The Efficient Market Hypothesis and Indexing

We will get slightly more theoretical in this article, but we`ll keep it simple and brief!

The Efficient Market Hypothesis (EMH) states that stock prices perfectly reflects information currently available. The market is therefore perfectly efficient at pricing an asset. As the output of new information is, by nature, random (could be positive or negative, and to varying degrees) it would be impossible to predict the future trends of a stock by either technical or fundamental analysis. While this is simply a hypothesis (and one that does not come without controversy) it is interesting to discuss and see how it relates to index investing.

Following the hypothesis that the market is perfect at pricing a stock under the current conditions, trying to pick a winning stock (one that is undervalued) is a loser’s game. Beating the market would therefore be impossible. An investor would be best off investing in an index fund and enjoying normal market returns while minimizing fees.

The controversy comes from certain fundamental conditions or examples in the real world that challenge statements and assumptions of EMH, for example:

• The response time to new information varies, and therefore perhaps some edge can be gained by responding to new information faster than others.
• Information (and stock valuation) is not viewed the same by all investors, thus there is not a linear translation from information interpretation to stock pricing.
• Potential in human errors or emotions in influencing stock prices provide an additional element that the EMH does not account for. 
• Some proven investors do exist, such as Warren Buffet, that have consistently beaten the market over a long period of time.

While these concerns definitely hold weight, the market is becoming progressively more efficient in terms of response time to new information given how easy it is to trade stocks. This reduces the window of possibility for timing edges. There are also such a large number of investors participating in the market that if we assume information perspective (and stock valuation by individuals) is random, then the distribution of these random perspectives would average out to agreeing with EMH. This leaves emotional aspects, which contributes to variance in the market. Having said that, human emotions can also be viewed as random and thus making stock picks based on predicting human emotions would also be a loser’s game! Now there are definitely some stock pickers such as Warren Buffet that have disproven the EMH by being long-term winners in the market. As a Warren Buffet could simply not exists under the EMH.

Likely the EMH as a framework holds weight but it is influenced by some factors such as those mentioned above, which can challenge the legitimacy of the hypothesis during their extremes. Either way, it does reflect the high degree of randomness involved in trying to beat the market. Even if an exceptional investor continues to hold a winning strategy in beating the market, there would be high variance in the performance outcome due to vast uncertainties from randomness. As human beings are generally not good at dealing with uncertainties, investing in index funds may very well be the best strategy for the vast majority of investors.

Thank you for reading, if you have an topic recommendations please comment below!

Source: Dilbert

-Yinvestors.

Index Portfolio Planning (with Excel)

In our previous articles we’ve discussed how you can balance your index account using some example portfolio models, and we’ve also discussed the general importance of yearly rebalancing. In order to do this effectively, you will need to keep track of your progress. One easy and efficient way of doing this is to use excel. Excel is an extremely powerful tool and can do a lot of the work for you (which is perfect for couch potato investors).

Here is an example of an excel spreadsheet that I use:

In this example, our new investor has $5,000 to invest in a brand new TD e-series portfolio. 

Add in some equations and your portfolio distributions can be calculated for you. All you need to input (for numerical values) would be your initial investment amount and the % allocations you decide on. I like to include summation operators just to ensure no mistakes have been made before I place any orders. I also use the spreadsheet to keep track of which date I added to my investment as well as the reference number of each transaction.

It becomes very slightly more complicated when it comes to rebalancing, but follows the same logic. Here is an example of a spreadsheet for rebalancing:

To build on the previous example, our investor friend is adding $2,000 to his portfolio (one month later). For simplicity sake, we are assuming his investments have individually broken even over the past month (amounts are unchanged). 

This time you will need to enter your beginning account value. If you are not 100% confident with you excel skills, you can include more steps to reduce the use of longer formulas. Using the spreadsheets above I can easily add to my investments and have one master file that holds all this information for me. That way I know exactly when money was added, how my percentage allocations have changed over time, how much money was contributed, etc. It's simply good practice and not very complicated to do. I also recommend you save your file in a Dropbox or some other location that allows you to have a constant backup incase your computer fails.

Hopefully this article gives you some ideas on how you can better keep track of your investments as well as simplifying rebalancing. If you have any questions, comment below!

Thank you for reading and give the blog a follow/share if you enjoy the content!

Here are some of our other articles on similar topics:

Best Index Funds and ETFs (Canada)

Setting Investment Goals with Index Funds

What is Couch Potato Investing

-Yinvestors. 

