Friday, 14 June 2013

Building Your Own Index ETF

Ever thought of building and managing your own equity portfolio using ETF-like index methods? Let's explore how much time, trouble and cost it takes.

The Basic TSX Composite
The TMX Money website lists all the 237 constituents of the TSX Composite Index but not the proportion of each stock, which is needed to know how much of each to buy, so we must turn to BMO, which offers an ETF that tracks the index. Well, almost. The BMO offering traded under symbol ZCN tracks a version of the Composite Index which caps the maximum holding of each stock at 10% of the total fund. BMO does post the percentage weight allocation of each holding, but not the industry Sector each stock belongs in. iShares Canada has an ETF (symbol: XIC) that tracks the same index and it does post the Sector for each stock.

Our comparison table shows the end result ETF-like portfolio, as well as the workings described below.
(click on image to enlarge)

Challenge #1 - Too many stocks to buy, picking a representative subset
An attempt to buy and hold all 237 stocks is would overwhelm even the most enthusiastic individual investor. We winnow the list down drastically and yet maintain something representative of the index by taking about 10%, or 24, of the stocks, spreading them across the various Sectors.

The principle upon which the Composite Index / ZCN is based is that each stock should be weighted and held in proportion to its total market value of shares, or market cap. We sorted the downloaded ZCN holdings by Sector and market cap and then took 10% of the stocks within each Sector, ensuring that each Sector was represented by at least one holding. For example, there are only four Health Care stocks in ZCN, so we selected one, Valeant Pharmaceutical, which has the largest market cap. As a result of picking more than 10% in small Sectors our final list of stocks expanded a bit to number 26 in total.

Maintaining the proper Sector weight, which is shown on the BMO holdings page for ZCN, required us to ramp up the allocation to each stock, done in proportion to the share each stock occupies in the Sector. That meant, for example, that Magna and Thompson Reuters went from 1.12% and 0.86% weighting respectively in ZCN, to 3.04% and 2.33% in our home-made ETF to keep the Consumer Discretionary Sector weight total at 5.37%. One of the good and encouraging figures we notice is that the end result 26 stocks make up fully half of the total market value weight out of the 237 original list. It doesn't take many stocks to represent a big chunk of the index.

Challenge #2 - Smaller weight stocks suggest a large amount of capital is required
The next part of our experiment was to estimate how much to buy of each stock. It quickly became apparent that the smaller weight holdings would require low dollar amounts and very few shares. Our example table uses a total portfolio size of $100,000 and even then the smallest holdings are quite puny, like First Quantum Minerals which gets $1269 allocated to it. There would be only 16 shares to buy of Canadian Pacific Railway.

Challenge 3# - Maintenance requires monitoring and trading
The world, and markets, don't stop the day shares are bought. Though the market cap basis of this pseudo-ETF means that values of Sectors will generally stay reasonably in line with the overall index, when non-included companies go up more than the overall Sector, our ETF will go out of whack. In addition, acquisitions and divestitures, mean companies enter or disappear from the index (index creator and maintainer S&P Dow Jones publishes changes as required here). Some trading will be required and expenses incurred.

Testing the feasibility of a novel ETF-like strategy - fundamental weighting of low volatility stocks
Despite the plethora of ETFs, some slants are not yet covered. Inspired by previous blog posts where we wrote about promising alternative index methods like fundamental weighting and low volatility stock selection plus this article - An Investor's Low Volatility Strategy - from Research Affiliates that advocates a combination of the two investment strategies, we decided to put our own home-grown version together.

The idea is to select the least volatile stocks from the fundamental index and to correct the small cap and Sector bias of a typical low volatility index. This is done by ensuring a) the stocks selected are the largest, as measured obviously by the fundamental factors sales, dividends, cash flow and book value (instead of market cap as the TSX Composite does), and b) that the Sector weights of the fundamental index are maintained. There is no such ETF on the market so we have built our own for Canadian stocks and the result is shown below.
(click on image to enlarge)

The PowerShares FTSE RAFI Canadian Fundamental Index ETF (PXC) already selects the largest Canadian companies by fundamental factors. From amongst those we have taken the third (c.29 of 88 stocks) with the lowest volatility,as measured by Beta (figures obtained from the Globe's My WatchList tool where we entered all of PXC's stock stock symbols).

In this portfolio we ended up with 30 stocks after applying the rule to select at least one stock from each industry Sector. Those 30 stocks only represent 35% of the value of the original PXC portfolio, much less than the ZCN-imitator. On the other hand, two companies alone, TD Bank and TransCanada Corp each make up an uncomfortably large 13% of the total portfolio. A mere five of the financial and energy stocks make up half the portfolio, quite a concentrated portfolio. There is a lot more difference in weight than in our first portfolio effort above between between the largest and the smallest holdings. The smallest holdings are really small, much more so than the ZCN-clone.

As both volatility and fundamental weights evolve, there would be a requirement for more monitoring and probably more rebalancing trading. In short, though the paper reveals some very attractive backtested performance results for such a strategy, it does not look very  practical for the individual investor to do him or herself.

Conclusion: For tracking a broad index, building your own ETF-like portfolio isn't worth the time and effort. BMO's ZCN charges 0.15% annually, which would be $150 on a $100,000 holding, ZCN holds the entire portfolio to boot, providing even greater diversification and, BMO does all tracking and rebalancing trading for the investor.

For constructing a portfolio to implement a trading strategy that has index features, it also looks to be impractical. Better to wait for an ETF provider to implement the strategy on a scale that avoids introducing concentration and holding size problems, providing of course that the fees are reasonable.

When it might make sense to build your own ETF-like portfolio - if the index has very few constituents - Specialized ETFs, such as those for individual Sectors, can sometimes be effectively copied with a handful of holdings. For example, the Canadian REIT Sector has only a handful of companies. iShares' REIT offering has 14 holdings, while BMO's has 19. Taking a handful of the main companies may replicate the Sector very effectively. Several years ago, Stingy Investor looked at various Sectors and whether unbundling them, as he termed it, made sense.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

No comments: