Issue #54 - High Price of Low Cost Investing

Over the last few years, the costs of investment products have been receiving a lot of attention and with good reason!  Far too many mutual fund managers provide little value for the exorbitant fees they charge.  In response, new ultra-low fee products have hit the shelves that promise better returns due to lower investment fees, but what are the consequences of these low-fees?  In this month’s issue of Innova Market Insights, we dive into the fastest growing segment of investment products in the world, Exchange Traded Funds.

 

Understanding Stock Indexes

Before we dive into ETFs, it’s important to understand the history of investment management services – and for that, we need to start with the indexes!

Stock market indexes are a collection of stocks lumped together to give you a general idea of how on particular market is doing.  When people talk about the stock market performance, they are usually referring to the ups and downs of stock market indexes.  In Canada, we use the S&P/TSX (TSX), a collection of Canadian stocks that represents the market as a whole.  The S&P/TSX tracks approximately 250 of the 1500 largest companies listed on the Toronto Stock Exchange weighted by size.  The index was created in 1977 with an opening value of 1000 points even.  When the collective stocks represented on the index rise, the index increases as well and vice versa during falling markets. 

During the next 40 years, the TSX rose to almost 16,000, representing an annual growth rate of more than 7%.  This metric is useful as a general gauge of market performance as it tells us the markets as a whole are up, and by how much.  Individually, the companies that make up the index may experience price movements that differ from the index, which can happen if bad quarterly results are released on the same day as the rest of the markets are up, or in the case of oil and gas stocks, if oil prices move in a different direction than the market as a whole.

The larger the company’s size, the greater its impact will be on the index’s movement.  The size of a company is determined by the price per share multiplied by the total number of shares available on the market, which is referred to as the market capitalization, or “market cap”.  By this measure, the largest company in Canada is the Royal Bank of Canada which represents more than 6% weighting of the S&P TSX.   In other words, if RBC has a bad day, it has a large impact on the index as a whole. 

This disparity in influence is one of the biggest flaws of the S&P/TSX as a general gauge of Canada’s economic health.  Over 35% of the index’s value is made of financial stocks with a further 20% going to energy stocks.  Obviously, energy and financial companies make up less than 55% of the Canadian economy, yet that is the weighting reflected in the S&P/TSX.

In the United States, the S&P500 is a much more comprehensive index comprising the 500 largest companies listed on the US stock market.  By comparison, financials make up less than 15% of the S&P500, which has more than 5 sectors with weights exceeding 10%.  Though still far from perfect, this weighting leads to a much more diversified index that produces a better gauge of the overall economic health of a country.

Investment Managers

Historically speaking, an investment manager parsed through the stocks listed on an exchange to develop a portfolio (grouping) of stocks that they felt might provide the desired rate of return for an investment client.  The investment manager would consider the investor’s goals and risk tolerance before looking through company financial statements to ensure that the long term prospects of a target company were sound and that their client was paying a fair price. 

This process became widespread with the advent of the mutual fund.  By pooling their investment dollars together, investors with similar goals and risk tolerance could benefit from economies of scale, improve diversification, and greatly reduce the costs of purchasing individual securities across multiple markets.  With growing popularity, the model of a central management team building investment portfolios on behalf of tens of thousands of investors in exchange for a management fee became the norm.  The successful management team who attracted $10,000 from 10,000 investors could see themselves earning $3,000,000 per year on their 3% management fee.

They say “A rising tide lifts all boats”.  With 7% annual returns being generated by the market alone, most investors were ‘ok’ to hold even the poorest performing managers.  In the world of investing, performance is often gauged in comparison to the indexes noted above.  This comparison lead many portfolio managers to a behaviour known as ‘closet indexing’ in which the management team would closely mimic the stock market index to generate returns that were close enough to the market to satisfy investors.  Obviously, replicating a pre-determined list of stocks without doing proper research is hardly justification for charging 3% per year.

Explaining ETFs

ETFS were developed precisely to address the issue of over-valued management fees.  Rather than paying someone to mimic an index, why not simply use a computer? 

An exchange trade fund is similar to a mutual fund in that it groups a series of investments together in a portfolio.  A key difference however is that it can be purchased directly from a stock exchange and typically doesn’t have a human manager to pick positions, relying instead on an index or a pre-determined formula to pick stocks.  For example, the largest ETFs in the world are often based on the same indexes we discussed earlier.  As such, an investment in a S&P/TSX ETF would buy up all 250 stocks in the index, mimicking the 6% allocation to RBC. 

