Passive Index Investing

Passive index investing has become an extremely popular form of investing. This strategy is not just popular with self-directed investors who manage their own accounts, many professional financial planners have moved their client portfolios to some form of passive index investing.

The growing popularity of passive index investing has led to a flood of products that are specifically designed to accommodate this style of investing. This competition has drastically lowered costs for investors and made passive index investing easier than ever to implement in your own portfolio with minimal prior investment knowledge.

Passive index investing can easily be implemented in just about any kind of account: RRSPs, TFSAs, and non-registered investment accounts to name of few of the most popular. All you need is an online brokerage account and some money to get started.

As with any investment strategy, it is important to take a long-term view and always be mindful of your current exposure to various forms of risk. Market conditions can change very rapidly and catch people off guard. Understand what is driving your portfolio returns—both positive or negative.

Be aware of apparent value adds. The main determinant of returns is the asset class mix, slight tilts within classes can add significant costs adding to long-term returns. With passive index investing costs matter more than anything else. As you are invested in the popular benchmark assets, the main cause of poor returns relative to those benchmarks are high costs.

What is Passive Index Investing Exactly?

Passive index investing, commonly called indexing, is a simple investment strategy where you hold the popular benchmark assets in an investable form. Current popular asset benchmarks include the U.S. S&P 500 Index, the U.S. Total Stock Market, Global ex-USA Stock Markets, the MSCI EAFE Index, Emerging Markets, and certain Bond Indices.

You cannot buy an index directly as they are just a computer calculated formula to measure the movement in price of a certain market or collection of markets. These indices need to be effectively copied though the holdings they track to become investable.

With passive index investing, you purchase funds that hold the components of the index they track in their correct weightings. These funds typically are available to investors as mutual funds or ETFs (exchange traded funds). Funds charge a management fee that covers the cost of maintaining the index components in their correct allocations and provide liquidity to investors in the fund. The management fee can vary between providers, but most good funds charge a fee that ranges from 0.05% to 0.25% per year depending on the holdings the fund has to manage. Some funds charge fees exceeding 2% per year for substantially the same product.

With passive index investing you typically would hold several different funds, each fund tracking an index that holds different components of the global investment universe. Most of the focus is on stock funds and bond funds as these represent two major asset classes with different return characteristics. How you mix these different asset classes will determine the historical level of risk and historical returns. This can provide some indication of how a portfolio with the same investments may perform in the future, depending on market conditions.

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Benefits of Passive Index Investing

There are a number of benefits to passive index investing. The first, and maybe most significant, benefit for self-directed investors is that passive index portfolios are very easy to manage. Academic research has shown that an investor can achieve great results by looking at their portfolio just once or twice per year. On these occasions they will simply rebalance their holdings to target allocations and then ignore them once more for another period of time.

The wide availability of index products also adds to the ease of management, although it can make asset selection a bit confusing for some investors. It doesn't matter where you live, which brokerage you use, or how large your account is. You will always be able to find good low-cost index products that you can purchase. Products within each asset class are substantially identical to one another so there should be minimal time spent on determining which exact fund to invest it. Just look at cost and trading volume to make your decision.

Another significant benefit is cost savings. Prior to index investing it was common for investors to pay an annual fee of 3% or more for a standard mutual fund that was invested in a selection of stocks or bonds. The returns of these funds after fees tended to be very poor over time. Ironically, most funds would end up lagging their appropriate benchmark by an annual percentage amount nearly identical to the fees they charged. This means most fund managers added no value to their funds by picking the stocks or bonds they thought would go up in price.

With the onset of passive index investing, fees have dropped massively. A solidly diversified global portfolio can be maintained for a management fee of 0.15% per year or less. With some trading and tax costs this might climb a little bit, but that depends on your personal situation. The funds themselves tend to be very tax efficient.

We live in a financial world where everything is benchmarked. Passive index investing means you will always perform at or very close to the benchmark. If the stock markets are suffering, you will suffer no more and no less than the average stock market investor. If stock markets are going up in price, you will participate equally in the prosperity. In this sense it is a very socialist and equal form of investing. On average your neighbours and friends will be doing as well or as poorly as you are doing.

