Indexing: The Market Anti-vaccer

Most of us are familiar with the term anti-vaccer. An anti-vaccer is an individual who is opposed to the use of vaccinations which prevent the contraction of disease. Despite popular arguments to the contrary, an anti-vaccer is highly rational.

The anti-vaccer benefits in two ways. First, they avoid the costs of getting vaccinated: time at the doctor’s office, pain from a needle in the arm, mild illness associated with the vaccine, and any negative long-term effects we don't know about, or effects they personally believe in.

Second, the anti-vaccer benefits from avoiding the diseases the vaccine is intended to inoculate against. As long as the vast majority of the population does vaccinate—maybe greater than 80 percent of people in an area—the diseases are generally inactive and do not spread.

In this sense, being an anti-vaccer is the best personal choice. No pain, all gain. However, it only works to the extent that the larger population does take the vaccine and the diseases remain dormant.

If too many people refuse vaccination, diseases will spread and are likely to take out the anti-vaccers as well as those who vaccinate due to slight mutations which may render the vaccines ineffective.

Benefits of the Index

This brings us to the financial markets. We live in a time where an increasing amount of money is invested in the markets in the same rigid style—tracking a major index such as the S&P 500 or the S&P U.S. Total Market Index or some similar variant of these at a very low cost.

Indexing is highly rational. In theory, somewhere out there, millions of market participants evaluate listed corporations. They buy or sell stocks which establish their individual value. This may be through direct investor participation or via professional managers.

Investors buy companies they believe will rise in price, rewarding good management and good products or services. Investors will sell, or even sell short, those companies who offer poor products or services or are mismanaged.

We know that evaluating corporations for financial purposes costs money. There’s a substantial amount of research involved, analysts must be paid, money managers assume financial risks, office space is leased, regulatory requirements must be met, and naturally profits must be earned.

On the other hand, an index reflects much of the hard work taking place behind the scenes. Companies that active market participants value highly will rise in price forming a larger part of the index; companies which are valued poorly form smaller parts of the index.

Someone who simply buys a fund that tracks the index benefits substantially. Not only do they completely avoid paying the costs of active management, they benefit from a significant portion of the work done by active market participants. As I stated earlier, being an indexer is a highly rational and even a smart strategy.

Elements of an Index-driven Market

However, indexing carries a real hidden danger that is lurking within its design. It’s something to be aware of because we may be near the danger point.

Indexing works very well under two conditions. First, there must be a substantial amount of money investing in an active style to appropriately value underlying securities. Second, there must be a substantial net inflow of outside money into stocks to drive prices higher.

Active Share in the Market

On the first point, the latest research from Moody’s suggests approximately one-third of assets are now passively invested. This is set to grow to one-half of all assets as early as 2021. Moody’s counts only the funds which are explicitly passive.

Back in 2006, Yale University researchers found one-third of active managed funds were actually “closet indexers”. Closet indexers charge high fees and claim they are active, but they effectively track the index very closely with their holdings and performance.

This infiltration of closet indexing is mainly due to the trend of benchmarking to an index, the fee structure of most funds, and difficulty in allocating large amounts of money in a highly differentiated manner.

Closet indexing was rising rapidly across active funds already back in 2006. We know it was particularly prevalent in large-cap funds and the funds with the highest assets under management.

While it’s anyone’s best guess over a decade later, I would not be surprised if well over 50 percent of assets in the U.S. market are either in index funds or closet index funds.

Inflow into the Market

On the second point, we know investors behave in a herd-like manner. Money flows into the market when markets perform well and money flows out of the market when performance is poor. However, there is a larger issue looming.

Around the developed world, we are seeing a shift where a large amount of wealth is held by people moving into retirement. As these retirees stop contributing to their portfolios and start pulling out money to live from, money flow might begin to drop in a sustained manner—a worrisome trend.

Also, money flows are often closely associated to the overall money supply. As central banks around the world tighten the money supply, less new money is available to be invested in the financial markets.

