funds, or mutual funds that look like the index,” says Mackenzie. “The problem right now, is that investing in an index can expose you to some serious sector concentration.

“Market indices were built to track markets, but they were not built to build portfolios, and that’s particularly true in Canada.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(10/28/05)

Steven Lamb