# Index-fund pros and cons



## the-royal-mail (Dec 11, 2009)

I found a rather frank (and ad-free!) discussion about the pros and cons of index funds. I thought posting it here would be of interest. Anyone disagree with what is written here?

http://www.bylo.org/gm25nov03gp.html


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## andrewf (Mar 1, 2010)

Wasn't Mr. Pape the fellow pitching the Canadian Cardboard Box Plan? 

I'd say bylo's rebuttals are mostly pretty fair and accurate. The biggest red flag was when Pape carefully selected an index and a short time frame to argue that actively managed funds outperform the indexing in general. This is the same trick the global-warming deniers use to say that we're in a period of global cooling because we had one very hot year 7 years ago that we haven't yet surpassed. The draw a trend line out of a seven year period, carefully ignore the overall trend. Such cherry-picking is terribly dishonest.


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## kcowan (Jul 1, 2010)

Gordon Pape earns his money by writing, not by investing. Although much of what he writes is good food for thought, he is often wrong. But aren't they all?

BTW I included his YE forecasts in our 50Plus contest, and he is currently in 3rd place.
50Plus Forecast Contest

Here is his take on Owning Florida Properties. He owns in Naples.


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## Belguy (May 24, 2010)

I would imagine that a lot of people who are involved, in one way or another, with the lucrative financial services industry own second homes in the sunny south!!


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## OhGreatGuru (May 24, 2009)

Gordon Pape make his living selling books, articles, and other advice on what funds (in his opinion) are good or bad investments. If he ever concluded that index funds were the best choice, he would have nothing more to write (and sell). (Which is not to say I don't enjoy reading his reasons/analysis for rating funds.)


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## the-royal-mail (Dec 11, 2009)

Gordon Pape...that name sounds familiar. Was he the pitch man for CHIP reverse mortgage? Or that guy with the tax infomercials?


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## Belguy (May 24, 2010)

Well, you makes your money any way that you can!!!!


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## Four Pillars (Apr 5, 2009)

the-royal-mail said:


> Gordon Pape...that name sounds familiar. Was he the pitch man for CHIP reverse mortgage? Or that guy with the tax infomercials?


Yes, he pushed the reverse mortgage.


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## Bupp (Nov 13, 2009)

One problem with index funds is that the way they select companies to be part of the index is explained in the prospectus.

It makes it possible for investor's to front run the index funds when they know the funds are going to rebalance.


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## Belguy (May 24, 2010)

Said what???


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## Bupp (Nov 13, 2009)

Take for example XIU. It holds the 60 stocks in the tsx 60. When there are companies added or removed from that list of 60 stocks xiu must buy or sell them respectively. 

However, the shareholders of xiu will not get a good price on the purchase or sale because traders will have bought or sold the shares in anticipation of xiu's many millions of dollars of shares being purchased or sold.

In this type of situation xiu would still match the return of the tsx 60. However the return of the index itself would be lower than it otherwise would have been.

This impact is more noticeable on smaller cap indices where a few million dollars flowing into a security can really move the share price.

http://www.thetradenews.com/1578 <---this article from 2008 is an example of what I am talking about. If you bought additions to the index in the 3 days prior to rebalancing you would earn between 1%-6% return over the 3 day holding period


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## Larry6417 (Jan 27, 2010)

The data are squarely against Pape. Standard and Poor's has been tracking Canadian mutual funds vs. the index. Over the past 3 and 5 year period, only 10.9% and 3.3% of funds respectively beat the index. One old saw referred to in the article is the belief that actively managed funds outperform in bear markets because they can hold cash while index funds must be fully invested. That hasn't been the case in the latest downturn. See www.standardandpoors.com/servlet/Bl...lobwhere=1243726765269&blobheadervalue3=UTF-8


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## Soils4Peace (Mar 14, 2010)

I am keeping two actively managed funds that I bought in 1985. Why? Because their risk adjusted returns beat the indices. Sold all the others though, and I hold more index than active.


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## humble_pie (Jun 7, 2009)

in the past, from time to time, there have been articles in the financial media about the phenomenon bupp is writing about. Buying the stocks about to be included in the tsx 60 immediately prior to their inclusion has been shown to be profitable because xiu will also perforce have to be a buyer.

it would not be difficult for a lay person to turn this into a discipline. I haven't tried, myself. There's a far easier way to harvest extra returns from xiu. Sell otm calls against position. Plus sell otm puts against a portion of position.

looking at my records, i see that i first became the proud owner of xiu in 2001, so nearly a decade has passed. In XIU, annual adjustments to cost base have to be made. Taking these adjustments into consideration but not considering any distributions (mine are cash divs, not drips) and not considering any capital gains obtained from option sales, my XIU is up roughly 25% over cost base. For myself, this is a poor return. For myself, i look for underlyings in long-stock-short-option positions to double over the course of a decade.

