Canadian Index Primer

When you hear the news that "S&P/TSX Composite is up 102 points today" most people have no idea what that means.  Today I hope to break it down so we can have further discussion about the instruments that replicate or compare against the index.

For starters the index is a creation of financial professionals for the purpose of having a widely agreed upon measuring stick which we are able to compare similar investments.  This allows people to see if the investment they have is under- or out-performing the index in question.  Here are some of the details about the TSX Composite Index -

Index Characteristics

Number of Constituents	237
Adjusted Market Cap (C$ Billion)	1,522.984
% Weight Largest Constituent	6.09%
Top 10 Holdings (Market Cap Share - C$ Billion)	524.864
Currency	CDN Dollars

Inclusion Criteria

• Listing: Only stocks listed on Toronto Stock Exchange are considered for inclusion in this index.
• Domicile: Only securities which are Canadian incorporated, established in the case of income trusts, or formed in the case of limited partnerships, under Canadian federal, provincial, or territorial jurisdictions are eligible.
• Market Capitalization: Stocks are assessed based on their float adjusted market capitalization. A company's float adjusted market capitalization is calculated by removing control blocks of 10% or more.
• Liquidity: Only stocks that are actively and regularly traded are considered for inclusion in any S&P/TSX index. A stock's liquidity is measured relative to liquidity thresholds

Sector & Top 10 - S&P/TSX Composite Index

Sector Breakdown

Sector	Weight %
Financials	33.97
Energy	25.02
Materials	13.88
Industrials	6.96
Telecommunication Services	5.57
Consumer Discretionary	5.30
Consumer Staples	3.07
Health Care	2.55
Utilities	2.04
Information Technology	1.65

Top 10 Constituents by Market Cap

Data is based on End of Day Values

Constituents	Symbol	% Weight
Royal Bank of Canada	RY	6.087
Toronto-Dominion Bank (The)	TD	5.093
Bank of Nova Scotia (The)	BNS	4.665
Suncor Energy Inc.	SU	3.234
Canadian National Railway Company	CNR	2.952
Bank of Montreal	BMO	2.727
Enbridge Inc.	ENB	2.533
Potash Corporation of Saskatchewan Inc.	POT	2.442
BCE Inc.	BCE	2.428
TransCanada Corporation	TRP

We can see a couple very basic facts about the 'TSX' -
1) It largely consists of financial, energy, and materials companies .
2) It contains 237 companies and the top 10 biggest companies make up over 30% of the index.

Up next . . . . how to buy the TSX.

Market Factors - Size and Value

One of the things I have noted over my years of investing is that research points to some notable premiums that can be captured when investing in equities.

The small cap and value premiums are well established over various time horizons in US market history.  See Fama and French Three Factor Model.

The table shows that the average value and small cap premiums in the US equity market have been positive over the indicated periods. The return premiums have been volatile, as indicated by the standard deviations. While the averages have been positive, the annual return differences have been negative for several of the years in the historical record.

The value premium is defined as the difference between the average returns of value stocks and growth stocks (value minus growth). Value is defined as the top 30% of stocks ranked by book-to-market ratio (high-BtM stocks); growth is defined as the bottom 30% of stocks ranked by BtM (low-BtM stocks). NYSE firms are used to determine the breakpoints for value and growth; AMEX and NASDAQ stocks are then added to the NYSE stocks to form the value and growth indexes. The small cap premium is defined as the difference between the average returns of small cap and large cap stocks (or small minus large). The size breakpoint each year for small and large is the median NYSE market equity (i.e., the bottom 50% for small and top 50% for large). AMEX and NASDAQ stocks are added to the NYSE stocks to form the small cap and large cap indexes.

The table shows arithmetic averages of annual premiums. For example, from January 1946 to December 2012, the returns of value stocks exceeded those of growth stocks by an average of 4.56% per year. The return difference had a 13.83% annual standard deviation during this period.

First Post - Why Indexing?

I have had a interest in passive, index linked, or enhanced indexing portfolio construction since 2007 and I took some major steps to further develop my understanding and use of these solutions over the past 12 months with a career shift into a fee-based financial planning practice here in the beautiful Fraser Valley.  For years, working at a different bank-owned brokerage, I was a prolific earner of trailer fees, which is a rather opaque and undesirable way to conduct business from my point of view.  Now, working for a different and more open bank-owned brokerage, I operate a fee-based financial planning practice to provide transparency and objectivity for my clients. 

In terms of portfolio construction, after determining client needs, asset mix and a financial plan, currently, I almost exclusively use index based solutions when building client portfolios with only a few exceptions for tax or other planning reasons.

My hope with this blog is to deepen my own understanding of the plethora of index based products available to Canadian investors by featuring and analyzing the various products from time to time.  Additionally, I hope to provide insight to readers that will help them understand why index based investments are the preferred method of portfolio construction after developing a suitable asset mix.  Lastly, I hope to profile why fee-based financial planning, in combination with a passive investment approach, works out exceptionally well for clients over the long-term.

Enjoy

And to finish today's post I quote William Sharpe:

"Today's fad is index funds that track the Standard and Poor's 500. True, the average soundly beat most stock funds over the past decade. But is this an eternal truth or a transitory one?"

"In small stocks, especially, you're probably better off with an active manager than buying the market."

"The case for passive management rests only on complex and unrealistic theories of equilibrium in capital markets."

"Any graduate of the ___ Business School should be able to beat an index fund over the course of a market cycle."

Statements such as these are made with alarming frequency by investment professionals¹. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.

If "active" and "passive" management styles are defined in sensible ways, it must be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.