THE HIDDEN PERILS OF INDEXING

Active management may not raise your rewards, but it can cut your risk

Kelly Rodgers, MoneySense December/January 2000

AS I WRITE THIS COLUMN, A SMALL ARMY OF PEOPLE ARE publishing articles, selling books and delivering speeches, telling us again and again that indexing is the only investment strategy that makes sense. Some commentators suggest that any investor using actively managed funds must be suffering from an intellectual deficit.

Is the superiority of indexing fact or fiction? I'll admit my bias up front. I am a strong believer in active management. I don't think that the choice between active and indexing strategies is solely a matter of returns. The issue boils down to how you want to structure your portfolio to meet your objectives.

The people who believe in buying index funds always argue that indexing is the best solution because active managers usually trail the index. This is far too simple. Your first question when you hear this argument should be "which index?" Three U.S. indexes demonstrate how much one index can differ from another. Take a look at the accompanying table, Choose your yardstick, and you'll see three U.S. stock indexes with very different patterns over the past few years.

Choose your yardstick Different indexes can provide radically different measurements of the market   3 Month 1 Year 3 Year 5 Year Dow Jones Industrial Average -5.8%  31.8%  20.7%  21.9%  S&P 500 -6.2%  27.8%  25.1%  25.0%  NYSE Composite -8.3%  12.6%  25.1%  20.5%  Median U.S. Equity Fund -6.6%  19.7%  20.2%  19.3%

The Dow Jones industrial average tracks 30 stocks that were originally selected to represent the industrial core of the U.S. economy. These days, however, the index includes a big dollop of financial service companies and a significant dose of technology stocks. The Dow tracks the cumulative prices of the stocks that make up the index. As a result, the stocks with the highest share prices, such as IBM, have the biggest impact on the index.

The Standard & Poor's 500 index is a much broader gauge of the market, although it's still far from being a universal indicator. It includes 500 stocks. About 23% of those companies are in the information technology sector, about 8% in telecommunications, 11% in health care and 14% in financial services. Unlike the Dow, the S&P is based upon the market capitalization of each company - in other words, how much all the shares of a company are worth at any given time. The bigger a company is, the greater its impact on the index. In recent months, giant technology companies such as Microsoft, Cisco, Sun Microsystems have been driving the index.

Neither the Dow nor the S&P attempt to measure the overall stock market, just limited portions of it. The New York Stock Exchange composite index is more far-reaching. It's composed of all the stocks listed on the New York Stock Exchange, and it's based upon changes in stock price. This means that large companies or those with high stock prices don't have a disproportionate impact. The New York Stock Exchange composite is the most representative index of the U.S. stock market as a whole.

If you look at the U.S. evidence, you'll see that the median manager did match, or beat, "the market" over the past three years as defined by the NYSE composite index but failed to beat the other indexes. If you're a U.S. investor, you have to begin by asking which index most closely reflects your objectives. If you want the broadest possible diversification, then the NYSE composite index is the best yardstick by which to measure an active manager. And, by that yardstick, active managers have performed respectably.

This comparison of active management versus indexing becomes even more interesting when we look at three Canadian stock indexes: the Toronto Stock Exchange 300 index, composed of the 300 largest companies on the exchange; the TSE 100, composed of the 100 biggest companies; and the new S&P/TSE 60, which includes only 60 companies.

I've looked at each of these indexes and measured what percentage of their stocks are in the highly volatile resource sector and what percentage of their stocks are sensitive to interest rates. I've put the results in Hidden Risks.

Hidden Risks The three major Canadian indexes are heavily tilted toward resource-sector and interest-sensitive stocks   Resource Stocks Interest- Sensitive Stocks TSE 300 21%  32%  TSE 100 18%  36%  S&P/TSE 60 22%  25%

These numbers indicate that some of these indexes aren't really all that broad. If resource prices tumble, for instance, investors in all three indexes will be hit hard.

There are other dangers as well. Investors in the TSE 300 or the TSE 100 will feel the pain if interest rates rise. Say you have half your portfolio in bonds and half in a TSE 100 index fund. If interest rates rise, your bonds will tumble in price and so will a large chunk of your stock holdings. In all, 68% of your portfolio will he affected by the ups and downs of interest rates. If so much exposure to interest rates isn't consistent with your investment strategy, you may want to reconsider an index strategy.

If you're retired and you want to live off the dividends from your investment portfolio, then indexing is definitely not the way to go. The TSE 300 has a dividend yield of only 1.5%. Unless you have a very large portfolio, you're going to have trouble living off such a paltry yield. The solution might be to look for an index of larger cap stocks that pay higher dividends, like the new S&P/TSE 60.

If you want your portfolio to be highly diversified, though, you may want to steer clear of the S&P/TSE 60. Two stocks - BCE Inc. and Nortel Networks-represented 29% of this index as of the end of October. That's hardly a diversified portfolio.

The point is that none of these indexes, by itself, is a complete answer to every investor's needs. The goal of active management is to fine-tune a portfolio's risk. A manager who increases the risk has a chance to substantially outperform the index. A manager who reduces the risk may underperform the index and yet still do an excellent job. Before jumping on the bandwagon that says indexing is the simple solution, you should take the time to understand the index you're buying and decide if it actually meets your objectives. If the index falls short, you may find that active management still has a lot to offer.