Private Counsel Portfolio ManagementSimple + Modern

Core Beliefs

The Index House follows a simpler non-predictive approach to investing. This modern approach aims to capture the returns of the market in which we invest, avoid underperformance, and do so in the safest, most cost efficient and tax smart manner.


If you can beat the market return, great! Do that. If not, then index!

Market Returns

Each year investment professionals attempt to predict which stocks will be the best investment, which managers will outperform, or when to be in or out of the market.

These recommendations are sold to investors. The implication is that good brokers/mutual fund managers/portfolio managers will be rewarded for their thorough research and astute selections with returns greater than the market return.

Predictions, however, are often wrong. Common sense tells us that, in any intensely competitive industry, making consistently accurate predictions is problematic. Ask yourself, “What does my advisor know that every other advisor doesn’t?”

Thus, instead of making predictions and attempts to beat the market, The Index House structures portfolios to capture market returns in the safest and most cost efficient manner by indexing portfolios. No crystal ball required!

Better investment results start with a strategy that is achievable. Indexing your portfolio avoids missing returns through underperformance and eliminates the guesswork with trying to identify just the winning securities.

Less Risk

Many investors feel stock markets are more volatile and that investing is riskier today than ever before. With this in mind, how are you protecting your portfolio?

Our best technique for protecting portfolios is called modern portfolio theory (MPT).1 Put forward by Harry Markowitz in 1952, this theory says that it is insufficient to look at investments in isolation, such as the traditional approach of security selection. Rather, you will get better returns and take less risk if you seek out combinations of securities, or "efficiently diversified portfolios."

Efficient portfolio diversification is achieved by combining asset classes that are not perfectly correlated or are, ideally, negatively correlated. Thus, if in the short term an asset declines in price, another rises, thereby mitigating portfolio risk. These optimal portfolios are found on the Markowitz Efficient Frontier shown below. Portfolios that fall below the efficient frontier provide less return for each level of risk.

An "asset class" is a broad group of securities sharing similar economic or geographic traits such as Canadian stocks, U.S. stocks, international stocks, bonds, real estate investment trusts, or emerging markets. Each asset class normally consists of several hundred or several thousand similar securities and represents the universe of securities that can be chosen.

Portfolios A, B, and C are efficient portfolios representing different asset mixes ranging from safer A to riskier C. Portfolio D is an inefficient portfolio. A successful investor would never choose portfolio D because portfolio A has the same expected return but much less risk.  Similarly, portfolio C that has the same expected risk level as D, but a much higher expected return.

Markowitz Efficient Frontier

Investors have traditionally hired brokers, mutual fund managers or portfolio managers to research and choose a relatively small number of favoured securities from each asset class for their portfolio. Active portfolio management implies that astute research and selection will generate extra returns above the asset class market return.

Alternatively, investors may choose asset class securities called "index funds", "asset class funds" or "exchange-traded funds", which are designed to earn the asset class market return by owning the same or substantially all of the securities that trade in the asset class. These index funds are easily combined into efficiently diversified portfolios. This is referred to as "passive index investing".

While the theoretical underpinnings of modern portfolio theory are complex, there are two main objectives: Firstly, efficient portfolios capture the return of each asset class represented—nothing more and nothing less. Modern portfolio theory makes no requirement to outperform. Secondly, portfolios should take compensated risks and diversify away uncompensated risk.

“Passive investing is, however, the best way to rid a portfolio of as much uncompensated risk as possible (and the only way of eliminating the risk of underperforming a given financial market.)”2

Most investors hold a collection of investments accumulated through the years. These inefficient portfolios aren’t compensated for the risk that they take, and they often underperform.

The Benefits of a Safer Approach

The following illustrations reveal the powerful effect of combining asset classes to reduce risk. From 1970 to 2009, a Canadian stock portfolio (single asset class) earned an average annual return of 9.70% with a "standard deviation" of 16.57%3.  Standard deviation is a statistical measure of volatility around an expected return and a lower standard deviation is representative of lower portfolio risk. In other words, over the period of study, Canadian stocks averaged 9.70% per year but, in any given year returns fell between -24% and +43%, 95% of the time.

Efficient diversification aims to combine asset classes and reduce portfolio risk (standard deviation) such that annual returns are closer to the expected return each year.