Dangers Lurking in Index Fund Design

By their mandate, an index fund must invest their funds in a manner that closely reflects the underlying index which they follow. This means if a S&P 500 fund experiences inflows, it will inject those dollars exactly in the index weightings.

Currently (January 2019) for every $100 in inflows, the fund will buy $3.69 of MSFT, $3.13 of AMZN, $3.12 of AAPL, $1.79 of BRK-B, $1.59 of JNJ, and so on. This systematized buying drives up the value of these big names, even if they are not deserving of the "purchase at any price" methodology.

However, the inverse is also true. In a scenario where net inflows turn to net outflows, these same funds will sell the index constituents in their exact weightings.

Unlike the true active manager, there is no control mechanism in place in an index fund to hold the best companies or those with appealing valuations. Everything must get dumped out of the fund without consideration to any outside factors.

A closet indexer must follow the selling simply to avoid holding falling stocks and again failing to meet their index benchmark. Obligated selling begets discretionary selling, forming a vicious circle.

This worse case selling scenario could have a drastic impact on the markets, especially a market where maybe 50 cents of every dollar is forced to participate in selling regardless of price.

Shiller’s research on the 1987 crash suggests that roughly 10 percent of institutional money and wealthy investors had stop-loss mechanisms in place. Less than half of these were in the form of mandated portfolio insurance as part of their prospectus.

This means at most a couple percent of equity market assets were forced to sell into the crash. We now know this small percent of obligated selling caused a vicious selling cycle, ultimately causing the largest single day drop in U.S. stock market history.

Now we are in a system where ten or twenty times the market participation seen in 1987 is mandated to sell if investors flee these funds. If a virus takes hold, the devastation could truly be epic. Financial markets, particularly in the U.S. large-cap space, could experience contagion.

Strategies for Investors

Despite the gloomy thoughts I share in this post, I still believe index funds are the best way to invest for most investors in the current environment for several reasons.

When it comes to investing you should always act in your own self-interest. Why would you not choose low-cost funds that benefit directly from the efforts of active market participants?

There’s also the idea of “damned if you do, damned if you don’t”. If my vaccine analogy holds, a market decline would be felt harshly by those who index as well as those who are active market participants.

In other words, as a virus can mutate and infect those who vaccinated as well as those who are not, being an active market participant is not likely to save you from a disastrous market event as long as you participate in the market.

Instead, the best strategy is having a plan to avoid the mess. If a viral contagion occurred, the best thing to do is leave the crowds quickly and move to a remote area where you can sustain yourself with no outside contact indefinitely. Or at least until a cure is found. If financial contagion occurs, the best strategy may be to leave the market and wait out the disaster until the storm settles.

There are some simple, but not cost-less strategies that can help protect you in a systematic way that requires relatively minimal effort. The first would be investing via the Dual Momentum strategy which I share on this blog. Dual Momentum gets you out of equities when markets decline and into equities when markets rise.

That said, Dual Momentum comes with a very real expense: whipsaws. Whipsaws out of and quickly back into stocks will hurt your returns. During a rising overall equity market, Dual Momentum underperforms the equity index in many years. However, when the equity market experiences a sustained decline, Dual Momentum shines and significantly outperforms equities.

The nice advantage to Dual Momentum is that it’s easy to understand and execute while using low-cost index funds. Even a relatively inexperienced investor can follow Dual Momentum without any trouble.

Another strategy would be diversifying outside of U.S. stocks and bonds as these are most affected by the index trend. Although it takes more work—adding costs in the form of time or fees—investing strategically in safety holdings like precious metals, adding emerging markets and European markets to your portfolio, holding good cash-yield rental properties, and using stop-losses on your positions can limit the downside.

Like everything, I believe this cycle of indexing will subside in the future. There’s always room for indexing, but not everyone can be an indexer. As we've seen in the past, the system will fail when there’s too much money locked into a rigid investing style.

