Wednesday, June 17, 2015

Why buying index can be bad

I saw a post by Lancelot Yoo on Why buying index is good, so I decided to explore the counter argument.

First, I will address the benefits that he listed:

  1. Well diversified portfolio
  2. Low management fees
  3. Easy to understand
  4. Safer than aggressive stock picking / trading

The 2 index funds that he was talking about are the index funds on the SGX that track the STI. One is run by State Street and is commonly known as the SPDR and the other is run by Nikko AM. Although both the ETFs are similar, I do not think that they are. The biggest difference is liquidity

Well diversified portfolio? Maybe.

This depends on your definition of a "well diversified portfolio". 

The index is very heavily skewed to certain sectors. Is the goal of a "well diversified portfolio" to have an accurate representation of the Singapore stock market, or to limit and reduce the risks by keeping sector weights to a maximum? Financials make up a whooping 51.15% of the index. "well diversified"? I don't think so. "accurate representation" is the better word.


Related to the heavy skew to certain sectors, is also the heavy skew to companies with bigger market cap. The top 4 constituents make up 42% of the index and the top 10 makes up 68% of the index. This means that the index is actively making a bet that the biggest companies are going to get relatively bigger than the smaller companies, hence the out-sized bets on them.

Compare this to an equal-weighted portfolio. In an equal-weighted portfolio, the weights would be a mere 13% for the top 4 and 33% for the top 10. An equal weighted portfolio can actually reduces unsystematic risks that comes from each company and enhance returns by inadvertently having a skew towards smaller cap and value.

Low management fees? Depends who you are comparing with.

For both index funds and individual securities, they have to be bought on the SGX though a broker. There's no way around it, so the minimum cost would be 0.18% of the transaction as commission.

For individual securities, that's where all the costs end, until you sell it. Still, selling an index ETF would also incur the same changes, so there's no difference.

However, index ETFs have expense fees, since rebalancing and managing the index is not free. This takes a bite of 0.30% (from the SPDR) or 0.42% (from Nikko AM) out of your portfolio.

Of course, compared to unit trusts which charge usually around 1.5% as their annual expense ratio, index ETFs are cheaper. After you add in the sales charge (which varies but realistically is about 3% if you are NOT buying from a discount broker), the fees really do take a huge bite of your portfolio. However, you aren't getting the same product. Unit trust managers have a different approach, and they can outperform (though, most would underperform) the index.

What has the lowest management fees? Individual securities. They have $0.

Easy to understand? Says who?

I don't really think so. Most people cannot even wrap their heads around the concept of a unit trust, which I think is much simpler than an ETF.

Aren't individual stocks even easier to understand? Followed by unit trusts? And then ETFs?

Anyway, this is a moot point. How does being easy to understand help much? Easier does not mean better.

Safer than aggressive stock picking / trading? Really?

Safer in what sense? Higher total returns? A guaranteed surrender value?

Diversification is a double-edged sword that not only reduces your downside risks from individual companies turning sour, but also caps your upside risks from an individual company turning in Apple.

There are many index ETFs to choose from, and you can also "pick" the wrong ones, just like how you can pick a wrong company.

As a listed form of security on the SGX, index ETFs can still be traded aggressively. Yes, the product can be bought and held, but it is also possible to trade with it. In this case, the "tradability" of the ETF has nothing to do with the product, but with the investor / trader instead.

Also, the constituents are actually PICKED for you using some sort of qualitative measure already. Yeah, you aren't stock picking. You are outsourcing your stock picking to... SPH, SGX and FTSE. And guess who is in the STI?

Somewhat related to the above point on market capitalization weight, an index fund does not allow you to avoid companies that you don't like, or at least reduce your exposure to them. You either take it, or leave it. This can mean that your investing dollars are going into "riskier" companies and sectors that might be overvalued, instead of "safer" ones that might be temporarily depressed. There is no ability to micro manage your allocation within the ETF.

Summary

ETFs are great products for people who understand the product, who realize that they are still making an active decision to follow one index compared to another, and really don't care about how the index is constructed, maintained or the companies that make up its constituents. It's for people who really wants a hands-off way of investing and would be satisfied with returns less than the market (because of fees). Basically, people that don't give a shit about what going on in the market. Many investors like to classify themselves as such, but meh, I think most are just lying to themselves that they are being "model students". I know I am not. I'm too free and too itchy to be a hands-off investor.

Now, don't get me wrong. As much as I point out the problems of ETFs, individual securities and unit trusts have their own sets of drawbacks and shortcomings too. This is the same for all products. However, to tout ETFs as a holy grail because of "diversification" is way too simplistic.


There is no one path to get to Rome. Firstly, no one ever starts at the same location, with the same resources and in the same circumstance. Then everyone has different preferences, tolerance and skills. And finally, we all have different destinations, or "Romes". Following people only brings you to their destination, that is, if you can even keep up.

15 comments:

  1. Why buying index can be bad?

    As compared to an individual selecting stocks?
    As compared to buying Unit Trusts?

