Latest / The Chiro Money Show / 034 | Why "Just Buy the Index" Isn't the Whole Story (Part 2/3)
Transcript
- Chris: Welcome back to the Chiro Money Show, where we're helping chiropractors make better financial decisions so they can build stability in their finances and a lifestyle that they love. We're your hosts, Chris Scheele and Scott Campbell, financial planners with Align Wealth. Scott: Welcome back, welcome back. you thought last week's episode was a little nerdy, technical, what do you say Chris? Is it gonna get, is it gonna get worse? Chris: I don't know, we don't want to scare anyone away, Scott. Scott: water is warm folks, the water is warm. We're going to have a good conversation today. Fun topic. Chris: Yeah, yeah, So last week we talked about active management and what that means in the investing world. Some of the pitfalls of, know, mostly related to those high fees that you pay for active management and that net of fees, actively funds ⁓ tend underperform over the long term to the tune of 90 plus percent of the time. And so today we're talking about the most common alternative to active management, which is passive investing. Very, very fun, interesting, nuanced topic today. Scott: Yeah, as a refresher, have to keep in mind that the statistics out there say that roughly 70 to 80 % of the Canadian kind of investment retail market is still currently in actively managed funds. So there has been a growing shift away from active management to more of a passive strategy and investing, maybe not as prevalent in Canada as it has been say in the US, like we talked about in the previous episode, but we got to start. Here Chris, what is passive investment management? Walk us through that. Chris: Yeah, so start with, yeah, passive investing simply means just buying a fund ⁓ owns a list of stocks. And commonly we would connect this a market index. And so that that you're buying has one job and it's to match ⁓ that index. So we're not trying to pick winners or add different stocks at different times. We're not trying to time the market. We're simply saying, for instance, if the S &P 500 owns these 500 companies and you want to buy an S &P 500 index fund, that index fund's job is to mirror the S &P 500 as closely as possible with no tracking error. Scott: So there's two parties involved here, So there's the index provider. That's one party. So say there's a committee that that manages the S &P 500. They're the they're the committee that that essentially dictates when companies are added or removed from the S &P 500 index. And then you'd have a series of index fund managers that are putting together a fund that are trying to essentially mirror what the true S &P 500 index is compromised of. Chris: Right. Yep. And I think just to give some examples and paint some, make sure we're clear on the language. like index providers, this could be like the S and P S and P 500 or S and P T S X S and P is a company that provides this index. There's also MSCI, Dow Jones, the Russell. These are all examples of index companies that they make this index on the market. Okay. Now if you want to invest in those indexes, that would be done through a fund provider such as a Vanguard or a BlackRock or your local TD, E-Series, ETFs, ⁓ Scott: Yep. ⁓ of different ⁓ providers that are trying to replicate one of these indexes. ⁓ learned recently, this was an interesting stat that we heard of how many actual indexes are out there. We were in a room where this was pulled and I think the common guesses were right around what, five, 10,000, 15,000 different indexes. How indexes are there, Chris? Roughly. ⁓ Chris: 13 million different indexes worldwide. Scott: What? which basically means what? Chris: Basically if there is kind of idea that you have, there's probably an index made for it. ⁓ Scott: Yeah, we're essentially measuring something, right? Like we're trying to put together a certain group or collection of a certain type of company, be that like small cap, like a small companies or small tech companies or only companies that are in Japan that large in nature, like there's an index for everything, right? Yeah. Chris: Yeah, there's an index for everything. Exactly. So to say that you're an index fund investor, it's like, okay, well, what index are you trying to mirror? So there's 13, there's 13 million to choose from. hope you're picking the right index to mirror. that goes right into our one distinction we have to make here is that like passive investing has this, Scott: for sure. Chris: this belief that we don't have to make any ⁓ the reality is, as we've just illustrated, 13 million to choose from. So actually you do need to make an active decision before you even get started in investing. You have to decide ⁓ what are you gonna try to mirror and what are gonna buy to try to mirror that index. ⁓ Scott: All right, guys, I want