Reasons for Index Tracking Errors

Index funds and ETFs have the purpose of tracking a given exchange, or market benchmark. To do this, the fund will typically have a portfolio ownership that is closely in-line with the characteristics of its benchmark (generally based on market capitalization for stock indexes). However, there are some key reasons why passively managed funds can (and do) slightly deviate in actual performance from their benchmarks. Deviations are known as tracking errors, and can be thought of as general inaccuracies in terms of fund performance. These are interesting concepts to dig deeper into, which also depict some fundamental workings of index funds.

A quick note on comparing fund accuracy to a benchmark, recall Beta and R-squared, which are both useful measures to asses the extent of tracking errors. Beta (or Beta coefficient) depicts how much more volatile an index fund is from its benchmark, with 1.0 representing perfect tracking; an index with beta of 1.10 is considered 10% more volatile than its benchmark. R-squared depicts how strongly correlated the benchmark and index are, from 0-100 with 100 representing a perfect correlation. Note that while tracking errors are part of an indexing portfolio, by the nature of being passively managed, these deviations should be relatively minimal (beta close to 1.0 and high R-squared values are expected). Note that another clear indicator of fund accuracy is past performance as compared to benchmark past performance. For the purpose of this article, we will consider index funds and ETFs as one unity and simply refer to them as index funds.

Possible Reasons For Tracking Errors:
- Trading Costs: Any trading costs will result in some reduction in performance and therefore a slightly lower return in the index fund as compared to its benchmark. Having said that, index funds are passively managed, so transactions (and associated commissions) should be very minimal. Regarding trading implications there are other factors such as taxes and exchange rates that can impact fund performance.
- Structure of the Fund: While an index fund will typically be weighed by market capitalization (to mirror its benchmark), there are other indexing strategies such as smart-beta which weighs differently to give investors greater potential return. Such strategies will by default fundamentally deviate the tracking ability of a fund from the base benchmark (you can think of the base benchmark as being shifted for some strategy, for example towards ‘Aggressive Growth’).
- Number of Investments: Along the same lines as the previous point, it is possible for an index fund to include some minor investments outside of its benchmark index. For example, TD903 (Dow Jones Industrial Average e-series index fund) consists of 32 total investments, while there are only 30 companies in the DJIA.
- Cash Drag: Any amount of cash that is held in an index portfolio un-invested will create a fluctuation buffer that will reduce tracking accuracy. Given the nature of index funds, it is rare that any substantial percentage of the portfolio will be cash. One situation where cash drag would be present is due to dividends. These would then typically be shared with investors and/or be reinvested into the fund.

These are some of the key reasons why you can expect an index fund to have slight performance deviations from its benchmark. As an index fund aims to track an index, not beat it, the ability to track a benchmark is thus a fundamental characteristic of fund quality. Being aware of tracking error dynamics can allow individual investors to compare multiple index funds and assess which funds may suit their investment goals and strategies best.

Thank you for reading, if you have any comments of questions please post below! If you have any recommendations for topics also post below or contact me in the form located on this page. Please give the blog a share and follow if you enjoy the content (especially the fantastic handmade graphical example)!

Here are some of our other articles on similar topics:

- Best Index Funds and ETFs (Canada)

- What Exactly is an Index

- E-series Top Holdings Breakdown

-Yinvestors. 

Best Index Funds and ETFs (Canada)

If we assume that any two funds are identical in effectiveness of tracking an index, it would be most beneficial to own the cheapest one. After all, why pay more for more-or-less the same product? While this may be the case, there could be some situations where you might chose a more expensive product, for example, due to practicality. In this article we will discuss the major ETFs and index funds available to Canadian investors. While we've discussed Vanguard ETFs and TD e-series index funds multiple times before, there are other competitive options available.

To give a quick recap, index funds are passively managed portfolios that track major indexes by owning many investments within that index. Exchange-Traded Funds (ETFs) are index funds that are traded on major markets, which come with a commission for trading, but tend to have lower Management Expense Ratios (MERs). You obtain an index fund from the company managing it (usually at no commission), while you buy an ETF off the market.

In the following comparisons we will only focus on: Canadian stock index, U.S. stock index, Canadian bond index and international stock index. Note that there are other index options with most of the funds listened below, although we will only focus on the most common indexes.

