We’ve been through the background of the “new” S&P/TSX Index, and we’ve looked at the numbers in terms of what the index consists of. This week we’re going to draw a direct comparison between the S&P/TSX Index and mutual funds, as well as look at the implications of having a volatile index.
What is a “closet” mutual fund?
When an investor studies a mutual fund’s past performance and current asset allocation, they look to see if the fund is actively managed, or if it is a closet indexer.
In other words, they try and figure out if the fund’s past performance is good because the managers are good, or if the managers are simply mimicking the index (which is called closet indexing). So when looking at the S&P/TSX Index, knowing that it’s actively managed from looking at the numbers last week - is it just a closet mutual fund?
The Toronto Composite Index (S&P/TSX) risk analysis
Consider this: If a mutual fund manager had to hold an investment for at least a full year before they were permitted to sell it, how would this impact their investment decision? Would they think differently about their choices if they knew they could sell the investment at any time after they bought it? Do you think they would be more careful about their purchases? Probably.
Most investors and mutual fund managers will make more conservative investment choices if they know they are locked into their decision. If an investor can sell an investment at any time, they are much more likely to buy riskier investments. So (pulling this all together) if S&P can add (buy) and delete (sell) companies in and out of the index at any time, how much risk are they happy to take on in that process...more or less? More!
As we’ve already reviewed, since Standard & Poor’s began managing the index, the volatility in the number of companies represented has increased dramatically. An index that goes from 300 companies one year, to 213 in another, and then shoots back up to 269 the next year demonstrates the same behaviour you might expect from an actively managed mutual fund.
Apples to apples: the result of a volatile index
Why does this all matter? Well, if the new index is actively managed, then we probably shouldn’t give it the same respect we did the old TSE300 Composite Index. Maybe we should not use the index as a benchmark for our investments. Because if we’re not willing to mimic S&P’s management of the index, then it’s not fair to expect the same investment results of the index.
You would only want to compare how well your investments were doing against the S&P/TSX Composite Index if your current portfolio held investments in the same three stock market sectors as theirs (Financials (28%), Energy (26.52%) and Materials (23.45%). If you don’t, then you’re not comparing apples to apples.
Now that we’ve identified the S&P/TSX Index as a closet mutual fund - can we use it as a historical ruler? Read: The Toronto Composite Index (S&P/TSX) : A Historical Ruler?