Why We Took the Approach We Did


By Richard Croft

Last year your portfolio returned 8%. Was that good or bad? Well, if you are comparing the performance of your portfolio to GIC’s, then the return was pretty good. If you are comparing your return to the S&P/TSX 60 index, which returned 12%, then the numbers don’t look so good.

The problem of course, is that most investors don’t have 100% of their portfolio in GICs, nor do they have 100% of their portfolio in Canadian stocks. Most have a combination of investments, somehow divided between cash, fixed income and growth. We think of cash in terms of treasury bills. Bonds or bond funds represent fixed income assets. And stocks or equity mutual funds represent growth assets.

If we accept the position that most investors have a diversified portfolio, then we have to also accept that a 12% return tells us nothing about value. It’s like having a son who is seven feet tall. Is that good or bad? It’s good if he wants to play professional basketball. Not so good if he wants to buy ready to wear clothes.

Knowing a quantity how tall, how much, your percent return, tells us nothing about value. Only by comparing a diversified portfolio against a passive portfolio benchmark, can you make informed judgments about how well your portfolio did. If your passive benchmark returned 11%, and you returned 12%, then your portfolio did very well indeed.

The financial post indices are a passive benchmark. We have built three basic portfolios, each broken down by asset mix, and none holding more than 11 securities. What makes these indices unique, is that they are investable. Which means that an average investor can buy all the securities in whatever index most closely approximates their ideal asset mix.

When we talk about asset mix, we are really talking about what percentage of the portfolio should be allocated to cash, what percentage to fixed income and what percentage to stocks.

Too many investors spend too little time understanding the asset mix question. Too bad really. Because the asset mix determines 85% to 90% of your total return. Which means that the asset mix should be the starting point, not the end game, after all the investments have been selected.

When you think about it, investors generally fall into one of three basic categories; income, balanced and growth. Some financial institutions use six to nine categories. There have been instances where I have seen as many as twelve different investor categories. But really, this is just fine tuning. What’s most important, is that for each investor category, there is an appropriate asset mix.

Conservative investors want a low risk income producing portfolio. They lean toward investments that provide regular returns, even if these returns are low. Whereas others dream of wealth when they invest, income investors are motivated by the dread of poverty. This class of investor wants to make certain their principal investment is secure, although they share a keen interest in the income that can be generated by that principal investment. This is a category where we find many retired investors, using the income from the portfolio to supplement their living standard. The generally accepted asset mix for conservative income investors is; 20% cash, 50% fixed income and 30% growth.

Balanced investors pay attention to the income side of their portfolio, although generally it is not considered a critical supplement to their standard of living. At least not yet! Often the balanced investor will simply re-invest the portfolio’s income stream, effectively dollar cost averaging their investment program. Balanced investors understand that financial security depends on some growth being attained within the portfolio and to that end, will spend a great deal of time understanding just how much return is required to meet their long range financial objectives. They often set more reasonable goals that, for the most part, can be attained with their investment style. The generally accepted asset mix for balanced investors is; 10% cash, 40% fixed income and 50% equity.

Growth investors are not at all concerned about income. Usually, this group of investors has a long time horizon and often, a sizeable net worth. The objective here, is to maximize the potential growth within the portfolio, with reasonable risks. Growth investors have an appreciation about the trade-off between risk and return, and are willing to assume higher levels of risk as long as that is rewarded with greater returns. The generally accepted asset mix for growth investors is; 10% cash, 20% fixed income and 70% equity.

What the Financial Post Indices do, is provide the investor with a benchmark to compare how well their particular asset mix is performing. That’s important information. Because investors usually sit across the table from a financial advisor. And investors want to know if the advice they are getting is adding value to their portfolio. The best way to know that, is to see how well your portfolio did against a reasonable benchmark.

If you are a balanced investor, then you would compare the returns on your portfolio to that of the FPX Balanced Index. The same holds for income and growth investors, the former being tracked against the FPX Income Index and the latter against the FPX Growth Index.

Now when you are wondering if a 12% return is good or bad. We have the answer.

The Trouble With Indexes or How Do You Know How You Are Doing?
By Richard Croft

The TSE 300 Composite Index rose by almost exactly 15% last year. What's the information content of that piece of news? Why should investors care about how markets are doing and what indexes are recording?

