Index Investing
Part 7: Asset Classes and Index Funds
So far in this series we’ve been talking about index funds in general, now it’s time to get into the weeds a little bit and look at some of the specific indexes you might want to invest in.
The first thing to know is that there are different asset classes, the broad categories of things you can invest in. Indexes are usually created to track or represent a particular asset class. The Dow Jones Industrial Average, for example, was created to track the average of some large companies in the US. So, it would be an example of a “US equity” index. Of course, many other indexes have come out to provide better or more complete measures of American stocks, but that’s the underlying asset class those indexes are trying to track. When you’re building your portfolio, you’ll want to be diversified across several different major asset classes.
Asset Classes
There are many ways to group different investments together to form an asset class. The first is by the type of investment: stocks (or “equities”) vs bonds (or “fixed income”). You can group them by geography: Canadian stocks, US stocks, European stocks, Canadian bonds, etc. You can group them by industry: financial services stocks, government bonds, corporate bonds, oil and gas stocks, technology stocks, etc.
Almost any way you can conceive of grouping investments has led someone out there to create an index to track it, and then a fund that tracks that index. Most of these niche or sector funds may technically be index funds, but are not generally what we mean when talking about index fund investing.
Instead, focus on the largest, most diversified ways to create asset classes, which generally breaks down into these most common asset classes:
Fixed income: bonds, which may be sub-divided by government, investment grade corporate bonds, and non-investment grade or “junk” or “high-yield” bonds. Bonds can also be grouped by country, but for the most part Canadian investors will focus on Canadian fixed income.
Equities: stocks, which are usually sub-divided by region: Canadian stocks, US stocks, rest-of-world stocks.
Index Providers and Methods
Once you have an asset class you want to invest in, the next step is to find an index that tracks it. Different companies have emerged to create indexes to represent different asset classes. Standard and Poors, for example, which is better known as the “S&P” in the S&P500 – a very popular index that tracks US equities and is regularly featured in the news. Dow Jones (DJ), Morgan Stanley Capital International (MSCI), the Financial Times Stock Exchange group (FTSE), the Centre for Research in Security Prices (CRSP), and Solactive are other providers who create indexes to represent various asset classes.
Each may have slightly different ways of building an index for an asset class – different rules on which companies to include or exclude. For example, indexes that track large US companies are broadly similar, though there are some differences. For example, a recent disagreement was over Tesla. The S&P500 index had rules that a company had to have a year of profit before becoming included – simply being large wasn’t enough to be included. Tesla, despite becoming worth hundreds of billions of dollars on the stock market, had not actually made a profit until 2020 (and even then the “quality” of the profit was controversial as it came from tax credits rather than profitably producing cars). So Tesla was not added to the S&P500 until the very end of 2020, though the broadly similar MSCI USA Index and Solactive US Large Cap Index included it earlier because of the slight difference in methods, where there wasn’t a rule on profitability.
Generally, these slight differences in methods won’t matter for an individual investor – there’s no way to know in advance whether S&P’s method to build a particular index is better than FTSE’s, MSCI’s, or Solactive’s rules, so your choice of index fund shouldn’t depend on labouriously digging through the fine details of building an index.
Some broader methods will matter, particularly how an index is weighted. The original Dow Jones Industrial Index was a simple price average: if one company’s share price went up by $1, then the index of 30 companies went up by $1/30. But that led to some silly outcomes: if one company had a share price of $100, a $1 move for it would only be a 1% move, yet the index would move just as much as a $1 move on a company whose shares started the day at $20, even though that would have been a much bigger 5% move for that company. Price weighting made it easy to do the math by hand, but beyond that there isn’t much to recommend it.
Most modern indexes are market capitalization weighted (“cap-weighted”). That means that larger companies make up more of the index. That makes some sense – a move in a massive company like the Royal Bank should have more of an effect on the overall market than a similar move in a small company like Roots. It also conveniently makes an index fund tracking a cap-weighted index easier to manage: as a company gets more or less valuable, its weight in the index increases or decreases at the same time. So an index fund doesn’t have to buy or sell any more of a company’s stock to keep the fund tracking the index, which also reduces the drag of taxes and trading costs on returns.
Another approach to indexing is to equally weight every company in the index. While this can be appealing for diversification purposes, in practice it’s harder to implement: as a company become more valuable, an index fund has to keep selling shares to maintain its weight in the index, and conversely has to keep buying shares of companies that decline. As prices fluctuate, this can lead to a lot of costs for trading, and a tax drag as well. Not many index large index funds follow an equal weight methodology.
Summary
Some asset classes to consider include fixed income and equities, with indexes from different companies representing those asset classes. Some examples include:
Fixed income: FTSE Canada Universe Bond Index, which tracks government and investment-grade corporate bonds.
Equities:
Canadian: the S&P TSX Composite Index and FTSE Canada All Cap indexes track large and medium companies traded in Canada, while the S&P TSX 60 tracks the 60 largest.
US: the S&P500 tracks approx. 500 large companies in the US; the Solactive US Large Cap Index tracks the 500 largest companies in the US; the CRSP US Total Market Index tracks over 3,000 US companies.
International: the MSCI EAFE (Europe, Australia, Far East) index tracks large companies in developed markets; FTSE Developed All Cap ex North America tracks large and mid-size companies; the FTSE Global All Cap ex Canada tracks companies in developed and emerging markets outside of Canada, including the US.