you to give us an example. Could you walk us how you would go about even choosing a specific index to measure against? Like give us an example. Chris: Okay, so I think the easiest example is using the S &P the US 500 biggest companies in or so we think that's actually kind of wrong terminology. It's not actually the 500 biggest companies, but it is a select 500 companies in the US market, So that's probably the most common one that our listeners might've heard of. If you want to get US exposure, you want to try to emulate the US S &P 500 index. That's an example of one index, right? And so it's a common one. Scott: Okay. Yep. for sure. Often it's often kind of referred to as the market, right? The market. Yeah, but there's a much bigger global market than just the largest 500 companies in the US. Chris: the market in a lot of, yeah, totally. Right. Right. Exactly. And that brings up an interesting point that like, let's talk about US small cap. So small capitalization, small companies, smaller companies by market size or by company size, pardon me, in the US. So not as common as S &P 500, but still a fairly big market, like very big. So if you wanted exposure to US small caps, what index should you pick? Well, that's a great question. There's a bunch of different options. Like we could look at an S &P index that has small cap exposure or a Russell, like a Russell 3000 has small cap exposure or Crisp is another example. These three ⁓ different cap indexes that Scott: Hmm. Chris: have essentially the same mandate of what they do. Interestingly, look at a study of the last 20 years ⁓ three specific US small cap indices, their average annual has been five percentage points different over last 20 years, just with these three different indices. So, Scott: prettier. Yeah. Chris: Pick your small cap index fund wisely because it might make a difference of 5 % per year. So where do we start? I don't know. That's a great question, Scott. I don't know where to start to pick a US small cap index. Yeah. Scott: Right. Yeah, we're, well, the point that we're trying to kind of make here is that it's just not, it's not as passive or as, kind of simple as. maybe it's made out to be in terms of just like, I'll select an index by a fund that matches that index and you're good, right? In this case, you have to make an active decision. We're gonna talk about kind of the series of active decisions that kind of come with being a passive investor. One of them, like you said, you have to pick an index to match. And then you have to, once you pick that index, have to pick a fund manager that you're going to use to match that set index, Chris: Yep, and we've already skipped over one active decision, which is what's your asset allocation? You know, are you 100 % equity, 100 % stocks, or is there bonds or fixed income? Because that's gonna affect your decision as well. ⁓ Scott: geographical. Chris: geographical, do we want home country bias? How much weight do we want in Canada versus US versus international? And then, ⁓ yeah, what account should we invest in? So should it be RSP or TFSA? Should we care about our asset location? These are all a series of active decisions that we have to consider before we set out in investing passively. Yeah. Scott: Yeah. That's right. That's right. Chris: So I want to get into some stories, some examples of like funds and S &P 500 and kind of how indexing works that a lot of people are probably not quite familiar with. Scott, do you want to tell us the story about Lululemon? What's your favorite? Okay. Scott: I'll do Lulu, you do Tesla. Okay. All right. So what we need to know about passive index investing is that the index provider, in this case, we're going to talk about the S &P 500. They have their requirements for what qualifies for a company to be added to the S &P 500. Right? There's criteria. Chris: Okay, you go with Lulu. There's some criteria they have to meet. Scott: So what are some of the common criteria that we need to see to join the S &P 500, Chris? Chris: Honestly, the only one I'm aware of is that they have to have two positive quarters from a or earnings standpoint. Yeah. Scott: Yep. From an earning and profitability standpoint. Yep. And obviously they need to be sufficient. Like they have to be large enough to be considered like from a market capitalization standpoint. So are they big enough to qualify to get in? And are they profitable for, I think it's two or four straight quarters to get added into the index. Okay. ⁓ example that I want to share when it comes to ⁓ it's kind of referred to as ⁓ it's kind of like, it's kind like the waiting room. What happens over time is that I'm using BlueLimit because everyone kind of is familiar with that brand. But just because you are large enough and even in some cases where you have two or three quarters of profitability, it also comes