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How Can I Invest Passively?

Becoming a passive index investor is very easy and it is a good place to start as an investor. First, you will need to open a brokerage account. I prefer using Questrade as my brokerage for registered accounts (RRSP or TFSA) and Interactive Brokers for non-registered investment accounts. Other good options to look at include Virtual Brokers and National Bank Direct Brokerage. While different brokerages are similar in many ways, their fee structure and order systems vary. The best broker for you will depend on your individual situation.

Once your brokerage account is funded, you can begin thinking about how you will build a portfolio within your account(s). Your passive index portfolio should be well diversified across different asset classes. Popular asset classes for Canadians to consider include: Canadian stocks, U.S. stocks, global developed country stocks (ex-USA or Canada), emerging market stocks, and Canadian bonds.

There are ETFs available where a single ETF holds stocks and bonds from all of the above mentioned asset classes and automatically rebalances them for you on a regular basis to a predetermined allocation mixture. These portfolio ETFs are available in several different allocation mixtures based on the level of exposure to stocks. The ETFs with high exposure to stocks (75% to 80%) are called Growth ETFs. Those with a mid-level exposure to stocks (60%) are called Balanced ETFs. Those with a lower exposure to stocks (40%) are called Conservative ETFs. Portfolio ETFs may be the best choice for most investors who do not want to spend a lot of time on their investments. There is very little chance of making mistakes and you have a high likelihood of experiencing returns that are close to the benchmark.

The main benefit not to go with a portfolio ETF is to slightly lower costs and increase tax efficiency. Portfolio ETFs charge an annual fee that is approximately 0.05% higher than holding the individual asset class ETFs on their own. However, much of the cost savings on the management fees can easily be eroded by rebalancing costs and making small errors in rebalancing.

Tax efficiency can be a more important consideration. Different forms of income and investment returns can be taxed at different rates for different investment accounts. There are also considerations for withholding taxes. This topic is more complex and will be addressed below.

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Building A Diverse Passive Index Portfolio

Diversification is an important and often misunderstood topic in the investment world. On the surface almost any passive index fund can appear very diversified. Funds hold many different investments. It is common for a single fund to hold several hundred individual stocks or bonds. Some hold thousands of different stocks or bonds. This variety of underlying assets does not mean the fund is diversified.

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Major Asset Classes

It is important to look at asset classes rather than the assets themselves. There are two major asset classes most passive index investors hold: stocks (equities) and bonds (debt). The components of these major asset classes tend to move together. If stocks as a whole are going up, most individual stocks will benefit and most major stock asset classes will benefit. Likewise when bonds as a whole are going up, most individual bonds and asset categories within bonds will benefit.

The main consideration of a portfolio is how much of your portfolio you should allocate to stocks and how much you should allocate to bonds. If a high percentage of your portfolio is invested in stocks, you should expect the value of your portfolio to change quite substantially to the upside and downside in different market conditions. Bonds tend to be more stable and at times they can offset declines in stocks. While stocks may be important to grow a portfolio, bonds are even more important to preserve a portfolio.

Stocks are often the riskier major asset class. Over the long term, stocks are driven by earnings growth as each stockholder is entitled to a share of the earnings of the stocks he or she holds. At its core it is a tangible ownership participation in a corporation. As the corporation does well, shareholders will value the corporation higher. The inverse is also true. Corporate profitability is highly dependent on economic conditions and occasionally, when the economy suffers, pessimism about future earnings can pervade markets and corporations may be valued very cheaply. Stocks are riskier and can vary quite a bit in price over the short and medium term. However, a diversified portfolio of stocks is much safer than holding shares of a few individual corporations.

Bonds are much less risky than stocks. Most bonds are debt issues by countries. However, bonds can also be issued by companies as corporate bonds. Bonds are graded by ratings agencies who asses the risk of the bond issuer and the likelihood of the bond and interest being paid in full. Without diving too deeply into the different ratings, bonds can be divided into investment grade (very safe to relatively safe) and junk grade (high risk). Investment grade bonds, particularly bonds issued by well governed countries, tend to be very uncorrelated to stocks. These bonds form the majority of bond holdings. Junk grade bonds often behave more like stocks than like investment grade bonds. Aside from junk bond issues, diversification does not provide as much benefit in bond index funds.

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Mixing Bond Assets

To build a portfolio, think first about your allocation and mixture of bonds. Bonds are the safer, steady component of your whole portfolio. Bonds shouldn't be relied on for rapid growth. Instead, bonds are what preserves your wealth and provides you with some income.

A portfolio that is approximately 50% allocated to bonds is considered a balanced portfolio. A higher allocation to bonds will increase your portfolio stability while sacrificing some returns. A lower allocation to bonds will somewhat increase returns, but increases your risk as well.

Putting this into numbers, a balanced portfolio will experience a 25% drawdown at least once over the course of your lifetime. Think about how much money you can afford to lose in your portfolio before you begin panicking. For many people it is roughly 20% to 25%. A more aggressive portfolio may seem appealing when markets are rising, but it can be extremely stressful and may lead to poor investment decisions when large drawdowns occur.

The most popular bond funds used by passive index investors are broad bond funds. These funds hold a mixture of government bonds, government agency bonds, and corporate bonds which are considered to be investment grade. These bond funds will allocate capital based on the size of the bond issuer. While this may not be an issue with government and agency debt, with corporate debt this means these funds allocate the most to the companies with the highest debt issuance.

I prefer to hold bonds as the highest form of safety and liquidity in my portfolio. For this reason, I prefer funds that hold only government bonds, tilted towards shorter duration bonds. This means I will sacrifice some returns when things are going well, but I may have an extra level of safety in poor economic environments. For example, in 2008 even investment grade corporate bond funds fell substantially in value at the peak of the crisis. Government bonds did not experience the same lack of confidence.

If you think of your bonds as being the safer component of your portfolio, you should avoid holding junk bonds. While the interest yield and returns may be higher on junk bond funds, they are much more risky than government bonds. Junk bond funds behave more like stocks than bonds in their return profile.

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Mixing Equity Assets

Equities are the asset class that drives your portfolio growth. You need to have growth to build your portfolio's purchasing power and reduce long-term risks of outliving your portfolio or not having a large enough portfolio to support your lifestyle. Equities may provide growth, but they are also much more risky than bonds. Even major equity asset classes have experienced drawdowns of 80%. These are extreme and historically rare situations, but they do occur.

You should certainly assume that your allocation to equities will experience losses exceeding 50% at some point your investment timeline. Full recoveries can take many years. If you are withdrawing money from your portfolio, your portfolio may be permanently impaired by a large allocation to equities if those equity assets go through a severe downturn.

It is important to diversify across the major asset classes within equities to reduce your portfolio risks and improve your odds of obtaining reasonable returns in a larger range of market conditions. Most importantly, you should be globally diversified.

For most passive index investors, this means allocating approximately half of your equities in U.S. stocks and half to the rest of the world. You should include both developed country stocks and emerging market stocks. You might also hold an allocation to Canadian stocks, although this probably is not necessary if you hold primarily Canadian bonds.

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Rebalancing Your Portfolio

A key element to passive index investing is choosing an allocation to several asset classes and maintaining that allocation over your investment timeline. If you are in the earlier stages of investing, you can keep your portfolio balanced by contributing to the asset classes which are lower than their target allocation.

You should make sure you rebalance your portfolio at least once per year. This prevents asset classes from drifting too far from their target allocation, tilting risks in your portfolio. You can also rebalance quarterly or semiannually to keep your target allocations more consistent.

Alternatively, you might rebalance based on deviation from the asset class target allocation. In this case, you may choose to rebalance if the asset class is 25% higher than its target allocation. For example, if emerging market stocks are 10% of your portfolio, you may rebalance back to 10% if they are currently above 12.5% or below 7.5% of your total portfolio value.

