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Is your index too active?

Index funds are increasingly popular with savvy investors seeking low-cost diversified portfolios. As an added bonus, they often outperform many mutual funds. Indeed, Warren Buffett said in his 1993 annual letter to shareholders, 'By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.'

But there is an astonishingly easy way to beat the index at its own game. It turns out that indexes are too active. That is, they tend to buy and sell stocks too frequently which puts a damper on their performance.

Instead of tracking the index, Jeremy Siegel looked at how investors would have done had they simply bought and held the original list of S&P500 stocks. From March 1957 through to the end of 2003, 341 of the original 500 stocks survived (including spinoffs) and only 170 were still in the S&P500. Performance wise, the S&P500 itself gained 10.85% annually over the period, including dividends. On the other hand, the original stocks posted annual gains of 11.40% with dividends reinvested. That's an annual outperformance of 0.55 percentage points for the buy-and-hold investor.

While a 0.55 percentage point annual advantage doesn't sound like much, it is larger than the annual fee charged by many low-fee exchange-traded index funds. In the indexing game, and with investing more generally, even a small advantage tends to balloon over long periods. But a small advantage isn't worth reaching for when other costs overwhelm it.

Thankfully for main street investors, commission rates have plummeted in recent years. For instance, Interactive Brokers charges as little as $1.00 per trade for U.S. stocks. As a result, the commission cost of buying each stock in the S&P500 could be as low as $500 or 0.50% on a $100,000 investment. If you live in the U.S., you have more even more low-fee options. But it is important to do the math for your situation. It may make sense to build your own index if you have a large portfolio and if you trade using a very low-cost broker. On the plus side, if you build your own index one stock at a time, you can avoid the 'outrageously high' annual fees charged by index funds and, if history is a guide, you may pick up the 0.55 percentage point annual performance advantage.

If you want to build your own index, there are different ways of doing it. The S&P 500 is weighted by market capitalisation which means that it holds more of the largest stocks and less of the smallest stocks. Instead of mimicking the index you could buy an equal dollar amount of each stock. Siegel reports that if you had bought and held an equal amount of each of the original S&P500 stocks, you would have gained an average of 12.14% annually. That's a 1.29 percentage point annual advantage over the index's return for the buy and snooze investor.

Let's put that modest advantage into more concrete terms. If you gain 11.40% annually over 20 years (in line with the S&P500's past results), you'd turn $1 million into $8.66 million. However, if you obtain the equal-weight buy-and-snooze's 12.14% annual return over the same period, you'd grow $1 million into $9.89 million. That extra $1.23 million sure sounds good to me.

But why do the buy-and-snooze investors beat the index? It all comes down to a matter of value. The stocks added to the index tend to be hot growth stocks which usually sport both strong businesses and good performance prior to being included. The dull stocks slated for removal tend to have underperformed. However, the low prices of the dull stocks more than discounts their poor qualities whereas the high prices of the glamorous stocks more than reflects their favourable characteristics. As a result, the index tends to swap good values for poor values which leads to underperformance over time.

If you are just starting to build up your portfolio then you might think about slowly accumulating a buy-and-snooze index portfolio by beginning with value stocks. For instance, you could start with the stocks in the index that have the highest dividend yields or those that have the lowest price-to-earnings ratios. With subsequent purchases you can then buy different stocks until you have built a complete do-it-yourself index.

So far I've stuck to the S&P500 which, with its 500 stocks, can be a bit daunting. But it is much easier to buy the 30 stocks in the Dow Jones Industrial Average or to mimic Canadian indices. For instance, the S&P/TSX Composite Index holds about 270 stocks and trusts. But conservative indexers will consider the S&P/TSX60 instead which holds sixty of the largest companies in the country. Even investors with more modest portfolios can think about buying small amounts of all sixty stocks in the S&P/TSX60 if the commissions they pay are low enough. As an added plus, the do-it-yourself indexer avoids the relatively high fees charged by many Canadian index funds.

Without a doubt, buying each stock in an index is a little more complicated than buying an index fund. But, by doing-it-yourself, you have the option of being totally passive which helps to reduce taxes, fees, and the performance drag of overly active index funds. However, the approach isn't for every one. You have to be willing to hold stocks for very long periods. Also, trading with a low-fee broker is a must and it helps if you start off with a sizeable portfolio.

Additional Reading

The Future For Investors, by Jeremy J. Siegel (ISBN 978-1400081981)

Long-Term Returns on the Original S&P500 Companies, by Jeremy J. Siegel and Jeremy D. Schwartz, Financial Analysts Journal, Vol 62, No 1, January/February 2006.

First published in the October 2007 magazine.

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