down to a committee that's running that index to collectively make a decision to add a company to the index. Okay. So let's walk through an example. You're a fan of Lululemon. You've seen them grow from a small, local Vancouver, Canadian based company So in late, late 2018, they had become quite large in size, $17 billion market cap by that point. They were at that point comfortably a above S &P 500's minimum kind of requirement threshold size from a size standpoint to be included in the S &P 500. So they weren't added. A couple of years went by. zoom out to September of 2020. Their market cap hits 49 billion, larger than a meaningful chunk of the existing S &P 500 names, still not added. Then we fast forward to December, 2021. their market cap peaks at around $56 billion, which would have placed Lululemon in the top half of the S &P 500 by size. Still not added. So before I continue, you're an investor that's only in an index fund that's matching the S &P 500, you might assume that Lululemon is in your portfolio. Would you agree? Chris: Yeah, maybe. Scott: you would assume that like if if they're they're a large, they're a large company and surely they're in the S and P 500 given how large they were at that time. that they would be included in that, in that index, but they hadn't been yet. to continue the story. October we had to wait until October 18th my birthday For those that care just like how you brought that up a few episodes Chris October 18th 2023 Lululemon effective was effectively added to the S &P 500 So it was almost a five-year period of time in the waiting room where Back in 2018. They were almost large enough inside to be considered. They had some they had some quarters of profitability but they had to wait a long time from the committee standpoint at the S &P for them to be added to the index. Chris: Yeah, yeah. think there's just so much disconnect even with my opening statement where I basically said that the S &P 500 is the 500 biggest companies in the US. Like that's not correct. But a lot of people assume that when you're investing in that, that's what you're getting. And that if a company is on that list, you have exposure to it, which is simply not the case, Scott: right? And when we go, when we talk about active decisions, like we're kind of bringing this theme of like, there's a lot of active decisions that need to be made when it comes to passive investing. There had to, there was an active decision made by that, that committee who runs the S and P 500 index fund for them to decide when to add Lululemon to the index. Chris: Yeah. based on when the S &P 500 decides to add it. And we know from other past examples, say for with the example of Google, back in and 2003, the S 500 made the decision not to continue not adding Google to the S &P 500. And they actually made a statement about it at the time, which said, we're not going to add it because we believe what goes up must come down. Scott: Right. Chris: meaning that they were actually basing their decision on technical analysis. So they were essentially doing what active fund managers do when analyzing securities to add to their fund. ⁓ Interesting, when we expect it to be passive. Yeah. Scott: Yeah. Like, yeah. For sure. Chris: Okay, one other quick story about Tesla and I'm gonna talk about, this is similar. Tesla was also in the waiting room of the S &P 500, but I wanna talk about the other end of this as well. they were excluded, Tesla was mostly excluded for a few years because they didn't meet the profitability rule. But when they finally did meet that rule and were invited to join the S &P 500, they it was announced that they would be added one month later. So back in November of 2020, S &P 500 says, hey, one month from now, we're going to add Tesla to the S &P 500. So what happened over that period of time is that the stock price actually went from $130 per share up to $230 per share in those four weeks. Earnings hadn't changed. There was no There was no announcement that Tesla created some new technology, nothing like that. It was purely on speculation. And for reference, the US market at that time went up 4%. So it was a good run, good time for the market, but not to go from $130 to $230 per share. The reason it went up so much, beyond just the speculation and excitement of it being added to the S &P 500, Scott: Mm-hmm. For sure. Chris: is that everyone knew that on December 20th, every fund manager that manages an S &P 500 index fund was going to line up to buy Tesla. Because their job as a fund manager is to track the index with as little tracking error as possible. So on the exact day that it was added to the index, everybody lined up to buy it. That's kind like buying roses on Valentine's Day. You're going to overpay for the thing you want to buy. And everybody knows that. Scott: It's like playing poker with