Do you beat the TSE??? (or, the Irrelevance of Indices)

Market returns are not your benchmark, so give them the (lack of) attention they deserve.                                                                                                                                                                                                                                           


Around the turn of the century, in a previous role at a major Canadian bank, I was part of a team that Investment Advisors would call in when they needed help presenting to a foundation, endowment, or their biggest clients.  We would work with the Advisor to evaluate the client’s needs, conduct the manager due diligence, construct the portfolio, and make the presentation.  It was a fantastic training ground, as I had an opportunity to work with hospitals, charitable organizations, and some of Canada’s most sophisticated and prominent investors and their professional advisors.


One evening, an Advisor asked us to speak, at a dinner, to a small number of highly affluent investors.  We delivered a thoughtful, engaging, and innovative presentation (IMHO) on portfolio construction, risk management, and the importance of suitability, after which we invited the audience’s questions. 


From the back of the room rang out a shrill voice in heavily accented English.  “Do you beat the TSE!”

“Well,” we explained, “it isn’t about beating the TSE.  It’s about preserving and growing your money in a prudent way.”

“Yes, but do you beat the TSE???” he cackled.

“Well, sometimes, sure, but that’s not what matters.  A properly constructed, balanced portfolio matters.  In some years, it will do better; in some years it won’t, but you don’t need or want TSE-level risk, and the TSE has nothing to do with anything, really.”

“Your fees are too high!” he retorted, and left the room. 


While somewhat entertaining, this man’s myopic focus on a specific equity index isn’t entirely his fault.  We, as an industry, shoulder no shortage of responsibility, for it is we who have encouraged investors to believe that “beating” an index is a desirable outcome in the first place.  As an industry, we have advertised on the subject, we have paid our portfolio managers based on this metric, and we taught our clients to think this way (e.g. “Yes, Mrs. Client, you were down 30%, but the index was down 35%, so that’s not bad”).


Here’s the reality: Indices have nothing to do with you or your goals.  They are constructed of various, changing, and sometimes arbitrary criteria, and you should pay them almost no mind, for they are a distraction; not a guidepost.


For example, the S&P 500, like many indices, is constructed using market capitalization.  This means that the bigger a company is, the bigger percentage it makes up of the index.  The index is not an aggregation of 500 companies representing a broad cross-section of the market, weighted equally.  Apple makes up 4% of the index.  Together, the top 10 companies make up nearly 20% of the index.  By the time you get down to company #500, Four Corners Property Trust, you’re looking at a 0.000431% weighting.  How broad of a representation is that? 


Think the Nasdaq is any better?  Apple makes up 12% of that index. On some trading days, Apple alone can determine whether broad stock indexes are up or down.  One Monday, the Nasdaq fell 1.1%, while the Dow Jones Industrial Average, which doesn't include Apple, rose 0.6%.  Let’s stay on the subject:  Judging by the S&P 500 and Nasdaq, Apple is important to, and representative of, the US economy and market.  If so, why is it not included in the famous Dow Jones Industrial Average?  From the Dow’s own “Indexology” blog:   


“Typically a company is added to The Dow only if (it) has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors. While it's true that both Apple and Google would certainly seem to meet these criteria, this qualification doesn't necessitate their inclusion in The Dow-nor does their sheer size, although it also weighs in their favor. The Dow's methodology allows for subjectivity, and ultimately stock changes are made at the discretion of the Averages Committee." 


The CEO of Wealthfront describes the folly: “Just thirty stocks, hand-picked by committee by Dow Jones, with no rigorous requirements.  Worse, it's a "price-weighted" index, which is mathematically nonsensical.  When calculating the Dow Jones Industrial Average, they take the actual stock prices of each stock, add them together, and divide them by a "Dow Divisor".  They don't take into account how many shares outstanding; they don't assess the market capitalization of each company.  When a stock splits, they actually change the divisor for the whole index.  It's completely unclear what this index is designed to measure, other than financial illiteracy”.


Let’s use a Canadian example.  In 2000, Nortel made up fully one-third of the TSE, which is also a market-cap (size) weighted index.  One third of the whole index!  Between October 1998 and June 2000, Nortel, along with its parent BCE, accounted for 75% of the TSE’s increase (and 75% of the its subsequent decline).  For many investors, their success or failure relative to the index depended on their allocation to Nortel.  How could one “beat the TSE”?  If one invested more than one-third of their portfolio in Nortel, then they would have been beating the TSE.  We all know how that story ended.  (If you don’t, click here).  How prudent would it have been to overweight Nortel, or to have anything even close to a market-weight position?  Why?  Why would you ever?  If your Foundation’s assets depended on it, would you do so because the index did?


