What Qualifies As Passive Investment Management?

If I told you that someone who invests in an index fund that tracks the S&P/TSX composite index, with the intention of buying and holding, was taking an active bet against the Canadian stock market, you’d think I was nuts. But consider this: the S&P/TSX composite index was comprised of 211 names as of December 31, 2009, but there were 3,640 listed issuers on the TSX and TSX Venture exchanges collectively.

According to Standard & Poor’s the S&P/TSX Composite Index gives you 95% coverage of the float-adjusted Canadian equity market. This is due to market-capitalization weighting where the bigger a company is, the bigger it’s weight in an index. The top name in the index (again, at December 31st, 2009) was Royal Bank. This one issue was worth about $80 billion. It’s weight in the composite index was 6.18%. But the total market cap of Canadian equities according to The TMX Group was $1.8 trillion (I’m guessing that this is non-float adjusted). That means Royal Bank’s cap-weighted weight was 4.44% if your market was every Canadian issue.

4.44% is substantially different from 6.18%. In the S&P/TSX Composite Index you would be roughly 39% overweight the true market weight of Royal Bank at this point in time.

However, from a practical point of view we would run into problems if everyone indexed a market by owning every single stock as market capacity and impact would become a limiting factor. So, for all intents and purposes tracking the headline index would be close enough that you could call it passive management. But in reality, it isn’t. One way around this is to avoid saying that your benchmark is the Canadian stock market, but rather the S&P/TSX Composite Index.

So really my point is that the Canadian Stock Market and the S&P/TSX Composite Index are not exactly the same things.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 14 comments
  • Canadian Capitalist

    Maybe I’m missing something but I don’t understand the math. If the S&P TSX Composite covers 95% of the Canadian market, and RBC’s weighting in the index was 6.18%, the weighting of RBC in the total market would be 5.87%. The Composite overweights RBC by 5.2%, not 39%.

    • Preet

      Nope – your aren’t missing something. The 95% number comes from S&P’s index fact sheet and I was wondering about it myself as it didn’t add up. I’ll add a note to avoid confusing other people. I think the S&P figure of 95% is wrong.

      • Preet

        Looks like one number is float adjusted (S&P) and the other (TMX) is not.

  • Ink-Stained Gorilla

    “If I told you that someone who invests in an index fund that tracks the S&P/TSX composite index, with the intention of buying and holding, was taking an active bet against the Canadian stock market, you’d think I was nuts.”

    I don’t know if I agree with this. First of all, even investing in the Composite is not practical. So you invest in some form of the TSX 60 – which is 75% of the market-cap. I would say that’s a pretty strong bet on the Canadian Stock market.

    You can use fundamental or equal-weight indexing to minimize sector and issuer concentration risk.

    Maybe you could agument that with a small-cap index if you wanted huge Canadian stock market penentration. Again, you’re ramping up the risk profile of your portfolio considerably.

    Alternately, I could be tongue and cheek and suggest you buy a handful of financial stocks, invest in gold, oil, natgas and copper futures. Buy Potash and RIM. You pretty much have the correlated returns of the Canadian Stock market.

    • Ink-Stained Gorilla

      Scrap copper futures comments. Mining and Materials represents a huge weight of the stock market.

    • Preet

      So, are you saying I’m *not* nuts? :)

      Another way of looking at this, to take it a step further is to ask what is a good gauge for indexing Canadian equities – stock market prices (which build in people’s guess as to future earnings discounted to the present) or is something else better? Consider that in the US, when the “indexes” went down during the tech crash – the average stock went up.

  • Sean

    You can extend your market concept to stocks on the venture exchange (“Canadian market”) or how about all the little private businesses that are not even listed.

    Point: One always has to SAMPLE the market. You may not want to include tiny companies owned by a few people or institutions to make your representative sample/index.

  • Preet

    Good point about private businesses Sean, they outnumber public companies. From data I have in 2002 – of all US companies with revenues over $10 million, fully 88% of them are private!

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