your cards face up. Chris: That's right. Scott: you're telling everyone your hand a month in advance, right? So for, that case, active managers know exactly what the index fund providers are going to be doing on a certain date, a month ahead of time, right? Chris: Yeah. Scott: the index fund provider is mandated to buy ⁓ on that specific ⁓ I think it December 20th of 2020. On that day, and not only on that day, but at the very end of the trading day is when the index provider will buy their share ⁓ of Lululemon for again, their goal is to have that zero tracking here. They want to be as close to the index as possible. So in order to do that, they have to buy it probably the most expensive price at the very end of the day. Meanwhile, the active managers, which we're not saying that we want to go active management, but they knew what the index fund providers were going to do a month ahead of time. Chris: if you know what what some big company is going to do a month ahead of when they do it You could ⁓ make pretty educated decision to you know to do about that Like if you know that your mortgage payments gonna increase a month from now when you refinance should you prepare now or should you just wait? Obviously you're gonna prepare if you know what's gonna happen Scott: That's right. Yeah. Interesting story and there's lots of there's lots of them out there like this Tesla's just a obviously big brand name with with a with an interesting story and the hype that came around that period of time but perfect example of the passive fund provider kind of being Handcuffed to their mandate of how and when they buy Tesla and how they add it to their to their fund Chris: Yeah. Another thing I want to talk about I ⁓ want to talk passive ETFs These we hear these phrases terminology kind of Used either all the time. It's ⁓ on a passive investor. ⁓ I'm an investor ⁓ I bought a passive fund or I bought it. I bought an ETF like What are these? What do they mean? Okay Scott: Okay. Chris: So passive we've already determined or like discussed is the idea is that this strategy of owning the market instead of trying to time the market and predict the future. So you're gonna try to track some kind of index. That's the idea of index investing. ETF is simply a vehicle or a fund that you can purchase to get exposure to that index. Where are they going to? It's kind of like the wrapper. Yeah, it's the product. You need a means to get access and that is either through that ETF or in the case of last week's episode, we talked about active management, which is traditionally done through actively managed mutual funds. Mutual fund is just a product. Doesn't mean they're all actively managed and the same thing applies here for ETFs. Scott: That's right. It's kind of like the wrapper. Chris: Just because it's an ETF does not mean it's passive in nature. Scott: Yeah, because there's also actively managed ETFs, right? Chris: There are, yes. And there's a lot of growth in the Canadian ETF space. So over the last decade, the amount of dollars invested in ETFs grew by 653 % over the last 10 years. So a lot of that is going from mutual fund to ETF or new dollars going into ETFs. That's not necessarily a bad thing. Scott: time. Chris: But it's interesting because large portion ⁓ the new ETFs that are being like So there's these are new new. Scott: newly launched. Chris: Yeah, they're newly launched products, ETFs that maybe mirror a certain index. Obviously there's 13 million indexes, so there could be 13 million ETFs. And then there's all these different other types of ETFs that are more specialized in nature, that are more active in nature. it's actually about 23 % of all dollars that are invested in ETFs are actually in in actively managed ETFs. Scott: It's surprising start. Chris: So if you ⁓ non-mutual fund active management and you've transitioned to ETFs, you could still be an active management if you're not careful. Scott: Yeah. Typically speaking, those actively managed ETS will have a lower fee than say your bank provided actively managed mutual fund, which we said the average was closer to 1.9 on our episode last week. Some of those actively managed ETS might be a little bit lower, but they're they're still higher than a passively managed index fund ETF. Chris: Yep. Yep, for sure. Scott: Is that fair to say? But I think the point that you're trying to make, Chris, is that I think the media and the, you do your research, I think a lot of people kind of conclude the fact that mutual fund bad, ETF good, and leave it there. Chris: Mm-hmm. Right. Scott: We're just trying to demonstrate the fact that you can be active passive, have higher than higher unnecessary fees, lower fees, both in the world of investing with through a mutual fund, which again is the vehicle or an ETF. Chris: I do want to add though that some of the fees ⁓ with these