The growing allure of index investing, dollarama’s downdraft, and scotiabank is getting oversold – the globe and mail database error 7719 at exe

Costs are easy enough to analyze: according to Morningstar, the expense ratio on the universe of fundamental indexing costs investors about 39 basis points. But there are signs that expenses are coming down. Competition and the embrace by fund companies of loss leaders has exerted downward pressure on expenses. Vanguard rolled out its version of actively managed factor exchange-traded funds (aka fundamental indexing), with a fee of 13 basis points. Some competitors such as Goldman Sachs have upped the ante (or is that lowered?) with funds like the ActiveBeta U.S. Large Cap Equity ETF, which charges just 9 basis points.

Outliers aside, fundamental indexing is still more expensive than old fashioned capitalization-weighted indexing. Costs may be trending in the investors’ favour, but these are still more expensive strategies to manage.


The reasons for this are simple: fundamental indexing has more asset turnover and will thus have higher trading costs. One recent AAII study showed a range of turnover from 14 per cent to almost 50 per cent.

Let’s generously ball park the turnovers at 10 per cent to 20 per cent annually for fundamental indexing versus 1 per cent to 2 per cent for funds tied to the Standard & Poor’s 500 Index. Over longer holding periods, I expect that cost differential will persist. Keep in mind that expenses are a persistent drag on returns.

Speaking of performance: the lure of fundamental indexing is that it outperforms traditional benchmarks, such as the S&P 500. There is a robust debate as to whether fundamental indexing is capturing anything more than classic Fama-French factors. The classic model looks at factors such as value, size, beta (market-beating returns), quality and momentum as sources of outperformance. We can debate where those gains come from – such as increased risk or reduced liquidity – but the actual performance of factors is understood. The question for investors is twofold: are the potential gains captured by fundamental indexers worth the extra cost versus factor-flavoured products offered by firms such as Dimensional Fund Advisors, Vanguard, Black Rock, State Street and others? And second, once you move from truly passive indexing, do you have the self-discipline to stick with it through both good and bad times? My experience has led me toward the traditional factor investments over smart beta.

So as an experiment, let’s compare a fundamental index versus its benchmark. This is an exercise fraught with selection bias, so without explaining why, I asked Michael Batnick, the research director for my firm, to choose a typical smart-beta product and its benchmark. He selected the Invesco FTSE RAFI US 1000 Portfolio, which tracks companies based on book value, cash flow, sales and dividends, versus the Russell 1000 Index, which is made up of large capitalization stocks.

From the end of 2005 to the present the FTSE RAFI beat the Russell 1000, but not by very much – and at a cost of 39 basis points. Based on price alone, the FTSE RAFI was ahead by a little more than 6 per cent, while the Russell 1000 trailed by just 1 per cent based on total return. My best guess is the reason for this is that the companies as a group in the Russell 1000 were slower to recover from the financial crisis and the Great Recession.

This gets into another issue, one of behaviour, since investors tend to get bored and restless, especially when their holdings lag. Having decided to invest based on a quasi-active strategy, they tend to use underperformance as an excuse to sell current holdings in search of higher returns. Almost always, that is when they make decisions they later regret. Looking at fund flows during the past decade, we can see how the marketplace is voting. High-cost, actively managed funds have seen trillions of dollars in outflows headed toward low-cost, passively indexed funds. Some of this money has moved toward factor-based investing, and some toward fundamental indexing. I have my preferences, but each is an improvement over paying up for market-beating alpha that never seems to arrive.

Dollarama Inc. ( DOL-T). Everyone knows spring arrived late to Canada this year. Heck, many people knew in February that April would be cold, given the spring outlooks put out by forecasters. And yet, here we are in the first week of June, met with a weather-related earnings surprise from Dollarama Inc., the retailer that almost always exceeds expectations. The company said its same-store sales, one of the most important metrics in retail, increased at 2.6 per cent in the quarter ended April 29, versus expectations of at least two percentage points above that. How in the world did markets get caught off guard on Thursday, with the shares falling nearly 7 per cent? And, more importantly, are investors overreacting? David Milstead reports (for subscribers).

Bank of Nova Scotia ( BNS-T). This stock is almost oversold, reports Scott Barlow. BNS has an RSI reading of 31.3 that’s not far above the buy signal of 30. BNS’s price has been sensitive to RSI buy signals but not consistently so. A buy signal in August of 2015, for instance, predicted a significant 7.6-per-cent rally to the end of October but too often, buy signals were followed by tiny rallies before further downside. December 2015 and January 2018 buy signals are good examples of unsuccessful indicators. (For subscribers).

It’s taken a while, but interest rates for conservative investors are starting to edge higher. The upward creep of rates can be seen clearly in what banks, trust companies and credit unions are offering people willing to lock in money for a year with guaranteed investment certificates. There are several options that will give you returns that meet two important requirements. One, they beat the latest inflation rate. Two, they beat the returns on high interest savings accounts. There should always be a premium for locking your money into an investment as opposed to keeping it in a liquid savings account. Rob Carrick reports (for subscribers).

A new Merrill Lynch research report detailing the firm’s most promising investment themes, and subsequent stock picks, carries the usual assortment of technology-based strategies where reasonable investors have a right to be skeptical. The potential applications for big data, for instance, remain unclear despite the hype, as do the adoption rates for electric vehicles. Of all the secular growth themes detailed, investments surrounding the global obesity epidemic – Merrill Lynch has coined the term “Globesity” – seems the closest to a sure thing, even though regulatory risk remains a factor. Merrill Lynch’s top picks are stocks where Ms. Ma sees a high degree of exposure to the obesity theme. The companies are a mix of pharmaceutical providers, health-products manufacturers and health services. Scott Barlow reports (for subscribers).

Since the financial crisis, investors have gone all in on three big bets. They’ve gambled that the U.S. recovery will continue to lead the world, that technology companies will be the big winners in the new economy and that growth will be worth more than value. People who bet on these notions have left their peers in the dust. At this point, though, it’s worth asking if our collective obsession with this three-pack of trends isn’t just a bit overdone. Ian McGugan explores this in Saturday’s Globe Investor.

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