Weaknesses of Index Funds and ETFs
Much has been said about the inability of active managers to beat the stock markets. While this is sometimes true, it’s not always the case. In fact, passive management can easily expose people to undesirable investments, without realizing or intending to do so.
Passive Investing Overview
There are two broad categories of investment management: active and passive. Active management is the practice of trading carefully selected investments based on relevant information. Passive investing is mirroring the components of a market index and is usually done through an index mutual fund or an exchange-traded fund (ETF). For example, the iShares Canada S&P/TSX 60 Index ETF (symbol XIU on the Toronto Stock Exchange) is invested in the 60 stocks of the S&P/TSX 60 index on a market capitalization basis.
If an investor feels bullish on large Canadian equities, owning an ETF such as XIU is a good choice. After all, how worrisome is it to own Royal Bank, CN Rail, Canadian Natural Resources or Manulife Financial stock?
The issue
Where ETFs or index funds can become problematic is when they are used to gain access to smaller or more volatile sectors of the economy. Along with the potential upside of an index comes 100 per cent of the index’s risk. That risk becomes more emphasized as the scope of the ETF narrows. Additionally, the assets of an index fund or ETF must remain invested in a manner that replicates its underlying index, no matter what happens in the financial markets.
For example, during the financial crisis of 2008-2009, index funds had no choice but to continue holding the underlying indexes. The above-mentioned ETF, XIU, fell almost 50 per cent in less than a year, taking their investors along for the ride. Due to strategic trading, most actively managed Canadian equity mutual funds did not experience such declines.
Company risk
Another huge risk to index funds and ETFs is company risk, particularly in smaller, more popular areas of the economy. Demand for investments in these sectors can make it far too easy for bad companies to raise capital.
For example, consider the income trust sector during 2001-2008. Historically only used by the petroleum and real estate companies, corporations of all kinds, bolstered by extremely favorable tax rules and yield-hungry investors, began converting their common shares to income trust units. By 2005 the income trust sector in Canada was worth $160 billion, and income trusts were added to Canadian indexes.
Due to the prospect of easy money, the income trust sector attracted a lot of very poor companies. The quality of the sector began to fall. Because index funds and ETFs hold everything in their sector, they had no choice but to buy income trusts, regardless of quality. With an active investment strategy, a fund manager can pick and choose what to hold.
Company risk can also take the form of a company behaving in a certain way in order to meet the criteria of a particular index. For example, a poor-quality company may raise their dividend each year to an increasingly unsustainable level in order to continue being included in certain indexes. While a professional manager would be able to look beyond a dividend to discern the true health of a company, an index would simply include the company without further analysis.
Who should be wary?
Everyone who indexes should be cautious. After all, they are buying a specific sector of the economy in an unmanaged fashion. If that sector experiences high volatility or contains a lot of poor-quality companies, so will the investor’s portfolio.
Because there is no decision making involved, index funds and ETFs tend to have lower costs than actively managed funds. This can be a selling feature but should not be viewed as the most important factor of investment selection. People should always look beyond costs to understand why they are actually investing in, and consult with a financial advisor for further information.