Asset Class Average Yearly Return Standard Deviation (Risk) Risk Reduction
Canadian Stocks 9.7% 16.57% --

 

A balanced portfolio (two asset classes) consisting of 60% Canadian stocks and 40% Canadian bonds provided a substantial reduction in risk.

Shifting 40% of the portfolio into bonds reduced portfolio standard deviation from 16.57% to 11.49%.4 Portfolio risk declined by 30% and yearly returns fell into a tighter range between  -13% and +33%. Less risk and less downside are desirable portfolio traits.

Asset Class Average Yearly Return Standard Deviation (Risk) Risk Reduction
Canadian Stocks 9.7% 16.57% --
Balanced Portfolio
60% Cdn stocks, 40% bonds
10% 11.49% 30%

 

A similar outcome is achieved by combining a Canadian stock and bond portfolio with foreign investments. If we add global diversification to our portfolio and include 20% U.S. equity and 20% international equity, the four asset class portfolio return rises to 10.34% per year while portfolio risk declines to 9.67%.5

Adding asset classes such as bonds and foreign investments to a Canadian stock portfolio reduces risk by 40% and narrows the range of returns in a given year to between -9.0% and +30%.

This is how riskier asset classes, such as emerging markets, can improve returns and reduce portfolio risk even though an asset class may be considered volatile on its own.

Asset Class Average Yearly Return Standard Deviation (Risk) Risk Reduction
Canadian Stocks 9.7% 16.57% --
Balanced Portfolio
60% Cdn stocks, 40% bonds
10% 11.49% 30%
Globally Diversified Portfolio
20% Cdn stocks, 20% U.S. stocks, 20% Intl stocks, 40% bonds
10.34% 9.67% 40%

 

Lower Fees:

The vast majority of investors don’t know what they pay each year for the management of their portfolios. Even fewer are aware of all the costs. The Index House charges a fee for advice, portfolio management, and proper reporting. This fee is agreed to up front and disclosed on a quarterly basis and at year-end.

Market returns – fees = pre-tax investor return

Less Tax

The Index House has a process in place to minimize taxable transactions. Efficient rebalancing and trading only when necessary avoids incurring taxable gains. As well, tax-efficient portfolios are achieved by aligning investment return types among taxable and non-taxable accounts.

Market returns – fees – tax = after-tax investor return (in your pocket)

Better Reporting

Better reporting provides the information you require to maintain command and control over your portfolio. It should tell you how your money is invested and why. Better reporting should disclose fees, provide after fee rates of return over various time periods, and benchmark returns for performance comparison. Better reporting should be simple to understand and accessible.

The Index House reporting consists of:

  1. Monthly statements from the custodian (NBCN). These are produced for the months of March, June, September, December, and any other month that there is activity in the account.
  2. Online access to your accounts at the custodian is available 24/7/365.
  3. Quarterly Portfolio reports providing:
    1. Market commentary
    2. Rate of return (after fees are deducted) quarterly, year to date, and since inception
    3. Fees charged in the quarter and year to date
    4. Target portfolio asset mix versus current mix
    5. Book value as well as market value for portfolio investments
    6. Activity summary for the quarter

footnotes

  1. Harry Markowitz, "Portfolio Selection", The Journal of Finance, Vol. 7, No. 1 (New Jersey: Wiley-Blackwell, 1952), pp. 77-91, at http://www.jstor.org/discover/10.2307/2975974?uid=3739392&uid=2&uid=3737720&uid=4&sid=21101411859767
  2. W. Scott Simon, Fiduciary Focus: Active vs. Passive Investing (Part 5), MorningstarAdvisor, June 30, 2005, http://www.morningstar.com/advisor/t/54136437/fiduciary-focus-active-vs-passive-investing-part-5.htm.
  3. Asset class return statistics, S&P TSX Composite Index returns, January 1, 1970—December 31, 2009, provided by S&P/TSX, TSX Inc. Rebalanced monthly.
  4. Asset class return statistics, DEX Long-Term Bond Index return, January 1, 1970—December 31, 2009, provided by PC-Bond, a business unit of TSX Inc. Rebalanced monthly.
  5. Asset class return statistics, S&P 500 Index returns January 1, 1970—December 31, 2009, provided by Standard & Poor's Index Services Group, MSCI EAFE Index (net div.) returns, January 1, 1970—December 31, 2009. MSCI data copyright MSCI. Rebalanced monthly.

Fixing Broken Portfolios:
Case Studies