Friday, June 28, 2013

Canadian Index Instruments - Pros and Cons

Last post we discussed what exactly is the TSX Composite Index

Most investments containing Canadian equities are in some way measured against that index.  Is this justified or not and, as discussed here, is an active or passive vehicle the best one to choose for an investor?

Let's talk about this for a minute with a hypothetical scenario.  Let's say that it is 1999 and you own the TSX Composite Index in the traditional market-cap weighted manner.  You own technology stocks, including Nortel Networks, JDS Uniphase, and others.  These technology companies comprise over 1/3rd of your Canadian Equity holdings.  Did you want that exposure?  How did that work out for you?  Is there a solution to avoid overexposure to one stock or a sector of stocks?

Enter the Capped Index or Equal Weighted Index.  These have been created so investors can track equity performance without the 'bubbly' excesses of overinvestment and hype involved with many stock market manias.  Investors are also able to purchase active or passive instruments that track these indexes. 

There are also other new entrants into the index creation methodology including factor driven, intrinsic value, low volatility, income weighted, fundamental weighted indices and more.  These all have instruments available for purchase that track them. 

Now that we are fully confused about all of these options and choices what is an investor to do?  What is the 'right' index to follow?

For example, if your objective is high income and low volatility than a strategy employing instruments that use those indices may be best.  If your objective is to avoid bubbly market excesses, maximize growth, and take advantage of the small cap premium and value premium than a strategy employing those instruments may be best. 

In short, finding a fee-based advisor who works with low cost index tracking instruments like Exchange Traded Funds could help the most, provided the advisor listens to your needs.  Most importantly, it is vital to match your objectives with the indices and instruments that most closely fit what you are looking for in light of proper portfolio construction methods.

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