Valeant, which was up 85% between May 2014 and May 2015, was responsible for 60% of the TSX’s gain.  Over the five-year period ending May 2015, Valeant was responsible for 20% of the TSX’s gain as it became the third highest weighting in the index.  Is that truly a representation of broad markets, or one company’s fortunes?  As of May, the TSX had gained 4 per cent over the past 12 months, compared with a 7 per cent drop for a version of the index that weights each company equally.  So if an investor is doing the prudent thing, they’re underperforming the market.  The investor who seeks “market returns”, and focuses on “beating the market”, having learned little from Nortel, may have taken a larger position in Valeant than the 5% of the index it represented.  And how did that go?  Click here.  Nisht gut.


Yes, when considered in aggregate, indices can provide a picture of how a particular market is faring, and they are useful inasmuch as they inform on the behavior of a specific group of assets, but which index is right?  There are dozens, if not hundreds, all over the world, with differing composition methods.  Which should you invest in?  How much should you allocate to each?  How much of your portfolio should Apple represent?  4%?  12%?  0%?  From a portfolio-management standpoint, what percentage of any index it happens to be is irrelevant. What matters is how much the company dominates your overall holdings.  Same goes for Valeant, Nortel, Citigroup, Enron, or any particular manager, fund, asset class, geography, style, etc.  In the words of Cliff Asness, “Trying not to be wrong is great and something we all strive for, but it’s not risk control. Risk control is limiting how bad it could be if you are wrong. In other words, it’s about how widely reality may differ from your forecast.”


It doesn’t matter how much of the index is represented by a single company or small group of companies.  The reason it doesn’t matter is because what the index does has nothing to do with you—the investor.  What should matter to you, and what our industry should better help you understand, is that you need to preserve and grow the purchasing power of your money (because $100K doesn’t buy today what it did in 1981, and $1MM likely won’t buy in 2040 what it does today).  What should matter to you is your ability to travel comfortably in retirement, live in peace and dignity, take care of your children and grandchildren and great-grandchildren, save the whales, build a wing in a hospital—whatever—but what should matter is your goals—and the steady, consistent preservation and growth of your wealth needed for you to achieve those goals. 


Two concluding thoughts: 


You have likely heard the prevailing “wisdom” that the stock market returns about 10% a year.  Well, maybe, but, sometimes it doesn’t.  Ending Q3 of this year, the TSX has returned an average of under 5% for the last ten years, and only 4% for the last fifteen years.  The S&P500 numbers are virtually the same.  They did so with tremendous volatility and huge swings in both directions, so for the privilege of these paltry returns, you had to endure high levels of risk—far too high for the returns you earned.  From our friends at Equilibrium Capital Management, “An investor who bought the S&P500 on January 1, 2015, would have paid a price near the index’s all-time high.  It then essentially flat lined at that level for 7 months (with volatility) before suddenly collapsing -10% during the July/August market swoon.  So, the recovery in September/October brings the value back to about where it was on January 1.  In other words, an investor would have endured a lot of market volatility (another word for “risk”) simply to get his money back.  Not the kind of risk-reward opportunity he would normally seek out.”  And why is this?  Because when you lose, you then have to earn back more than you lost—just to get back to zero.  The impact of losses is greater than the impact of gains. Click here for a visual explanation of why.  Losses destroy the power of compound returns.  If you lose 30%, you have to make 43% to get back to where you were in the first place.  So don’t lose 30%.


What is an investor to do?  Should you have any exposure to stocks and stock markets?  Yes, of course.  They are the purest exposure to economic growth and the strength of a capitalist society.  But you should not have your entire portfolio and future exposed to the machinations of the market, and you shouldn’t be relying on “the market” to go up to generate returns.  You should invest in a manner such that you can participate in market growth while insulating from market losses, by having investments that are not correlated to, or dependent on, market strength, and you should not be benchmarking your portfolio to market indices—you should be benchmarking it to your objectives and the growth you require to fund your life. 


True hedge funds, which, by definition, seek to hedge out risk that is inherent in markets, are an important part of a properly built portfolio.  Again from Asness in 2014, “In some years, like the current one, the press runs story after story about how hedge funds are being trounced by long-only stock indices (as an aside, out of simple familiarity, the press also focuses on the US stock market, which is trouncing the world this year, even though hedge funds tend to be more global, making the comparison seem more dire).  More generally, in my opinion, there are great problems and great promise in the hedge fund world. Hedge funds carry out strategies that are quite valuable (producing return with low correlation with traditional markets), such as merger and convertible arbitrage, derivatives-based trend following, macro trading based on value and carry that are not available in other formats.”  Instead of buying “the market” because it’s what everybody talks about and because it is a random line item you can get “cheap” exposure to, have a portfolio that is built to provide consistent and stable returns so you can grow your wealth.


Do you beat the TSE?  Who cares.








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