Exchange-Traded Funds For Canadians - abbreviated fund name (ticker), MER
Vanguard ETFs

Canada All Cap Index (VCN), 0.06%
S&P 500 Index (VFV), 0.07%
Canadian Aggregate Bond Index (VAB), 0.14%
Developed Europe All Cap Index (VE), 0.20%
Emerging Markets All Cap Index (VEE), 0.19%
Developed Asia Pacific All Cap Index (VA), 0.20%

BMO ETFs
S&P/TSX Capped Composite Index (ZNC), 0.09%
S&P 500 Index (ZSP), 0.13%
Aggregate Bond Index ETF (ZAG), 0.23%
MSCI EAFE Index (ZEA), 0.25%

iShares (BlackRock) ETFs 

S&P/TSX Capped Composite Index (XIC), 0.06%
S&P U.S. Total Market Index (XUH), 0.11%
High Quality Canadian Bond Index (XQB), 0.13%
MSCI All Country World (ex. Canada) Index (XAW), 0.22%
MSCI Emerging Markets IMI Index (XEC), 0.28%

If you’re going to purchase ETFs, Vanguard funds remain the cheapest option available, although both BMO and BlackRock offer competitive products. Given the nature of ETFs (traded on exchanges) you should really be getting the cheapest ones possible, unless you wish to purchase a specific fund not offered elsewhere. Another option not mentioned are Horizon ETFs, Horizon provides a way range of ETFs (including commodity ETFs), although they are more expensive than those mentioned above. Currently Questrade discount broker offers free purchases of ETFs, while you will still have to pay transaction fees on sales, removing all purchasing costs is already fantastic.

Index Funds For Canadians - abbreviated fund name (ticker), MER
TD Canada e-Series Index Funds
Canadian Stock Index – e (TDB900), 0.33%
U.S. Stock Index – e (TDB902), 0.35%
Canadian Bond Index – e (TDB909), 0.50%
International Stock Index – e (TDB911), 0.54%

Even though TD increased the MERs of e-series slightly over the summer of 2015, they continue to be the cheapest index funds directly available to Canadians. You can purchase these investments online through a TD e-series Funds account (accessible online through TD Canada Trust EasyWeb, or through TD Direct Investing). It is also possible to purchase e-series through a TD TFSA. If you have a medium to small sum to invest, e-series index funds will very likely be your best option for simplicity and pure value.

RBC Global Asset Management Index Funds
Canadian Index Fund (RBF556), 0.72%
U.S. Index Fund (RBF557), 0.72%
Canadian Government Bond Index (RBF563), 0.67%
International Index (RBF559), 0.71%

National Bank Index Funds
Canadian Index Fund (NBC814), 0.66%
U.S. Index Fund (NBC846), 0.67%
International Index Fund (NBC839), 0.66%

While RBC and National Bank also offer index funds, they are substantially more expensive to own than e-series. If you have all your banking accounts with one of these banks and have a relatively small sum to invest, it may not be worth the trouble of opening an investment account with TD. Also take note that you have more indexing options with TD e-series than with either RBC or National Bank. An advantage to RBC and National Bank indexes is that they are also available through discount brokerages (although at that point, you really should be buying ETFs).

Tangerine Investment Funds
Balanced Income Portfolio (INI210), 1.07%
Balanced Portfolio (INI220), 1.07%
Balanced Growth Portfolio (INI230), 1.07%
Equity Growth Portfolio (INI240), 1.07%

I came close to leaving Tangerine funds off the list since having an MER of 1.07% is very high for an index fund, but there are benefits to owning these funds. For one thing, it does all the work for you. Each Tangerine fund listed above is actually already a balanced index portfolio, so you only need to buy one to be very diversified and don`t need to worry about rebalancing. For example, the ‘Tangerine Balanced Income Portfolio’ consists of: 70% Canadian bonds, 10% Canadian stocks, 10% US stocks and 10% International stocks. The other three portfolio options are simply more aggressive on stock index ownership. You have to open an account directly with Tangerine to obtain these funds (TFSA option available), and there is no account minimum. If you have just a small sum to invest, this may well be a great option; although if you have even just a couple thousand to invest, you would very likely be better off investing in e-series.

The index or ETF that is ideal for you will depend on a few factors such as: investment amount, frequency of transactions, simplicity, brokerage fees, products to purchase and personal preferences. Please have a look at the complete list of funds available before making a selection, as there are other funds I have not listed for simplicity sake. Also note that not all funds listed can be directly compared in terms of MER, as they do not all track exactly the same indexes (especially the case for international stock indexes). Its is also important to note that while index funds that track the same index are not identical in nature, they tend to be very similar.

Here are some of our other articles on similar topics:
Choosing an Index Portfolio Model
What Exactly is An Index?
TFSA: Index Funds vs. ETFs

Please help pass on this article and give the blog a follow if you enjoy the content!


