Pad profits by cutting manager out of the equation
By David Parkinson
published in the Globe & Mail
July 7, 2007

After more than 30 years in the investing game, Terry Shaunessy has come to a conclusion: "Simple is better."

That's why the former president of Gordon Capital, who now heads Calgary-based portfolio management boutique Shaunessy Investment Counsel Inc., has abandoned active management in favour of passive portfolios, which he says incur lower costs and less risk. And he's advising his wealthy clientele to go with about the simplest portfolio one could imagine: He takes the 50 biggest Canadian, U.S. or international stocks, buys an equal dollar amount of each of them, and the portfolio building is done. "We're trying to provide this in the cheapest and most efficient way," he said. "We're trying to eliminate manager risk. Most of the risk is in the manager, not the market."

Mr. Shaunessy's portfolios represent a style of passive investing known as equal-weighted indexing. You model a portfolio after all or part of a traditional market index that weights each stock by its market capitalization - but instead of market-cap weighting, you assign an equal weight to every stock. If you have 50 stocks in your index, each one accounts for 2 per cent of your total assets. Then you simply step back and let it trade, only intervening occasionally to rebalance the weightings so that the components all remain equal.

It's simple enough that a retail investor could mimic the strategy. And it works. Mr. Shaunessy, who launched his Canadian, U.S. and international "heavyweight" portfolios in 2005, has back-tested their performance to 2002 and found they have consistently outperformed their respective market benchmarks. Shaunessy's Canadian Heavyweight equal-weighted portfolio has a five-year annualized return of 15.8 per cent, almost three percentage points higher than the S&P/TSX composite; the U.S. Heavyweight portfolio has a five-year annualized return of 6.6 per cent, more than two percentage points above the S&P 100.

As Standard & Poor's has shown in its performance comparisons of its indexes versus actively managed funds, active management consistently underperforms the passive market benchmarks. Over the past five years, only 10 per cent of actively managed Canadian equity funds have outperformed the S&P/TSX composite index; annualized five-year rates of return are more than three percentage points lower for the actively managed funds.

That's a strong argument in favour of passive, index-based investing. Still, many indexing strategists have come to the conclusion that investors can still practise index investing while achieving better results than the S&P's market-cap-weighted indexes.

The one big knock against market-cap weighting is that it is permanently biased toward the largest-capitalization stocks. The bigger a stock gets, the more weighting it carries in the index - even if the price gains that have propelled that growth aren't supported by fundamentals.

"Market-cap weighting always overweights overvalued stocks and underweights undervalued stocks," Desjardins Securities chief strategist Peter Gibson wrote in a recent report. That means any passive portfolio mimicking the index is overexposed to stocks with more downside than upside, while they are underexposed to stocks with better growth potential.

But the periodic rebalancing of equal-weighted indexes solves this problem. It automatically instills discipline in the investor, essentially forcing you to take profits on stocks that have run up and to load up on ones that may have become undervalued, thus smoothing out volatility and risk exposure at the extreme ends of the portfolio.

Still, rebalancing is not without its own flaws. Investors will incur substantial transaction costs from buying and selling stocks to bring their portfolios back into balance, and that can cut into returns.

"The challenge facing any [index] provider or manager is determining the correct rebalancing frequency," Brad Pope, index strategist at Barclays Global Investors, wrote in a report last year on alternative indexing strategies. "Too frequently and transaction costs become prohibitive; too infrequently and the equal-weighted index will become capitalization-weighted."

To maintain a truly equal-weighted portfolio, you would have to rebalance it daily, which simply isn't practical or cost effective. But Mr. Shaunessy says high-frequency rebalancing is unnecessary to achieve the benefits of equal weighting: Through some trial and error, he has determined that his portfolios need only twice-a-year rebalancing to optimize cost and return efficiencies.

Equal-weighted indexes do contain an inherent bias of their own toward mid- and small-cap stocks - something that, Mr. Pope suggests, exposes them to a higher risk profile. But Mr. Shaunessy argues that as long as your equal-weighted portfolio is composed of stocks within the same "peer group" of size, the bias is negligible. That's why he focuses his portfolios on the 50 biggest Canadian and U.S. stocks, all of which could rightfully be considered large-cap stocks despite their size differences within that group. He said this provides a wide enough sampling to be representative of the broader market, while limiting any size-bias concerns.

Unfortunately for most investors, the two Shaunessy equal-weighted portfolios are out of reach: The firm has set the minimum investment at a prohibitive $5-million. However, Shaunessy also serves as subadviser to two mutual funds offered by Toronto-based Galileo Global Equity Advisors Inc., both of which use active management for 40 per cent of their assets and Shaunessy's passive portfolios for the other 60 per cent. The Galileo Canadian Active/Passive fund (using the Shaunessy Canadian Heavyweight portfolio for its passive component) and the Galileo Global Active/Passive fund (which uses the Shaunessy U.S. Heavyweight and International Heavyweight portfolios for its passive component) both have much more affordable minimum initial investments of $500.

Equal-weighted versions of the S&P 500 and Nasdaq 100 indexes also trade publicly as exchange-traded funds on U.S. stock exchanges. The Rydex S&P 500 Equal Weight ETF trades on the American Stock Exchange under the symbol RSP, while the First Trust Nasdaq 100 Equal Weight ETF trades on Nasdaq under the symbol QQEW