Andrew Hallam is the index investor for Strategy Lab. Globe Unlimited subscribers can view his model portfolio here and read more in the series online here.
Steve Perkins wonders what's going on at home. The Canadian teacher works at an international school in Bangkok. He owns a portfolio of exchange-traded funds through an Asian-based brokerage. But part of his portfolio smells like an open sewer. His Canadian stock market index fund stinks.
Steve owns three equity indexes. They include the iShares MSCI EAFE Index (XIN). It's made up of developed world international stocks. He owns the iShares Core S&P 500 Index ETF (XSP), composed of U.S. stocks. Like most Canadians, he also has a home country bias. Half of his stock market money is languishing in Canada. He owns the iShares Core S&P/TSX Capped Composite Index ETF (XIC).
"I'm rebalancing my portfolio each month by adding to the lagging index," he says. "More often than not, I'm adding to Canada. But the Canadian market has been really bad. I'm starting to wonder if I should shift strategies."
Steve's mettle is getting tested. It's easy to see why. He started his portfolio at the beginning of 2011. So far, his international index (XIN) has gained 46.28 per cent. His U.S. index (XSP) has gained a total of 80.44 per cent. But his Canadian index (XIC) has coughed and sputtered. It gained just 14.48 per cent after nearly five years. That's a compound annual return of 2.8 per cent.
Steve is facing a test that most investors fail. Should he keep adding to a lagging ETF or pump fresh proceeds into an index with a better recent track record? On paper, investing with index funds sounds easy – like lying in a hammock while the market rubs your feet. Our reflexes, however, often upend us, dumping us to the ground.
According to Morningstar, Vanguard's S&P 500 Index fund averaged 7.36 per cent over the past 10 years, measured in U.S. dollars. But most investors in that fund failed to relax. During years when it dipped or lagged, many sought different hammocks.
As a result, investors often sold the index at a low point, to purchase a strong, recent performer on a high. When the new fund slipped, they often jumped back.
As a result of their emotions, the average investor in Vanguard's S&P 500 index averaged just 5.08 per cent over the past 10 years. The gap between what a fund earns and how its average investor performs has costly repercussions. Somebody averaging 7.36 per cent over 25 years could turn $10,000 into $59,028. But if their fear and greed cost them 2.28 per cent a year, they would turn that same $10,000 into just $34,514.
Yes, Canadian stocks have been frustrating. But a Yale University professor does offer comfort. Robert Shiller developed a price-to-earnings (P/E) ratio that measures a stock's price, relative to a company's cyclical business earnings. It's called a cyclically adjusted price-to-earnings ratio (CAPE). When a country's stock market index reports a lower-than-average CAPE ratio, its stocks usually perform well in the decade ahead.
Based on this measurement, Canadian stocks look great. Joachim Klement, the chief investment officer at Wellershoff & Partners Ltd., says Canada's CAPE level is 17.4. The market's long-term average is 19.3.
U.S. stocks, in contrast, are at a nosebleed high. Their average CAPE level trades at 22.5 times earnings. Their historical average is 16.4. Based on historical data, Canada's stock market is poised to leave the U.S. market in its dust.
Investors, however, need to be patient. Nobody knows when, but Canadian stocks will rock once again. Smart investors need to stay on course. By rebalancing once a year, they'll buy a bit of what's low and sell a bit of what's high. By collaring their emotions, the test becomes easy. If only human nature could make such a promise.