Rebalancing is critical to the success of passive index investing. Over the long term, rebalancing means you will buy assets that are cheap and sell assets that are relatively more expensive. This taking of profits is important and keeps your portfolio working smoothly. You do not want to buy and hold the most expensive areas of the market with no systematic approach to reducing your exposure before the inevitable correction.

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Passive Investing Across Different Accounts

In Canada we have several different account options for investing. The most popular ones being RRSPs, TFSAs, and non-registered investment accounts (or some similar variation of these). The main difference between these accounts are their tax structures. You can read more about each account's tax implications in their linked guides.

In order to benefit the most from tax savings, some passive investors will view all of their accounts as a whole portfolio, but will allocate to assets based on each account type to reduce tax impacts from their investments.

All returns in RRSPs can be viewed as being subject standard income tax rates that are just deferred until you make withdrawals from the account. However, it is possible to significantly reduce taxes on your RRSP withdrawals by using certain strategies to offset those taxes.

RRSPs also benefit from being a recognized pension plan in most of Canada's tax treaties with other countries. As a type of pension plan, other countries do not withhold taxes on distributions made to RRSP accounts. This makes RRSPs an ideal account to buy U.S.-listed ETFs which hold U.S. stocks.

All investment returns earned within TFSA accounts are never subject to tax again. This makes TFSAs an ideal account to hold assets that are likely to grow faster and those which pay high distributions that may be taxed. TFSAs are great for holding real estate investment trusts (REITs) and other equity allocations.

Non-registered accounts are subject to taxation along the way and benefit from the preferential tax treatment of capital gains and Canadian dividends. This makes your non-registered account a good place to hold your Canadian stocks allocation and your bond allocation if you use a tax-efficient bond ETF such as HBB.TO, ZDB.TO, or BXF.TO. There are also some very tax efficient bond ETFs intended for international investors that are listed on the London stock exchange and are priced in U.S. dollars.

If you are using portfolio ETFs, you might consider purchasing a U.S.-listed portfolio ETF in your RRSP account and a Canadian-listed portfolio ETF in your TFSA and non-registered account to save on withholding tax costs.

Strategically allocating your assets across different accounts to be the most efficient can save a moderate amount of money in taxes. My estimation is that the savings are likely to be up to 0.5% per year. However, do not let taxes dictate your investment allocation. It is more important to have an appropriate investment allocation first and maintain this allocation. Then allocate carefully across your accounts for some tax benefits as a second priority.

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Risks With Passive Index Investing

Passive index investing may be the most popular investment approach that has grown enormously in the past decade, but it is not without its risks. There are indications that many investors who choose passive index investing believe the strategy to be much safer than it is. As the stock market performed very well since 2009, stock allocations have been steadily growing relative to bond allocations. Today it is not uncommon for many passive index investors to have 80% or more of their portfolio allocated to stocks.

Based on investor behaviour in past market events, many people begin to panic when they see their portfolio down by approximately 25%. This is a rough number and every investor is different, but the general observations apply. When investors lose a lot of money in stocks, they tend to panic sell out of equities and move into cash or bonds. Doing this when stocks are likely at much more reasonable long-term valuations is devastating to portfolio performance.

If you choose to invest following the passive index investing approach, it is very important to make sure you are not over-exposed to stocks. Bonds are important for stability and they encourage good investor behaviour.

Using U.S. data and a global portfolio, over the past four decades an investor with a 80% allocation to stocks would have seen an annual return of 8.6%. An investor with a 40% allocation to stocks would have seen an annual return of 7.8%. However, the more aggressive investor would have experienced two portfolio drawdowns exceeding 30% with one at 45%. The more cautious investor saw one 18% drawdown while all other drawdowns were less than 10%. This difference is significant psychologically.

Most investors would be very well served by choosing a portfolio with somewhat lower annual returns and much lower drawdowns. They will sleep more comfortably and are much more likely to stay on track and committed to their portfolio strategy.

It is important to recognize that past returns are not repeated in the future. While passive index portfolios have done well in the past 80 years, they may not do very well in the future. There can be a lot of benefits if you diversify your portfolio across more than one strategy. This way you are not relying on one market approach to drive forward your portfolio returns.

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