The combination of simplicity, technological advancements, and economies of scale have led to impressive cost reductions whereby an investor can now ‘buy the index’ for less than one tenth of one percent.  Now that investors can buy a diversified portfolio at such a low cost, the question becomes, should they?

What Are They Actually Buying?

ETFs’ rise in popularity has in large part been driven by more fee-conscious investors searching for value.  Ironically, the ETFs that are being purchased in today’s market provide anything BUT value!  Given that ETFs trade on the stock market, it is easy to forget that ETFs are merely investment vehicles and not actual stock investments on their own.  To determine the value of an ETF purchase, one must first examine the composition of the underlying investment index. 

An appropriate metaphor is the surprise candy bags I used to buy as kids.  A convenience store in my area used to sell a mix of candy in a brown bag for $1, I distinctly remember buying one of them and tallying up the value of the contents only to realize that the bag only contained $0.90 worth of candy!  Similarly, far too many investors focus on the price of the ETF rather than its contents and the value of the underlying shares.

We must first understand that a rational investor rewards a company with a higher stock price for growing its sales and profits.  At present, we are seeing the exact opposite of this on the markets and the suspicion here is that ETF ‘surprise bag’ buyers are pushing up stock prices without rational consideration for what they are purchasing. 

Take Coca-Cola for example – previously one of my favourite stock positions.  Over the last 5 years, sales have continued to crumble in the face of an increasingly competitive marketplace. Since 2012, both sales and profits dropped 20% and 18% respectively.  Despite this, the stock price is up 30% over the same time period. 

Similarly, Procter & Gamble, maker of Bounty paper towels, Crest toothpaste, Dawn Dishwashing liquid, etc. have seen their sales drop 23% and profits fall 22% over the last 5 years, but their stock price appreciated by 37%!

This kind of disconnect should not occur when investors are being rational however it does make sense when you consider the amount of money that has flown into ETFs over the past 5 years. P&G and Coca-Cola were both in the top 25 companies of the S&P500.  As a result, anytime an investor purchased an S&P500 ETF, they were buying a company not because of its performance but because of its relative importance in the index.  Crucially, the importance of a stock on an index is a factor of its share price multiplied by the total number of shares outstanding.  Every time a share is purchased, the price of that share increases, and so too does that company’s importance on the index.

In other words, it is a self-fulfilling prophecy. Shares that are on the indexes are purchased as part of ETFs because they make up a big part of the index, and thus the shares continue to appreciate in value.  In turn  the increased value of those shares increases their portion of the index and are thus purchased even more by the ETFs who readjust daily to closely track their stated indexes, regardless of the actual economic performance of the underlying company.  Coca-Cola and Procter & Gamble are just two examples of companies whose economic performance are completely unrelated to its stock performance.

Not only does this explain the otherwise totally irrational behaviour of investors over the last three years, but it also explains why we have seen little to no volatility on the markets.  ETFs are popular among unsophisticated, do-it-yourself investors, so it is no shock that they continue to buy while investment professionals sound the alarm; there is no one to advise them not to!

One of the advantages to ETFs is how quick and easy they are to buy and sell.  I am concerned that once fear takes hold of the markets and a healthy price correction takes place, the DIY investors will be quick to push the sell bottom which could push the correction into a crash.  More than likely, these are the same investors who were late to the bull market (buy high), and will end up selling after having already taken some losses (sell low).

In the end, that is a high price to pay for a low cost investment.

Innova’s Strategy?

As many of you are aware, we make use of ETFs in our investment portfolios although we stay away from market cap weighted ETFs for the reasons noted above.  When we purchase mutual funds, we focus on managers who take the time to do their research and hold stocks not commonly listed on the index, thereby justifying their management fee.  Holding stocks that differ from the index is known as “active share”, which measures how much the investment manager is making their own choices rather than simply copying the index. 

Most of our key positions have high ‘active share’ as we prefer to find highly tenured management teams with established track records of picking concentrated stock portfolios.  In many cases, these funds tend to outperform their peers, leading to better overall returns.

All that said, with perfect hindsight, we would have allocated much more heavily to US equities, technology stocks in particular, despite their eye-watering valuations.  Given the concerns discussed above, we will continue to err on the side of caution, waiting for our opportunity to get greedy.