Discover the 7 criteria to build a portfolio with the best trackers: the stock market indexes followed, the fees, the amount outstanding, the quality of the tracking, etc. First, we remind you why trackers are more efficient than active funds for investing in stocks. Finally, we explain in concrete terms how to invest in trackers.
Why trackers to invest in the stock market?
The 2 methods of investing in the stock market
To invest in the stock market, you have the choice between 2 methods:
Active management
In active management, you select your own shares and mutual funds (active funds). This is the image that the French have of the stock market and of investing in shares: choosing the best stocks (“stock-picking”), buying and selling them at the best time (“market timing”). And the banks are pushing in this direction because the management fees are higher than in passive tracker investment: 2% per year on average.
Passive management
You invest in trackers, also called ETFs** (Exchange Traded Funds). Trackers simply replicate their benchmark: CAC 40, Nasdaq, etc. Trackers’ management fees are low: 0.25% per year on average.
Trackers beat active funds in the long term
More and more investors are investing in the stock market through trackers, rather than through active funds. Why is this? Contrary to what you might think, being active and multi-trading does not earn more than being passive. The fact is that passive investing in trackers has historically performed better than investing in active funds. So the time spent selecting active stocks or funds is counterproductive. In the end, it’s better to be lazy and invest in ETFs, which is what we call lazy investing.
Over the last 10 years, the vast majority of active fund managers have failed to beat their benchmark. That is, they have been beaten by trackers. See the result in pictures.
Share of active fund managers beaten by their benchmark (the indices tracked by trackers)
What interests us as long-term equity investors is the long-term performance of active funds versus index funds (trackers). Let’s look at the “Global Equity” level, i.e. global equities. In other words, the World tracker has outperformed 99% of the active funds (European managers) in the global equity universe over the past 10 years. The victory is overwhelming and you have to be very lucky to find the small 1% of active funds that outperform because they change frequently. And this is not an isolated case: the victory is also clear for trackers compared to European, emerging and US funds.
The arithmetic in favor of ETFs
It’s mathematical: the fees of active funds weigh heavily in the long term: 2% per year versus 0.25% per year on average for trackers. Imagine a 10-horse race: 9 jockeys are weighted with 20 kilos (the active funds) and only one jockey has no weight handicap (the tracker). The jockey without a handicap has the best chance to win, especially if the race is long. This was also demonstrated by William Sharpe, the 1990 Nobel Prize winner in economics.
That said, you can take the gamble of investing in a few active funds. Good luck betting on the right horses and keeping them the best in the long run. You’ll want to keep an eye on the management team, their strategy and manager changes. We explain in more detail here, through the units of account in life insurance.
Warren Buffett’s advice
This is good news for you: no particular skill to develop to analyze and select stocks or active funds and no time to waste reading reports. Just invest in trackers and you’ll do better in the long run than most professional managers! This is also the statement of the best investor in the world, Warren Buffett: “Investors, large and small, should stick to low-cost index funds.”_ Okay, but which trackers to choose?
Investing in trackers: which tracker to choose?
We are convinced: trackers are the ideal way to invest in stocks for pragmatic investors. But how to build a tracker portfolio? There are more than 500 ETFs listed on the Paris stock exchange! So, what are the criteria for selecting ETFs? We will present you with 8 criteria to choose your trackers.
1/ The stock market index to follow
This is the main criterion for selecting a tracker. Your ETF will track a stock market index: **Decide on your allocation between the different geographical zones. And more incidentally, between company sizes (small or large caps). Here are the main indices to know:
The MSCI World
The MSCI World is the most general index. It includes the world’s 1,600 largest companies (in reality, the index is concentrated on 23 developed countries). Note: this index is composed of more than 60% of American companies! It is a fact, American companies are very powerful and represent a large part of the world economy. Next, Japan weighs about 8% of the index. The United Kingdom is close to 5%. Then France and Switzerland each have about 4%. Finally, the other developed countries weigh in at about 15%.
The S&P 500
This is the flagship index of the United States. It is composed of the 500 largest American companies**, hence its name. It is the most representative index of the American market. In the S&P 500, we find the famous technology stocks GAFA: Google, Apple, Facebook and Amazon.
The Dow Jones (DJIA)
The Dow Jones Industrial Average, more commonly known as the Dow Jones, is the oldest index in the world! It was created in 1 884 by two financial journalists: Charles Dow and Edward Jones. It only includes 30 American companies**, which does not make it the ideal index to follow.
The NASDAQ
The NASDAQ Composite includes more than 4,000 American companies. It is generally a more volatile index than the others, as it is heavily weighted in technology and computer stocks.
The RUSSEL 2000
This is the index for US small caps. “Small but strong”: the 2,000 companies that make up the RUSSEL 2000 index weigh an average of $2 billion. This index can be interesting for diversifying into small caps compared to the other indices mentioned. However, it is important to note that small caps are more volatile than large caps.
The Nikkei 225
This is the main Japanese index. As a reminder, Japan weighs about 8% of the MSCI World index, so it is not a small index. It is twice as important as the French flagship index, the CAC 40! The Nikkei 225 is composed of 225 companies. The Topix is the other stock market index of the Tokyo Stock Exchange, it includes 1250 listed companies.
The MSCI Emerging markets
This is the index of the emerging countries, which in principle will be the developed economies of tomorrow. It includes 24 countries, mainly China, South Korea, Taiwan, Russia, India, Brazil and South Africa.