In a perfect world, indexing might be reserved for inexperienced, low net worth investors. Higher net worth individuals and those with experience can participate actively in the markets or pay a moderate fee to someone who can do that for them.

In the meantime, the active fund managers who are lazy and follow benchmarks, as well as the ones who charge way too much money for their services are deservedly going to be purged if this market goes down in an index-driven event.

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New Vanguard All-in-One Portfolio ETFs

I know I promised to talk more about leveraged strategies in February. I have been back-testing these strategies diligently and, believe me, I’m excited to start tracking them so you get an idea of my thought process.

However, Vanguard Canada just came out with some game-changing ETFs for passive investors! Now any investor can buy a single ETF and get great, automated results for a super low price (0.22% management fee).

This is the kind of competition stuff I love and it’s going to trigger a new price war for similar products with Blackrock (iShares Canada) and BMO ETFs. I just had to do a post on this!

It’s also why I stopped tracking the Couch Potato-like portfolios each month in the Portfolio Updates. There is no longer any compelling reasons to buy three or four ETFs and do the re-balancing yourself.

One-Solution Fund Products

One solution funds are a great way to make investing easy for investors. A single fund—usually categorized as “Conservative”, “Balanced”, "Aggressive", or “Growth”—will automatically re-balance stocks and bonds to a specified allocation on a regular basis.

These funds will mix Canadian stocks, U.S. stocks, International stocks, Canadian bonds, U.S. bonds, and International bonds for you. They may also add in other components like REITs, gold, commodities, and other asset classes.

Conservative funds target about 40% stocks and 60% bonds, Balanced funds target 60% stocks and 40% bonds, and Growth funds target 80% stocks and 20% bonds. There are some variations depending on the fund manager, but it looks pretty close to this.

There are also funds that tailor to other needs like Income funds, or Tax-efficient funds. Both are questionable in my view as they tend to be heavily marketed. In my skeptical mind, heavily marketed products are not doing a good job selling themselves so there is often a “catch”. In the case of these products, it’s usually higher fees while pushing the emotional sell of “less tax”. They tend to provide meaningful tax benefits to the small portion of investors who are very, very wealthy, but are often sold to the typical investor with less than $1 million in financial assets.

One solution funds do all the work for you. So instead of trying carefully to re-balance once or twice a year, maintaining balance with new contributions, or letting your allocations get out of wack—you just mindlessly buy the one ETF and get back to knitting, racing bicycles, or whatever else you enjoy. (Money is quite ho-hum after all).

Until now there was no great way to invest in a one-fund solution. You could choose Tangerine Funds and pay 1.07% in fees, you could buy a big-bank/insurance company rip-off mutual fund for 1.5 - 3% in fees, or you could invest in an iShares CorePortfolio product and pay 0.25% plus expensive fees in the underlying products up to 0.65%. In a nutshell, you were getting soaked one way or another on these total portfolio products.

New Vanguard Canada Multi-Asset ETFs

This month, Vanguard began offering a new suite of ETFs labelled Multi-Asset ETFs. These are one-solution funds that are truly low cost. The management fee is set at 0.22% and the underlying holdings are all low-cost Vanguard ETFs. I expect the true MER (Management Expense Ratio) with all costs included to be around 0.25%, but that’s a guess. That would land around $250 in total hidden costs per $100,000 invested.

These new ETFs are a fantastic deal as they are. In my mind, they are so cheap it’s not worth buying the separate ETFs and re-balancing yourself anymore if you're a passive buy-and-hold investor. You don't have to worry about tax triggers, screwing up your portfolio, humming and hawing about which ETF to buy this month, or any other worries that newer investors deal with.

All of these new Vanguard ETFs trade on the Toronto Stock Exchange in Canadian dollars—so no fuss with currency or exchange hassle. I think these new, cheap one-fund ETFs are the answer for most Canadian investors who want to manage their own money.