however, it's not unacceptably poor because, again for myself, XIU is a highly defensive holding. I'm happy to sacrifice some growth in return for what is, effectively, close to or better than a top-rated preferred share quality.

the tax-advantaged combination of quarterly dividends plus capital gains from option sales are yielding well north of 10% per annum, regardless of whether this yield is calculated AFY or HPY 

in the course of a year, total "management time" i might spend on XIU, including time required to carry out 6 or 8 option trades, is approximately 40 minutes. For myself, having fairly large numbers of option positions, i am acutely mindful of time spent on each trading decision. The only strategies i carry out are those in which time can be rationed as economically as possible. This usually means highly liquid underlyings plus selling options that are 6 months out, rather than 3 months out, so that fewer strategy decisions are required per annum.

what i find is that even an index etf as dull & boring as never-go-bankrupt XIU, together with its options, can play a defensive role and generate close to 10% in tax-favoured yield combinations in just about anybody's portfolio, imho.


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## alphatrader2000 (Aug 18, 2010)

Bupp said:


> One problem with index funds is that the way they select companies to be part of the index is explained in the prospectus.
> 
> It makes it possible for investor's to front run the index funds when they know the funds are going to rebalance.


Are you referring to the increase of stock price when it is added to an index fund? For example when a company is about to be added to S&P500, the stock price tend to rise. Because, this is just normal course of business. A function of satisfying the high demand by the fund at the close by the market. While in technicality you might be correct, I believe it is the wrong connotation. “Front running” implies an illegal action, as oppose to this transparent mechanism.


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## Bupp (Nov 13, 2009)

Alphatrader you are right that it is not frontrunning in the sense of a broker placing his own trade in advance of a trade made by a client.

Index etf's are a fine solution for an investor with a small portfolio. However once you have a modestly sized portfolio you might as well own the equities directly.


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## Bupp (Nov 13, 2009)

alphatrader2000 said:


> Are you referring to the increase of stock price when it is added to an index fund? For example when a company is about to be added to S&P500, the stock price tend to rise. *Because, this is just normal course of business. A function of satisfying the high demand by the fund at the close by the market.* While in technicality you might be correct, I believe it is the wrong connotation. “Front running” implies an illegal action, as oppose to this transparent mechanism.


Since everyone knows that the big funds especially the index funds are likely to have to buy sizeable positions in the stock, they are able to purchase a few days before hand. This drives up the stock price. The index fund ends up overpaying for their shares.


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## alphatrader2000 (Aug 18, 2010)

Bupp said:


> Since everyone knows that the big funds especially the index funds are likely to have to buy sizeable positions in the stock, they are able to purchase a few days before hand. This drives up the stock price. The index fund ends up overpaying for their shares.


It is not as straight forward as your pointing out. The price goes up generally because there is SOLID demand for the stock that is added to the index fund and anything that mirrors that. While the stock price might drop a bit the next day after the inclusion. The drop (if any) is nothing comparing to the increase from the annoucement to the inclusion.


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## kcowan (Jul 1, 2010)

*Artis REIT to be included in TSX*

*Index Inclusion Imminent? *


> The Street has been speculating for a couple weeks now that Artis REIT has made the cut and will be added to the S&P/TSX Composite on S&P’s next quarterly revision (announced on September 10, effective September 17).
> 
> If the Street’s analysis proves correct and Artis is added, analysts are expecting overall net index demand to be 2.5-2.9 million units (approximately 3.8-4.5% of total shares outstanding and 15 days trading), which should put positive pressure on Artis’ unit price.


From Canaccord-Genuity daily letter.


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## Bupp (Nov 13, 2009)

alphatrader2000 said:


> It is not as straight forward as your pointing out. [TB]he price goes up generally because there is SOLID demand for the stock that is added to the index fund [/B]and anything that mirrors that. While the stock price might drop a bit the next day after the inclusion. The drop (if any) is nothing comparing to the increase from the annoucement to the inclusion.


Alpha, let me spell it out more clearly with an example.

ABC corp is trading at $100 per share. 

It's market cap has grown enough that it is likely to be included in an index when the index updates its constituents.

Because people expect abc to be added to the index and know that there will be solid demand for the shares from XYZ index fund, they start buying shares of abc corp.

This drives the price up to $105 per share.

XYZ now buys their shares at $105.

Even if the share price of ABC does not drop below $105 owners of XYZ have lost out because they paid $5 more for their shares then they should have.

This causes the overall return of the index to suffer.

Markets are not efficient. Stocks do have downward sloping demand curves.

EDIT: sp500 announces deletions/additions one week before they are added to the index. Gives people plenty of time to get in before the index funds have to load up or dump their shares.


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## Bupp (Nov 13, 2009)

kcowan said:


> *Index Inclusion Imminent? *
> 
> 
> From Canaccord-Genuity daily letter.


Lets see what happens here, my guess is a run up between now and the inclusion date followed by a sell off 3-5 days after the inclusion.


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