-Yinvestors


Note that MERs consist of management fees and all associated operating fees. It is typically based on the previous costs experienced over the last 12-month period (or as reported). It is worth nothing that it is based on 'historical data' and does not perfectly depict future costs. Having said that, the most recent numbers provided by each company are used and MER does provide the most accurate basis for cost comparison available. MERs are also fairly consistent given an index fund will typically have relatively stable and predictable costs due to its passive nature. 

Setting Investment Goals with Index Funds

Establishing investment goals can be difficult given the number of uncertainties and complexity with time scales. Never-the-less, investment goals are useful in establishing how reasonable certain expectations can be. In this post, we depict a simple way to establish and assess long-term investment goals with index funds. This is good practice when you start out investing (or start to have a stable source of income) to give you a very realistic chance of achieving your goals.

Framework for index investment goals
Objective: How much do you want to have saved and for when.
Limitations: What is your time frame, starting investment sum, risk tolerance, etc.
Savings target: How much per year (or per month) can you add in contributions.
Portfolio model: Which portfolio model will you be following (article on portfolio models).
Rebalancing strategy: How often will you be rebalancing.
Monitoring strategy: How often will you monitor your investment and for what reason.

Let's look at an example:
Objective: Save $1,000,000 post-inflation (assuming 3%/year) in a TFSA for retirement.
Limitations: Invest for 40 years, with starting portfolio value of $30,000 at relatively low-risk (decent bond exposure).
Savings target: $5,500/year for first 10 years, then $6,000/year for remaining 30 years.
Portfolio model: Following the bond-by-age model (to lower risk exposure with age).
Rebalancing strategy: Once a year.
Monitoring strategy: Monitor investments biyearly, if an index ever shifts 10%+ in this time period, rebalance portfolio.

We also need to make an assumption on the annualized return of the modeled index portfolio. If we assume it generates 7.5%/year, this would represent a post-inflation corrected return of 4.5%/year. Will we achieve our goal?

While the graph looks great, under the given conditions, this portfolio will only be valued at $829,376 after the 40 year period (with a 3% annualized inflation correction). By knowing this, we can play with certain conditions to place ourselves in the best situation possible to achieve our investment goals. For simulation purposes, conditions we can change include: starting investment sum, investment time period, contribution amount/frequency and expected annualized rate of return. For example, if we were somehow able to begin investing with $58,200 instead of $30,000 with all other conditions unchanged, we would end up with $1,000,778. If markets performed better than expected and we averaged 8.5% annualized (5.5% post-inflation), without changing any other conditions, our portfolio would be worth over $1.1 million. I recommend you set your investment goals and apply some conservative conditions and then some slightly optimistic conditions, so that you can have an idea of the realistic range of expected return.

Post below if you have any questions and thank you for reading!


-Yinvestors.



keywords: index fund investment strategy, investing framework, index funds, index portfolio, inflation, rate of return, investing goals.

What is Couch Potato Investing

The term 'Couch Potato' is perfectly defined by the Urban Dictionary as:

“A lazy person who does nothing but sit on the couch and watch television.”

It comes with fantastic synonyms like: slacker, lazy, bum and slug.

That doesn’t sound too much like a life goal, but it actually does present a viable strategy for investing. A couch potato investor would be a passive investor who deals with his investments once a year. The rest of the year, this investor may or may not contribute to their investments and they may or may not even care to see how their investments are performing. How could this possibly be a good strategy?

1) You are not being emotionally influenced by short-term market fluctuations. How can you be when you’re not even looking at your investments! If you hold a balanced index portfolio, you are so heavily diversified that any short to medium-term swings will likely be insignificant. Not tracking your performance daily or even monthly allows you to keep an eye on the bigger picture, which is long-term growth.

2) You are avoiding heaps of fees. While you may have free transactions if you are buying e-series or other index funds, ETFs tend to come with commissions. The more you trade, the more fees you accumulate. By trading only once a year (adding to investments and rebalancing) you are limiting fees while maintaining some level proactivity.

3) It’s an easy approach. Yep, being lazy is easy. A couch potato investor might deal with their investments for an hour or two a year and achieve better returns than their neighbour who spends nights trying to find the next hot stock. You could know next to nothing about the stock market and still carry out a couch potato investment strategy (and obtain solid results), making it an attractive option.

The key concept here is that a couch potato investor keeps things simple, there is incredible power to simplicity when it comes to investing.  

