Creating my own index fund

[Kaspar]

I’m a fan of index funds so I’ve been contributing to FNZ and OZY using their regular savings plan. I’ve been pleased with the returns of both funds but the $ value of my FNZ holding will surpass six figures this year (barring any crash of course) and a thought occurred to me that it could be possible to get a similar market return, but with lower fees.

We’re unique in NZ in that the NZX 10 market cap is such a huge chunk of our market and the NZX 10 correlation with the NZX 50 index is almost identical. We’re probably one of the few markets where what I propose is possible.

So I was thinking I could make my own modified version of TNZ. Let’s call it the Kaspar NZ Leaders Fund and I have 100k to begin with. I like to keep things simple so instead of having the holdings by market cap weight like TNZ I will start off with equal weightings for each stock and they will be left to float freely. So 10k in each stock initially. Letting them have equal weighting can move in my favour sometimes or against me other times, but in theory it shouldn’t make too much difference over the long term.

10 trades will cost $300 so the MER is effectively 0.3% vs TNZ 0.6% and FNZ 0.75%. With dividends and savings I will buy in once a year with approx 25k. It will cost 1.2% to buy in each year (300/25000) but the overall MER will still be cheaper.

Now there’s the subject of rebalancing. There’s hardly any constituent changes except recently with Xero entering the NZX 10, so don’t need to worry about that much. When it comes to buying the shares each year, I was thinking about putting an equal amount ($2500) into each. But then I thought what if Xero becomes a monster and puts the balance way outta whack. Then I might put more into the other 9. I need more opinions on this.

The pros I can think of so far are more control, less cost, quarterly dividends (currently biannual with Smartshares, but doesn’t really matter as they get reinvested anyway). Cons include less diversification (10 stocks vs 50), and prob not as tax efficient as the other funds due to them being PIEs.

I don’t like maths and these are just my initial thoughts, so I could be overlooking something, what do you guys think?

[BlackPeter]

I’m a fan of index funds so I’ve been contributing to FNZ and OZY using their regular savings plan. I’ve been pleased with the returns of both funds but the $ value of my FNZ holding will surpass six figures this year (barring any crash of course) and a thought occurred to me that it could be possible to get a similar market return, but with lower fees.

We’re unique in NZ in that the NZX 10 market cap is such a huge chunk of our market and the NZX 10 correlation with the NZX 50 index is almost identical. We’re probably one of the few markets where what I propose is possible.

So I was thinking I could make my own modified version of TNZ. Let’s call it the Kaspar NZ Leaders Fund and I have 100k to begin with. I like to keep things simple so instead of having the holdings by market cap weight like TNZ I will start off with equal weightings for each stock and they will be left to float freely. So 10k in each stock initially. Letting them have equal weighting can move in my favour sometimes or against me other times, but in theory it shouldn’t make too much difference over the long term.

10 trades will cost $300 so the MER is effectively 0.3% vs TNZ 0.6% and FNZ 0.75%. With dividends and savings I will buy in once a year with approx 25k. It will cost 1.2% to buy in each year (300/25000) but the overall MER will still be cheaper.

Now there’s the subject of rebalancing. There’s hardly any constituent changes except recently with Xero entering the NZX 10, so don’t need to worry about that much. When it comes to buying the shares each year, I was thinking about putting an equal amount ($2500) into each. But then I thought what if Xero becomes a monster and puts the balance way outta whack. Then I might put more into the other 9. I need more opinions on this.

The pros I can think of so far are more control, less cost, quarterly dividends (currently biannual with Smartshares, but doesn’t really matter as they get reinvested anyway). Cons include less diversification (10 stocks vs 50), and prob not as tax efficient as the other funds due to them being PIEs.

I don’t like maths and these are just my initial thoughts, so I could be overlooking something, what do you guys think?

Nothing wrong with banking the fees you otherwise would pay your fund manager for yourself! I don't see a lot of downsides in doing it yourself, would personally however go for a somewhat larger diversification than sticking with the NZX10. Why not taking the NZX15 or NZX 20 instead?

However - just looked at the composition of the NZX10 - all sort of good companies, but a good number of them in my view currently overvalued (AIA, XRO, TEL, RYM) with potential to go sidewards for some time or at the top of their cyclical phase (e.g. FBU). Maybe a bit of active management might pay off, but than - who am I to tell Mr Market he got it wrong?

