Rodgers Investment Consulting - Counselling

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Counselling - INDEX MANAGEMENT

When evaluating the appropriateness of indexing as an investment structure we must make a judgement 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 TSE is the broadest index available in the Canadian market. Over the past year the resource sector, including oil and gas, has represented over 20% of the index and the interest sensitive sector over 30% of the index. 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.

Over the past year a more significant problem has developed due to the gains in a few particular securities. Nortel now represent approximately 30% 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 is Nortel is due to the very strong gains in this stock over the past year.

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 company specific risk. This non-systemic risk is reduced by owning a basket of securities. 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 TSE 300, with Nortel representing approximately 30% of the index means that the reverse is now true. An index portfolio now bears more company specific risk than a well diversified actively managed portfolio.