and mutual like just to give ⁓ some ranges, ⁓ right? So we last ⁓ about actively managed funds being the 2 % range, like average, I think we said 1.9%. We've seen actively managed mutual funds or segregated funds at three, three and a half percent or higher. On the ETF side, it's not uncommon to see management expense ratios in the like 0.2, 0.25 % for well diversified ETFs. to compare that now just for another point of contrast, like you can buy low cost mutual funds that are nicely diversified balanced funds that are in the same range of 0.28, 0.29%. So again, it's not so simple as mutual funds, high fee, ETFs, low fee, mutual funds, active ETFs, passive. There's so much nuance to it. We gotta know what we're buying and how we're invested. Scott: So what do you think the takeaway here, Chris, is? if there is a takeaway, how does that segue into the conversation that we're going to have next week in this three-part mini-series? Chris: Yeah. Great question. So I think the bottom line is passive is still better than active for most Canadians. do believe that, but the picture is nuanced and the media ⁓ does not it easy to understand. Even doing research it does not make it easy to understand. We also want to leave listeners with this understanding that Every passive fund still has a series of active decisions that are made by you, by the index provider and the index fund manager. And those decisions... Scott: that don't always yield in a necessarily positive outcome. Chris: Yeah, yeah, in a lot of cases those decisions are actually costing real money to the investor. Scott: Yeah. Chris: The other interesting point is that the indices or fund providers ⁓ care about the end investor. simply ⁓ an index or provide a product that mirrors an index. They're doing it based on what is best for the end investor. ⁓ They're it based on what they think they can sell. Whether it's passive ETF or an active mutual fund, same purpose. They're trying to get market share, so as much dollars as they can invested through their fund or tracking their index so that they can earn a profit. Scott: Yeah, like a Vanguard passive. index fund, doesn't matter which kind of indices they're trying to match. Their goal, like you said, Chris, is that we refer to it as zero tracking year. So say it's a Vanguard index fund that's matching the S &P 500, like we talked about. When the S &P 500 adds or removes companies from the index, Vanguard is going to match it on that exact same day. Their sole objective is not to get you a better return. Their sole objective is to have that zero tracking year. And if they do they're gonna proudly say, we've done our job. That's why you bought this product. We did our job and as close to zero percent tracking year as possible. And they hit their mandate, which is not a bad mandate, it's fine. Chris: That's right. Mm-hmm. That's right. Yeah, mean, it's probably suboptimal, but it's not bad. ⁓ Scott: That's what I mean. Like it's suboptimal, but it's not. We've talked about in the previous episode about how active management is a losing game after net of fees, right? So if Vanguard is charging a fairly low, you know, 0.2 % fee MER on their index ETF and they're hitting their mandate, like that's good, but like we're going to dive into in our next episode, is there something that you can do that's a little bit more optimal? Well, kind of staying true to some of the philosophies of passive being ideally global diversified, Chris: Yeah. Scott: keeping our costs low, but can we do a bit more than just following what the index does? Chris: Yeah. Yeah. That's the fun we have next week for our listeners. This third path. So is there, we're going to explore it. Is there a path that keeps the good parts of indexing like broad diversification, low cost, transparency, evidence-based design, but also drops the bad parts where you have forced trades at higher prices like Scott, like you were just sharing in that example. You know, is there a philosophy that exists? Scott: Got it. For sure. if you know Chris and I, we're going to be talking about a philosophy that's backed data, right? We're nerds at the end of the day, and we want the research, we want the data to support a good investment philosophy. ⁓ But the end of the day, your metaphor that you used earlier when it comes to index investing, it's like buying roses on Valentine's Day. I've never, I can't think of a time that I've done such. Like, if I'm gonna buy roses for my wife on any holiday, the day of. It's few days before when they're a little bit cheaper. Right? I still want the roses. Chris: Yeah. Any other day of the year is fine. Yeah. Yup. let's leave her there for today, Scott. ⁓ back. See you guys next week. Scott: Any other day of the year is fine, just not on February 14th. That's right. Sounds good. Thanks for tuning in. We'll see you all next week.