[Kaspar]

Good point, the NZX15 would still be relatively cheap to manage. Although my 'buy in' cost per year is getting quite high. Is it really worth the extra cost when the NZX10 is already quite a diverse bunch of stocks?, I don't really know, I guess it's an individual thing.

[BlackPeter]

Good point, the NZX15 would still be relatively cheap to manage. Although my 'buy in' cost per year is getting quite high. Is it really worth the extra cost when the NZX10 is already quite a diverse bunch of stocks?, I don't really know, I guess it's an individual thing.

Not quite sure, whether the top up cost need to increase if you have higher diversity. Just reduce the top up frequency per stock accordingly. E.g if you go for the NZX10 and want to top up every stock annually, than you pay 10 transaction fees per year. If you put however 20 different stocks in your portfolio and top up each only once every 2 years, than you have still the same 10 top up fees per year.

As well - if brokerage fees are a major concern for you: you could look for share reinvestment plans and utilise them ... saves you the brokerage fees and often adds an additional discount (but not every NZX10 company will have a SRP).

[BlackPeter]

Good point, the NZX15 would still be relatively cheap to manage. Although my 'buy in' cost per year is getting quite high. Is it really worth the extra cost when the NZX10 is already quite a diverse bunch of stocks?, I don't really know, I guess it's an individual thing.

just a follow up on diversification ... relevant table in Wikipedia:

http://en.wikipedia.org/wiki/Diversi...risk_reduction

Referring to this table - the average standard deviation of annual portfolio returns for 10 (randomly selected) stocks would be 23.93 percent, and for 20 stocks would go down to 21.68%. Admittedly not a huge reduction in uncertainty. However - this formula is only true if the movements of the 10 stocks are independent of each other and stocks are randomly selected (which they are not in your case ...) - i.e you are with your NZX10 stocks still somewhat higher on the portfolio standard deviation curve than the table implies and more diversification will give you a somewhat larger gain.

[noodles]

Not quite sure, whether the top up cost need to increase if you have higher diversity. Just reduce the top up frequency per stock accordingly. E.g if you go for the NZX10 and want to top up every stock annually, than you pay 10 transaction fees per year. If you put however 20 different stocks in your portfolio and top up each only once every 2 years, than you have still the same 10 top up fees per year.

As well - if brokerage fees are a major concern for you: you could look for share reinvestment plans and utilise them ... saves you the brokerage fees and often adds an additional discount (but not every NZX10 company will have a SRP).

One of the advantages of index funds is that you can put in lots of little amounts during the year. This means you reduce of the risk of mis-timing entries. You really want the average price for the year. Buying only once a year means you could buy a market top.

The DRP idea may mean you don't need to add to some shares annually. Perhaps you could buy 10 DRP stocks in the first year. Then second year buy 5 non-DRP stocks. That way you would have 15 stocks, but still paying 0.3%(or close to) for the first 2 years.

DISC: Don't own or sell any index funds.

[Kaspar]

Thanks BlackPeter, this is the sort of input I was hoping to get. I do like diversification that's why I originally bought into FNZ instead of TNZ, but because of the relative size of the NZX 10 (I read somewhere that it's close to 50% of the entire NZX market cap), I'm not sure if the whole diversification thing is really necessary for our small market. The link of the interactive chart I'm looking at won't work properly if I post it, but if you go on Yahoo Finance and compare the NZ10 gross chart to the NZ50 gross chart over 10 years you can see how closely they track.

[Kaspar]

One of the advantages of index funds is that you can put in lots of little amounts during the year. This means you reduce of the risk of mis-timing entries. You really want the average price for the year. Buying only once a year means you could buy a market top.

Yes this is one of the best features, being able to contribute monthly with no brokerage costs, and getting any dips in price etc

[voltage]

Kaspar why make it complicated keep it simple, as you say you can add with no brokerage costs

[Harvey Specter]

Couple of things:

- your brokerage looks expensive. Are they with Direct Brokerages rates or are you using a full service broker?
- You could modify the NZX10 in a different way to your own 10% even split. I think there is a version of the NZX50 that caps any one stock to 5%.
- similarly, you may not have to buy all 10 stocks in your annual or 6 monthly rebalance. Only buy thoses that are significantly underweight. And maybe consider selling any that get considerably overweight.
- Have you considered moving slightly away from the index approach and deliberately being under/overweight in a particular stock. Ie. you may consider FBU expensive at the moment so be a bit light but if it were to drop down into the $6's, go overweight.