The first explanation is that investors follow indexes because they recognize that the market itself has a systematic pull on a portfolio. If you own common shares, it is likely that up to as much as half of the daily returns on those shares are affected by how markets are performing. If, in fact, you have a well diversified portfolio, most of the returns, possibly in the order of about 90%, will be affected by the systematic pull of a proper market index.

Second, market indexes are used by some investors to gauge the momentum and sentiment of the market. This approach is called technical analysis and indexes factor heavily in its use.

Most important, investors used indexes for performance measurement. Investors structure investment portfolios with specific objectives in mind. For some it's to provide for a specific purchase such as a house at a future date. For others, it's to earn a nest-egg for retirement. Whatever the objective, investors like to know how they are doing. Indexes are supposed to give you a measure of how a market (stock, bond) performed that day or over a period of time and thus to serve as benchmark or bogey for the performance of your own investment portfolio.

For example, if you have an actively managed stock portfolio, it is useful to compare its performance to a simple passive index portfolio. The difference between the performance of your portfolio and a passive index may reflect the value added by active management. If, for example, your portfolio earned 16% while a suitable or appropriate benchmark earned 13%. then you would surmise that your active selection added 3% in value. (The 3% difference could also be attributable to sheer chance!). The key is the word appropriate. In order to benchmark your portfolio properly you need to use an appropriate index.

An index is simply a proxy for some underlying basket of securities. The basket can be large (such as the TSE 300 Composite Index) or small (S&P/TSX 60 Index); broad-based (such as the Value Line Index of over 1,700 companies) or narrow (TSX Financial Services Index).

It is important to recognize strengths and weaknesses of indexes so they specific applications can be properly assessed. Some indexes are unrepresentative of a recognizable sector. Others lack transparency-- you don't know precisely how they are calculated and how revisions take place. And many aren't investable -- you cannot buy them.

Here's what to look for:

Is the Index Managed?

The problem with most pure indexes is that they are unmanaged since they do not contain management, administration, transaction costs and other expenses associated with actually maintaining the underlying basket.

Is the Index Representative?

An index should be representative of a particular market segment. However, if it is a narrow based index such as the S&P/TSX 60 or the Dow Jones Industrial Average it represents a select segment of the stock population - the bluest of the blue chips and may not fairly reflect a more broadly based portfolio that might include small cap stocks.

A sector index such as a oil and gas may be representative of oil and gas investments although clearly not so for the broad market. On the other hand, if the benchmark is very broad it has the merit of being representative, but it may not be investable. The Standard & Poor's 500 Composite Index is broad-based but actual ownership of the underlying stocks would be out of reach for most investors.

Can you Calculate it--Is the Index Measurable?

An index should be calculated and published periodically and subject to precise measurement and calculations.

Can You see it-- Is the Index Unambiguous?

The index composition should be published and investors should know exactly how it is comprised and how its value is determined. Most important, users should know how and when the indexes composition may be revised or altered and the conditions under which it may be rebalanced.

Is the Index Appropriate?

The index selected should match the investment or portfolio. A balanced mutual fund or balanced portfolio should be measured against a balanced index.

Can you Do it-- Is the Index Investable?

An ideal index represents a passive alternative. You should be able to actually trade it or find a useful proxy for it. Investors who have diversified portfolios face the task of putting together a benchmark or bogey to measure performance. For example, if they are holding a 20/30/50, comparing the portfolio return to a stock or bond index is clearly in appropriate. Instead the investor has to construct a benchmark index.

The FPX indexes are designed for a specific purpose. Investors will be able to use them as benchmarks (albeit crude) to measure their entire portfolio not just a component.

The Components of the FPX Indexes
By Eric Kirzner

Each of the FPX indexes are composed of cash, fixed income and equity components. These correspond to the safety, income and growth nomenclature generally used in conventional investment planning asset allocation models. The following is a brief description of the financial products we selected for the portfolios as well as our motivation in selecting them.

The Cash Component

The cash component is designed to provide nominal capital preservation and liquidity for the portfolios. Given our overriding objectives of objectivity for the FPX portfolio, we selected Government of Canada 91-day Treasury- bills. (Although money market mutual funds would be suitable alternatives, we didn't want to violate the prime directive -keeping our grubby hands out of the cookie jar!)

