Index funds best for small investor
As portfolio grows, buy one Berkshire B share
Richard Morrison, Financial Post Published: Friday, July 18, 2008
A young colleague asked what stock investments he should own in his self-directed RRSP.
Unless you have some expertise -- perhaps you've passed the Canadian Securities Course, for example -- an independent advisor is your best bet for specific investment advice.
In general, however, an investor with $20,000 or so allocated to equities would not go too far wrong by gradually investing in four index funds or exchange-traded funds: 30% representing stock markets in Canada, 30% in the United States, 30% in the rest of the world and 10% in gold.
Heather Pelant, head of exchange-traded products for Barclays Global Investors in Canada, said she made a similar asset mix recommendation for her younger sister.
"It's a simple and elegant solution," Pelant said. "You're not going to overperform or underperform, you're just going to perform. It's the all-weather vehicle, the little black dress of investing."
We used the Yahoo Finance ETF Center (finance. yahoo.com/etf ) to screen for exchange-traded funds that represent a broad base of stocks and have reasonable management expense ratios (MERs). Small investors must also be able to buy into the funds in odd lots (less than 100 units).
With their low management expense ratios, funds that simply track indexes and don't try to beat them achieve better returns than all but a few managed mutual funds.
Standard & Poor's Indices Versus Active Funds (SPIVA) Scorecard for the first quarter of this year, for example, shows only 8.2% of Canadian equity active managers were able to outperform the S&P/TSX Composite in the first quarter of this year. Over the past three years, only 8.4% of actively managed Canadian equity funds beat the index; the number drops to 4.1% over five years, the S&P study shows.
"The report shows how difficult it is for a fund manager to outperform the index," Pelant said.
For index funds, the Financial Post's online mutual fund listings provide detailed tables of management expense ratios, simple and compound returns, standard deviation and net asset value for more than 400 funds. Go to financialpost.com/markets/market_ data/ index. html and tap in "index" in the "search by fund name/ company" box, which lists 48 index funds in the Canadian equity category alone.
For our young colleague, we suggested the $500-million iShares Canadian Composite Index Fund (XIC/ TSX), which carries a 0.25% MER and holds such Canadian household names as Potash Corp., EnCana Corp., Royal Bank, Suncor Energy Inc., Research In Motion Ltd., Manulife Financial Corp., together with all major banks and energy companies.
In the United States, most index funds are not available to non-residents, but exchange-traded funds are.
The US$10-billion Vanguard Total Stock Market ETF (VTI/AMEX) includes the giants of Wall Street: Exxon Mobil, General Electric, Microsoft and so on. Its main attraction is its minuscule MER of 0.07%. Unfortunately, it is off 15.6% this year and 20% over the past year.
The fund comes via the recommendation of Berkshire Hathaway Inc. chairman Warren Buffett, who, speaking after Berkshire's 2006 annual meeting, offered advice for those unprepared to do the research to identify market-beating investments.
"I would just have it all in a very low-cost index fund from a reputable firm, maybe Vanguard," Buffett said in response to a shareholder's question. "Unless I bought during a strong bull market, I would feel confident that I would outperform ... and I could just go back and get on with my work."
The June 6 edition of Fortune magazine describes Buffett's wager with Ted Seides, principal at hedge fund manager Protege Partners LLC. Buffett has bet that even five carefully chosen hedge funds won't return more than the market -- specifically, the Vanguard S&P 500 index fund (which isn't available to Canadians).
Each side put up roughly US$320,000. The total funds were used to buy a zero-coupon Treasury bond that will be worth US$1-million at the bet's conclusion in 10 years, payable to the winner's chosen charity.
Buffett, 77, wrote Seides "my estate attorney is going to think I'm out of my mind for complicating things."
For outside North America, the US$47.56-billion iShares MSCI EAFE Index fund (EFA/NYSE), launched in August, 2001, is a solid bet. It holds some of the largest companies in the world and carries a modest management expense ratio of 0.34%. It's also available in a Canadian-dollar hedged version (XIN/TSX), with a 0.5% MER.
Holding gold bullion has traditionally helped reduce volatility, although it has poor long-term returns. We recommended our young colleague hold 10% of his assets in the giant US$18.26-billion SPDR Gold Trust (GLD/NYSE), now a qualified investment for RRSPs.
Our colleague seemed satisfied with the advice, then asked what he might add once the portfolio grows a bit larger. We recommended a single B share of Berkshire Hathaway (BRKb/ NYSE). The "Baby Berkshires" as they are known, trade at about US$3,800, following a near 20% decline this year. Unlike most mutual funds, Berkshire's manager does consistently beat the indexes.
As Mr. Seides at Protege Partners said in the Fortune piece: "Fortunately for us, we're betting against the S&P's performance, not Buffett's."
--- - Richard Morrison is a senior editor at the Financial Post and a long-time active trader.
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