Alternative Canadian Indexes

A reader, J.H., asked the following thoughtful question about non-market-weighted indexes in Canada (edited for length):
“I wonder if it’s wise to not buy a Canadian Index ETF because these funds are so over-weighted in financials and energy equity (as high as 65% in November in some indexes).

“I note a more equally-weighted fund, ZLB has beaten the index since its inception, and is doing better than the Canadian index during these unsettled times. It's designed to defend against volatility, but its composition of generally equal-weighted stocks also offers more diversity than a Canadian Index ETF. Index funds seem to be better investments when they have greater diversification, like those mirroring the US market. At least that's the hunch of this investor who is still learning the ropes.

“If ZLB is not for some, they could try a strategy of setting up their own Canadian portfolio of equally-weighted stocks.”
A great virtue of market weighted indexes is that when a stock’s price changes, it remains market-weighted. No trading is needed to rebalance as stock prices fluctuate. However, with equal market weighting or anything other than market-weighting, price changes put the allocation out of balance and ETFs must make trades to get back into balance.

This means that market-weighted indexes will tend to offer the lowest cost way to invest. Any other weighting method must outperform a market-weighted index by enough to cover the extra trading costs (and in taxable accounts income tax costs).

These higher costs may not be large, but I’ve cast my lot on the assumption that ETFs based on alternative weighting methods will not give better results after costs than market-weighted ETFs. I don’t know for certain whether I’m right or wrong about this, but that’s the choice I’ve made.

As for the concern about the concentration of financials and energy in Canadian stocks, I deal with this by only having 30% of my stock investments in Canada. The rest are in the U.S. and international index ETFs.

I can’t resist commenting on “during these unsettled times.” The present is always unsettled, and the future is unknown. The past seems more settled because we know the outcomes and they can’t change. The human tendency of hindsight bias makes us believe we knew the past would unfold as it did even though the truth is we didn’t know what was going to happen.

It’s true that over short periods of time some non-market-weighted indexes have outperformed market indexes. I’ve decided to bet this won’t persist. The bigger the gap in total costs between a non-market-weighted ETF and a market-weighted ETF, the more skeptical I am that the outperformance will persist. Others may see things differently.

Comments

  1. AnonymousJanuary 19, 2015 at 8:22 AM

    Not sure that I would even necessarily argue that ZLB is even more "equally-weighted". It appears much less diverse and much more susceptible to company-specific risk.

    ZLB holds only 41 companies; 252 for ZCN
    The top 10 companies in ZLB represent 38% of the fund, compared to only 35% for ZCN
    There are only 2 companies in ZCN with larger positions (% weight) than the largest in ZLB, so it's not as though ZCN is extraordinarily biased toward any specific companies. Granted the financial sector exposure is ~14% higher.
    As noted, the fee is 30 basis points higher for ZLB

    ReplyDelete
    Replies
    1. Michael JamesJanuary 19, 2015 at 8:31 AM

      @Anonymous: The equal-weighting crowd might argue that if one stock grows unreasonably large (think Nortel), ZLB would limit its exposure, but many more market-weighted indexes would not. In any case, I still prefer market-weighting.

      Delete
  2. AnonymousJanuary 19, 2015 at 12:00 PM

    “If ZLB is not for some, they could try a strategy of setting up their own Canadian portfolio of equally-weighted stocks.”

    Or, they could buy HEW which is actually an equally-weighted ETF tracking the TSX60 instead of a kinda-sorta-but-not-really equally-weighted ETF.

    Over a full market cycle, I would not really expect an equally-weighted index to outperform a cap-weighted index though.

    ReplyDelete
    Replies
    1. Michael JamesJanuary 19, 2015 at 12:10 PM

      @Anonymous: I guess it comes down to whether you're aiming for low beta, equal-weighting, or neither. I'm happy to stick with cap-weighting.

      Delete
  3. My Own AdvisorJanuary 19, 2015 at 6:10 PM

    I'll stick with my cap-weighted ETFs, and my individual stocks of course.

    I recall when J. Bogle was asked about any indexed products other than cap-weighted ETFs, he labelled them as "witchcraft".

    I've avoided low volatility and fundamental ETFs to date, likely always will but never say never. I'm just not convinced the extra fees for these products are worth the payout.

    Mark

    ReplyDelete
  4. GrantJanuary 19, 2015 at 10:29 PM

    The other point about equal weighted indexes is that they have a higher exposure to small cap stocks and would therefore be expected to outperform the broad market over the long term. You can get less expensive and more efficient exposure to the small cap premium by buying a cap weighted small cap Etf. Similarly for fundamental indexes and cap weighted value ETFs.

    ReplyDelete
  5. JHJanuary 23, 2015 at 2:14 AM

    Michael James, alias the Capped Crusader!

    :)

    ReplyDelete

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