Treasury-bills are pure discount securities, i.e. they are purchased at a discount to mature at par value. The yields quoted in the financial press are bond equivalent yields and are based on simple interest and do not reflect true effective yields.

Normally, Treasury-bills are issued and traded in $100,000 minimum denominations, although $1,000 units are available from some brokerage firms. Treasury-bills are generally good interest rate hedges since they keep pace with short-term interest rate changes. They are highly liquid and have little or no interest rate risk exposure.

Fixed Income

The income component of our portfolio is designed to provide nominal capital preservation and to generate periodic income cash flow for spending or reinvestment. To get a cross-section of maturities, we chose the "on-the-run" (or bellwether) government of Canada bonds maturing in three, ten and 30 years for this section. Government of Canadas were selected since they are default free. (We didn't want to hand select provincials or high quality corporates.) Although Government of Canada bonds are issued in par values or maturity values of $1,000 and multiples thereof, they are typically quoted in the financial press in terms of $100 par value. A quote of 113.20 means $1,132 per $1,000 par.

Equity

The third category in the FPX portfolios is equities. This category is primarily designed to for capital growth and secondarily, for dividend income. We chose index based exchange traded funds for a number of reasons, the most important of which are:

  • They are strictly passive products
  • Their unique design allows them to track the underlying index very closely
  • They are relatively low cost products in terms of the bid/ask spreads, expense ratios
  • Our Canadian equity product is the S&P/TSX 60 iUnits (symbol XIU). The XIU replaced the TIPS 100 and TIPS 35 index funds, and provide investors with a one stop solution to the Canadian market. The 60 companies in the S&P/TSX 60 index represent 60 of the largest exchange traded Canadian corporations chosen from a cross section of Canadian industry.

    XIU is traded on the TSX at a price that is normally very close to 1/10th the value of the S&P/TSE 60 Index. Dividends, based on the underlying S&P/TSX 60 index companies, are paid on a quarterly basis and are eligible for the dividend tax credit. No expenses or fees are charged. XIU trades exactly like a stock, subject to a minimum price fluctuation of 1 cent per share. The market for XIU is extremely liquid and XIU is fully eligible for inclusion in RRSPs, RRIFs and other tax shelter plans.

    For our U.S. component we selected Standard & Poor's Depositary Receipts or SPDRs (Ticket symbol: SPY). SPY is based on the US S&P 500 Composite Index. SPY is traded in minimum increments of one cent per share. SPY is also quoted and traded at 1/10 the value of the S&P 500. For example, if the S&P 500 index is at 1,094.87, the core value of SPY will be US$109.48. SPY pays quarterly dividends based on the dividend declared and paid by the 500 companies in the S&P 500 index.

    For our international component we selected MSCI iShares. As with XIU and SPY, iShares are index based exchange traded funds representing an investment in a specific country. MSCI iShares are currently offered on 22 different countries spanning the European, Pacific Rim, Far East and Latin America regions. There are also iShares representing specific regions like Europe Australasia and Far East (EAFE) as well as the European Monetary Union (EMU). iShares are traded on the American Stock Exchange and are priced in US dollars. They are bought and sold in the same manner as traditional common shares and are traded at a specific fraction of the underlying index.

    The choice of which iSHares to use was a challenge between finding the balance between replication and reasonability. We wanted this section to replicate the MSCI Europe Australasia and Far East (EAFE) index (note there were no EAFE products available when the FPX indexes were originally designed) yet be small enough that an investor could implement it.

    To deal with this, we ran an optimization program and found that five country specific iShares selected with specific weights had a sufficiently high correlation with the EAFE index to be acceptable. The five iShares chosen were Germany, France, Japan, Mexico and the United Kingdom. The characteristics of the iShares selected are:

    fpx_international_components

    Each of the FPX Indexes is Constructed
    By Eric Kirzner

    Our overall objective was to create a passive yet investable and user-friendly set of indexes. To the extent possible it was our intention to make the portfolio as neutral and objective as possible, i.e. the asset allocations and composition should be forward-looking and should not reflect the bias or views of the designers.

    To be a proper index of market performance and to serve as a useful benchmark, each index should be investable (you can actually buy it), reportable (you can describe its performance with a number) and transparent (you know and understand how it is constructed and how it is used).