    Can you tell me which a better choice?

    Tell me where I am going to die and I will not go there 

    ReplyDelete
    Replies
    1. There is no "better" choice. Choose any path also can die.

      Today eat KFC, McDonalds or Burger King? Choose any path also can get health problems in the future.

      The choice should depend on your own self. There is no simple answer to your question.

      Sorry.

      Delete
    2. KFC, McDonalds & Burger King ( Stock selection, units trusts) - Die faster
      Slice Fish beehoon (Lower cost, Better diversification Index ETF) - Live longer

      I am telling you where you will live longer :)

      Delete
    3. i think his last few paragraphs is to say that there is more than 1 way to live longer...

      Delete
    4. May I join in the fun?

      To Anonymous 8:00 AM,

      1) Will you ever do individual stock buys going forward? (Eat fast food once in a while)

      2) Or will it be index ETFs only and nothing else? (healthy food only diet)

      SMOL

      Delete
  2. hi SMOL :)

    I am the one who waits behind the head zebras until the lions have had their fill and than move to the front to eat the green green grass :)

    I will do individual stock buys (of good companies like F&N, STE, OCBC, WFC, JNJ, DOW during the GFC) when there is blood on the street, but then when there is blood on the street everything is cheap... so I will still chose index ETFs with the added elements of DCA and only investing with money that I do not need for the next 1 year:) and going LONG TERM of more >20 year (GM of 7 to 8%)

    The point I want to make is that it is VERY HARD for passive investors or most investors to beat the index in the long run thus my investment framework:

    Core investment: DCA, Long Term ETF index
    Individual stock buys: When the lions had their fill :)

    ReplyDelete
    Replies
    1. Anonymous 11:28 AM,

      Ah! An opportunistic omnivore ;)

      There you go! When I saw you "poking", I knew I had to join in.

      You have "substance"!

      Jolly good fun :)

      Delete
    2. This is a very conservative method which I subscribe to as well. Extremely passive, 99% of the time we have to carry on our 'real' jobs to earn an income.

      Delete
  3. Great post by the way.

    Fast food or healthy food, why not have both? The world isn't just black or white, there's grey and of course colourful rainbows.

    Healthy food may be good but it isn't suitable for everyone. Must eat in the right portions and perhaps, eat for a duration of time to see the positive effects.

    Disclaimer - I support "healthy food" too.

    ReplyDelete
  4. Perhaps novice investors could read the Random Walk Down Wall Street, it provides good insights on this topic, among other things. My 2 cents.

    ReplyDelete
  5. Hey everyone,

    I do agree that most people would be better off indexing than trying to stock pick. It is easier to execute and implement into a long-term savings / investing plan. Planning with no implementation cannot be fruitful, no matter what the final investment decision.

    My point of this post is to point out that as subjectively "good" indexing is, it is not the no-brainer investment choice for all investment decisions. There are pros and cons to indexing, as with other investment products. To say that it is the "best" fails to take into account the ability, resources and personality of each investor.

    Which is why beloved uncle Warren doesn't do indexing himself, and many others don't index as well. Is it because indexing is bad? Of course not. It is just different.

    ReplyDelete
  6. Thanks GMGH for your sharing (it helps me to see the other side of the coin, indeed a lot of people are preaching to novice investors like me to buy STI-ETF) and Anonymous for sharing the book title!

    ReplyDelete
  7. Well ah gong Warren is not just “any investor“ (to me he is part of the Superinvestors of Graham and Doddsville) and I honestly think that investors should consider what he had instructed to be carried out for the wellbeing of his wife before he goes to investors heaven.

    ”Index 90 %, bond 10% so that my wife will be well taken care of”

    Smi)e

    I am Anonymous of June 17, 2015 at 5:18 PM and June 18, 2015 at 11:28 AM

    ReplyDelete
    Replies
    1. Hi Anon,

      Of course he is not any investor, he is one of the best of our time!

      However, I think we are debating on different fronts here on what constitutes "good".

      To me, "good" means it will help you achieve your financial goals. I think ETFs can be "good", if used correctly, which also means understanding its pros and cons so you can see if it is suitable for you. But I also think that any product can help you do that if you use it the correct way.

      To me, it seems that you are saying that "good" is highest probability of a successful outcome. If that is the definition, then yes, most people would be better off using ETFs as their tool of choice, rather than trying stock picking. Many studies agree to that.

      However, because sometimes work 90% of the time for most people, that doesn't mean that it is the best solution for the remaining 10% of people. Left hand-ed people would be able to identify with this.

      If you engage in "opportunistic" stock picking yourself, it means you can accept that there are times where the reward of individual stocks can outweigh its risks and be more attractive than ETFs.

      What if someone is further along down that frame of mind and thinks that individual stocks should be the norm, and the lack of individual opportunities should default to ETFs?

      Delete
  8. Smi)e

    On the ETF Bandwagon

    ReplyDelete

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