To expand on index investing, taking the couch potato approach can be very beneficial to youth investors. One of the key objectives is to begin investing at a young age and use time to your advantage (as depicted in our previous article: The Power of Time). Most young people tend to know little about the stock market and investing, creating a barrier to entry as investing is viewed as being immensely complicated. In most North American education systems, business literacy is given little importance. It is also viewed as a personal topic and rare that people will openly discuss their finances. Most youth likely have little idea what their parents’ true financial situation is (and nor do their parents tend to want to talk about it). This results in young people making bad financial decisions as no one has taught them how to deal with money. Getting involved in index investing is perfect for young people as it is a passive approach that doesn’t require deep market knowledge to be effective. So, for once it may actually be a good idea to be a couch potato.

If you enjoy the article, please help share and give the blog a Google+ follow! Learn how you can begin investing in index funds.

-Yinvestors.

keywords: couch potato investing, index investing, what is couch potato investing, index funds Canada, e-series, index investing strategy. 

Choosing an Index Portfolio Model

We discussed briefly in the 'Combining a Tax-Free Savings Account and Indexing' article about how to balance your index fund portfolio, but it is a fundamental step in getting started and worth discussing more in-depth. How you first set up your index portfolio will likely impact how you invest for years to come.

The purpose of having a balanced index portfolio is to increase exposure to various markets and investment types. A common strategy for North American investors is to include the following four index types:
- Canadian Stock Index
- U.S. Stock Index
- International Stock Index

- Bond Index

For the U.S. stock index, you can either choose an S&P 500 index or a Nasdaq Index. I tend to prefer an S&P 500 index as it consists of more companies. For example, the e-series Nasdaq index actually consists of 110 investments, while the S&P 500 index consists of 504 investments. Regarding the bond index, you should obtain one that is in your local currency. The reason for this is that currency fluctuations can often be greater than bond returns. Since you are looking to get bond exposure, not currency exposure, sticking to a bond index in your local currency is most logical. An international stock index will typically consist of the some of largest international markets combined as one unit. If, for example, you only wanted to invest in European stocks, you could purchase an all-European stock index instead.

Great, so now we have an idea of what to buy, but how much to buy of each? There are four general strategies you can follow as a balanced index investor:

Strategy 1: bond allocation = age
(example for a 22-year-old investor)
Bond Index (22%)
Canadian Stock Index (26%)
U.S. Stock Index (26%)
International Stock Index (26%)

One effective and common solution is to set your bond percentage allocation as your age and to then split the remaining allocation across all stock indexes. As in the example above, a 22-year-old investor would place 22% in a bond index and split the remaining 78% across the three stock indexes. One advantage of having this strategy is that your bond allocation naturally increases over time. Meaning you are gradually decreasing risk exposure with age while having substantial stock exposure at a younger age, giving you a chance at greater returns.

Strategy 2: even distribution across all indexes
Bond Index (25%)
Canadian Stock Index (25%)
U.S. Stock Index (25%)
International Stock Index (25%)

This option is great for simplicity and offers strong stock exposure, but you are not reducing risk over time.

Strategy 3: bond index heavy
Bond Index (70%)
Canadian Stock Index (10%)
U.S. Stock Index (10%)
International Stock Index (10%)

An option for a low-risk portfolio still with some stock exposure. This option will be the least volatile, but will generally have the lowest average expected long-term return.

Strategy 4: stock index heavy
Bond Index (10%)
Canadian Stock Index (30%)
U.S. Stock Index (30%)
International Stock Index (30%)

An option for a higher-risk portfolio still with some bond exposure. This option will be the most volatile, but will generally have the highest average expected long-term return.

Pie Chart Overview of the Four Index Portfolio Models

These are only some general models you can follow. You can select indexes and set percentage allocations are you see fit for your own situation. Keep in mind that greater stock exposure tends to represent greater risk but greater potential rewards.

Steps Overview:
Step 1: decide which types of index funds you want to invest in. I recommend choosing between 3-5 indexes, including a bond index in your local currency.
Step 2: decide which portfolio model strategy you want to follow. If you are unsure, I would recommend going with the first option (bond allocation=age).
Step 3: if you already have an investment account, you can now place orders! Continue to rebalance to your original allocations through contributions (at least once a year).

If you have any questions about portfolio models, comment below!

Here are some of our other articles on similar topics:
Best Index Funds and ETFs (Canada)
The Case For and Against Rebalancing Your Index Portfolio
Adjusting Your Index Portfolio During Market Downswings

-Yinvestors.

keywords: index portfolio models, index investing, e-series, bond index, stock index, how to balance my index portfolio, S&P 500 index, index funds.