    The Technical Characteristics of the FPX Indexes

    In order to fulfill our mandate of making the indexes investable, reportable and transparent, a number of decisions had to be made. Here, in the interests of transparency, are the technical aspects of the three indexes and how they will be maintained and revised.

    The Base Year and Index Level

    The base period for all three indexes is April 1, 1996. Each of the indexes were initially set at values of 1,000 as at the base period.

    If, for example, the FPX balanced index is at 1,425 as at April 1, 1999, this means that the index has appreciated by 42.5% over the three -year period. This 42.5% number, in turn, can be expressed as 12.517% on an annual compounded basis; i.e. (1.425)1/3 -1 = 12.517%.

    The Composition of the Three Indexes

    There are three FPX portfolios, each based on conventional strategic or long-term asset allocation models, spanning the range of 70/30 to 30/70 debt/equity mixes. The three portfolios and their components are:

    fpx asset allocation

    The FPX income portfolio is the most conservative of the three and consists of 20% in a 91-day T-bill; 50% evenly split among the three Government of Canada’s spanning the maturity structure; and 30% in equities allocated between XIU (25%) and SPY (5%).

    The FPX balanced portfolio is a classic 50/50 portfolio and consists of 10% in a 91-day T-bill; 40% evenly split among the three Government of Canadas spanning the maturity structure; and 50% in equities allocated among XIU, SPY and the five iShares that met our criteria.

    The FPX growth portfolio is the most aggressive of the three and consists of 5% in a 91-day T-bill; 25% allocated strictly to the medium term bond, and 70% in equities allocated among XIU, SPY and iShares.

    To select the country percentage composition we attempted to replicate what Canadian investors are doing with the equity components of the portfolios. We used equity mutual funds as our proxies. We calculated the respective aggregate asset values of broadly diversified Canadian equity mutual funds (we excluded dividend income funds; small cap funds and other specialized funds), U.S. equity mutual funds and international equity mutual funds and used the values as the weights for our portfolios.

    An Actionable and Realistic Portfolio Size

    Each of the three indexes is based on an assumed portfolio size of $100,000. Our research indicates that this portfolio size is relatively representative of the average investment portfolios held by Financial Post readers.

    The Denominaire Currency is the Canadian Dollar

    The indexes are denominated and expressed in Canadian dollars. Although each portfolio/index is marked-to market daily in Canadian dollars, the U.S. investments are held in U.S. dollars within the portfolio.

    Treatment of Interest Income

    Interest accrues daily on the Federal government Treasury-bills and Federal government bonds. We calculate the interest as earned in a daily mark-to-market and thus the closing index level includes the interest income accrued that day. However, interest is not earned on the accrued interest. The actual interest is deemed to be received when paid on the specific payment dates, and is then reinvested in Treasury-bills.

    Treatment of Dividend income

    IPUs generally pay dividends quarterly (TIPS and SPDRs) or annually (WEBS). No accrual of dividends is assumed. The actual dividend income is deemed to be received on the payment date and is immediately reinvested in the Treasury - bills, subject to rebalancing on April 1.

    Whole Numbers Only

    No fractional bonds, shares or units are purchased. Instead, purchases are rounded down to whole numbers and the remainder is allocated to the cash account.

    Index Reporting

    Each index is marked-to-market in Canadian dollars at the close of markets each day. The indexes are reported in the Financial Post daily and reflect any surplus cash, accrued interest and closing bond, share and units values.

    Annual Rebalancing

    Each of the portfolios is rebalanced back to the target weights annually on April 1. Rebalancing is the process of bringing a portfolio back in line with a target structure when the deviation is caused by fluctuations in market values. The FPX portfolio rebalancing is not conducted precisely to the weights since we do not purchase or sell fractional bonds, shares or units.

    Commissions and other Transactions costs

    Commissions and other transactions costs (other than the bid/ask spreads that are implicit in market pricing) are not included in the index calculations.

    We estimate the initial commissions associated with purchasing a $100,000 version of each of the three portfolios as follows:

  • FPX income $325
  • FPX balanced $700
  • FPX growth $975


    No taxes, personal or otherwise are included in the calculations, nor are the withholding taxes which are charged on SPDRs and WEBS distributions.