Counselling - INDEX MANAGEMENT

When evaluating the appropriateness of indexing as an investment structure we must make a judgment as to whether the current structure of the index is prudent. Historically the Pension Commission has issued guidelines for prudent management of pension funds and the mutual fund industry has adopted regulations designed to ensure the prudent management of these funds. In both cases a limit has been placed on the proportion of a fund’s total assets that can be invested in a single company. This limit has been 10% of the book value of the fund.

Currently the S&P/TSX is the broadest index available in the Canadian market. The TSE 300 index is a market capitalization weighted index which means that the largest companies will have the largest impact on the returns of the index. This also means that the weightings of any single company or sector can change significantly from one quarter to the next as the market price of a company rises or falls. This can create difficulties for investors who wish to maintain a diversified portfolio.

Over the past few years we have seen all commodity prices rise and a number of Canadian resource companies have been taken over by global competitors. The result has been that the Basic Materials sector of the index is now dominated by agricultural commodities. It has also meant that the energy sector now represents a much larger sector of the Canadian markets than it does of global markets. The following chart demonstrates the difference between Canada and the rest of the world.

If you had invested in the S&P/TSX Composite Index on January 1, 2007 you would have had a portfolio that was over 75% Financials and Resource. These sector weightings could not be considered a diversified portfolio. The Materials sector has done very well since that date but the Financial have not. Large exposures to any one industry exposes a portfolio to higher risks from unforeseen events as we have seen in the banking sector over the past year.

These types of risks occur at the single security level as well as at the industry level. During the technology boom a more significant problem developed due to the gains in a few particular securities. Nortel at its peak represented approximately 33% of the TSE 300 index. The disproportionate impact of the returns from this issue and related company Bell is evident from the 1999 return of the index (31.5%). Without these two stocks the return from the TSE 298 was approximately 8.5%. This heavy weighting in Nortel was due to the very strong gains in this stock from 1998 to 2000.

There are two types of risk that investors must deal with. The first is systemic risk, or the risk of being invested. This has always been represented by the volatility of the index. The assumption is that the index is a proxy for the whole market. The second type of risk is called non-systemic risk, or industry and company specific risk. This non-systemic risk is reduced by owning a basket of securities that are not strongly correlated. Some research has indicated that a portfolio of 30 to 40 stocks will diversify away approximately 80% of the non-systemic risk. Other research has indicated that 17 to 25 securities will achieve adequate diversification. As a result it was always assumed that an index portfolio had diversified away this company specific risk.

The current composition of the Index, means that the reverse is now true. An index portfolio now bears more sector specific risk than a well diversified actively managed portfolio.

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