If you use Questrade or National Bank Direct as your brokerage, you can purchase these ETFs for free! Because you never need to re-balance, you don’t incur any extra costs directly. Basically you pay the MER (automatically deducted from your ETF) and that's it.

Vanguard Growth ETF Portfolio (VGRO.TO)

This is the new Growth ETF offered by Vanguard Canada. Consistent with it’s brand, it targets an 80% allocation to stocks and a 20% allocation to bonds. It’s an ETF wrapper product that holds other low-cost Vanguard ETFs, so let’s take a look at what the approximate holdings will be.

U.S. Broad Stocks:  30%
Canadian Broad Stocks:  24%
Developed Countries Stocks:  20%
Emerging Markets Stocks:  6%
Canadian Broad Bonds:  11.7%
International Broad Bonds:  4.7%
U.S. Broad Bonds:  3.6%

This portfolio is for younger savers with higher risk tolerances. It’s going to provide similar results as the Growth Portfolio I've been tracking monthly to this point. Returns are likely to be quite high in rising stock markets, but during a broad market downturn this ETF could fall around 40% in value.

Vanguard Balanced ETF Portfolio (VBAL.TO)

The new Balanced ETF is going to target 60% stocks and a 40% allocation to bonds. Again, it’s an ETF wrapper product and here are the underlying holdings rounded to approximate allocations.

U.S. Broad Stocks:  22.5%
Canadian Broad Stocks:  18%
Developed Countries Stocks:  15%
Emerging Markets Stocks:  4.5%
Canadian Broad Bonds:  23.5%
International Broad Bonds:  9.5%
U.S. Broad Bonds:  7%

This portfolio ETF will provide similar results to the Moose Income Portfolio, but it won’t have the tilt to dividend income. The downside risk is lower than the Growth ETF Portfolio (VGRO.TO), so this is designed for a middle of the road investor who can stomach a 30% drop in the value of their portfolio.

This portfolio configuration would typically be used by an investor with moderate risk tolerance and a longer timeline, or a retiree with larger savings and a margin of safety.

Vanguard Conservative ETF Portfolio (VCNS.TO)

The Conservative ETF will target a 40% allocation to stocks and 60% allocation to bonds. Here are the underlying holdings and their approximately target allocations.

U.S. Broad Stocks:  15%
Canadian Broad Stocks:  12%
Developed Countries Stocks:  10%
Emerging Markets Stocks:  3%
Canadian Broad Bonds:  35%
International Broad Bonds:  14%
U.S. Broad Bonds:  11%

This portfolio ETF is designed for a more risk-averse investor. I would say it might be most appropriate for a more risk-averse retiree or someone who gets nervous about even the smallest losses. It might also be a good choice for someone who needs to use their money in the mid-term (5-10 years).

In a relatively bad stock market situation, this portfolio will probably drop around 20% in value. That’s really quite small! In my view, if you can’t stomach a 20% drop, you should not be investing. Life is about risk management, not risk avoidance.

The Future of Portfolio ETFs

Vanguard seems to be the trend-setter in Canada when it comes to ETF products. However, you can expect that iShares, and maybe BMO, will soon offer competitive products.

Both iShares and BMO have the building blocks in place for low-cost portfolio ETF offerings, so I think it’s only a matter of time. In the past, iShares especially has really pushed to make the price of their competing products even lower than Vanguard. BMO tends to focus on being slightly different, so they might stick with more specialty products and drop the price a little on their Income Portfolio ETF (ZMI.TO). I guess we'll see.

I would not be surprised to see fees on portfolio ETFs drop to the high-teen range by 2020. This would put the fees just a few basis points higher than the massive portfolio mutual funds offered to Vanguard’s U.S. investors.

All in all, this is a huge win for investors! If you are an ambitious new investor, I would say you can still put all your money into XAW.TO and keep making those monthly contributions. However, once you hit around $50,000, you might want to change gears and throw money into VGRO.TO or VBAL.TO to temper the volatility of your portfolio. You might also choose to wait and see what iShares and BMO come up with…

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