The STOXX Europe 600
You will have understood: the STOXX Europe 600 groups together the 600 largest European capitalizations. The United Kingdom, Germany and France account for more than 50% of the index, which includes 18 European countries.
The CAC 40
It must be admitted that this is not a large index on a global scale, but we mention it out of patriotism! It includes the 40 largest French capitalizations. Sanofi and Total often compete for the top spot. Financial companies (BNP, Société Générale and Crédit Agricole) weigh heavily in the CAC 40, as well as luxury goods companies (Hermès, L’Oréal, Kering and LVMH).
The evolution of 4 major indices over 13 years
Starting point at 100 for each index, as of 22/09/2008. The market is bullish over the period, with a few corrections, but the rise is not at the same pace. The American indices take off !
We can never remind enough the importance of diversifying. At worst, it is better to take a single World tracker, rather than investing only in France. Note: we have removed the MSCI World index from the chart, as the curve was merged with the S&P 500 index, as the performances are very similar (the United States accounts for 60% of the World index).
2/ The tracker issuer and the volume of assets under management
Invest in ETFs from solid issuers. Lyxor is a subsidiary of Société Générale and Amundi is owned by Crédit Agricole. Their business is to issue and manage trackers. In France, these are the 2 most reputable names for investing in trackers. So select trackers (Lyxor, Amundi or other large solid issuer) that manage a lot of money, at least 70 M€ under management. This is called the AUM.
Liquidity and spread
Know that a good outstanding amount also ensures a good liquidity, i.e. you will be able to buy and sell easily. If the tracker is not liquid enough, the risk is to have a purchase price that differs too much from the sale price. This difference is called the “spread” and we try to reduce it as much as possible, thanks to good liquidity.
3/ Dividend distribution policy
Capitalizing or distributing tracker? Dividends - paid by the companies making up your tracker - can be :
- Capitalized**: dividends directly and automatically reinvested in the tracker. Capitalizing trackers are preferable, especially if you invest in a securities account (CTO) and not in a PEA.
distributed: dividends paid into your cash account. You can therefore do what you want with them. This is interesting if you want to reinvest elsewhere or to generate an annuity.
To know: **If the CAC 40 index rises from 5,000 points to 5,500 points over 1 year, you might think you’ve gained 10%. But that’s without taking into account the dividends that have been paid to you! In the case of the CAC 40, you can add about 3% in annual dividends.
For example, as of 9/21/2018, the naked CAC 40 is at 5,494 points, while the CAC GR (Gross Return, with dividends) is at its near all-time high with 14,385 points! That is a nice +100% in 10 years for the CAC GR (while the naked CAC has not progressed much over the period, see the previous chart):
4/ Fees
Management fees (total fees on assets: TFE) are 0.25% per year on average. Although managers have to be paid, they are much less greedy than their counterparts in active funds, who charge an average of 2% per year. Depending on the ETF, fees generally range from 0.10% to 0.55% per year. Beyond the high end of this range, you should choose another tracker. Note that fees are deducted directly from the tracker’s performance: the performance of funds (assets and liabilities) is always announced net of management fees.
Securities lending
Surprisingly, despite the management fees, some trackers regularly outperform their benchmark index (e.g. S&P 500) thanks to stock lending. So don’t stop at fees: compare the performance of several trackers tracking the same index (e.g. Lyxor S&P 500 vs. Amundi S&P 500). Finally, **a tracker with higher fees can beat another tracker with lower fees on the same index.
5/ Hedging against currency risk
Hedged trackers** allow you to hedge against currency risk. Indeed, an S&P 500 tracker composed of stocks quoted in dollars is sensitive to the evolution of the €/$ exchange rate, so you may want to hedge against the currency risk. Thus, you pay a little more in management fees on a hedged ETF, but you neutralize the currency risk to keep only the market risk. Note that in the very long term, hedging is less justified. Moreover, some hedged trackers are not eligible for PEA, such as the hedged World tracker, which is only available in a few life insurance companies (Linxea Avenir).
6/ The quality of replication
As we have explained, the main mission of a tracker is to perfectly “stick” to its benchmark, which is what we call replication. If the CAC 40 rises by 1.05% this Monday, the CAC 40 ETF must therefore rise by 1.05%; at least as close as possible. In concrete terms, the quality of the replication is evaluated on 2 indicators:
- the tracking difference. This is the difference in performance between a tracker and the index it replicates over a given period. It is a long-term measure.
- Tracking error**. This is a short-term measure. Every day, we evaluate the stability of the ETF’s performance compared to its benchmark.
Example: a CAC 40 ETF has exactly the same performance as its index over 1 year, let’s say +8.52%. But on closer inspection, the performance differences over this period are quite high: more or less 0.10% compared to the CAC 40 index every day! We are therefore dealing with a tracker that replicates poorly (good tracking difference but bad tracking error).
7/ Physical or synthetic tracker
There are 2 types of replication:
- physical replication (direct replication = DR). This is the standard: a physical tracker owns companies in exactly the same proportions as the index it tracks. For example, LVMH weighs 9% of the CAC 40, so LVMH will weigh 9% of the CAC 40 ETF.
- Synthetic replication** (indirect replication). In this case, the tracker buys companies and then exchanges the performance of this portfolio with the performance of the index it wants to track (via a “swap”) with another financial player.
Let’s keep in mind that some prefer the concreteness of physical replication, but this is not a major issue. Synthetic trackers have the great merit of allowing us to invest in PEA on trackers that follow non-European indices. They offer us the luxury of being able to diversify geographically on the PEA, outside Europe!