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The Toronto Composite Index: a "closet" mutual fund?

November 30, 2011 by Editor,

How often do you look at the Toronto Composite Index? Once a day? Twice? Three times? More than that? Let’s face it. A lot of us closely monitor the Index’s ups and downs using it as a quick proxy for our own investments. But should we? Is the Toronto Composite Index still relevant to investors today?

What is a composite index?

Here’s how Investopedia defines a composite index:

 “A grouping of equities, indexes or other factors combined in a standardized way, providing a useful statistical measure of overall market or sector performance over time. … These indexes are useful tools for measuring and tracking price level changes to an entire stock market or sector. Therefore, they provide a useful benchmark against which to measure an investor's portfolio. The goal of a well-diversified portfolio is usually to outperform the main composite indexes.”

 So, according to Investopedia’s definition, the Toronto Composite Index, like all indexes, should act as “a useful benchmark against which to measure an investor's portfolio.”


The TSE300 Composite Index was first implemented in 1977 as a benchmark for the Toronto stock market. For 25 years, the Index always contained 300 companies and the managers did not have discretion over this number. It was carved in stone. And the companies that comprised the TSE300 Index could only be changed once a year, at its annual review.

All of this changed when the management of the Index was contracted to Standard & Poors in the United States in May 2002.

The Index today: under new management

On May 1, 2002, the TSE300 Composite Index ceased to exist and 25 years of market data ended with it. A new index, the S&P/TSX Composite Index, managed by a new manager, Standard & Poors, with a new set of rules replaced it.

With this change came a complete overhaul of the index's structure, construction and management. New rules were set for a company’s inclusion and exclusion in the index, the number of stock market sectors represented was consolidated from 14 to 10, and the number of companies making up the index became variable and subject to the managers’ discretion.

Where the old TSE300 Composite Index was reviewed and adjusted once a year, the new Composite Index is adjusted quarterly and at the discretion of the seven members of the S&P/TSX Index committee.

From the Standard and Poors’ own description, the frequency of change to the Index is guided by the following:

Additions to the S&P/TSX Composite Index are generally only made as part of the Quarterly Review.” They also note(s) the following: “The Index Committee may nevertheless choose to review and add a security to any of the indices in between quarterly review periods.”S&P/TSX Canadian Indices Methodology

Unlike the managers of the old TSE300 Composite Index, the new managers have complete discretion as to how many companies are included in the Index and how often changes are made. They can select 269 companies one year and 204 companies the next year. If they no longer like one of the companies, no problem, just change it. If the new managers think more Gold stocks are needed, simply add them. If Technology stocks are no longer working for you, no problem, just eliminate them, as they did between 2005 (14 companies) and 2011 (6 companies).

With this new set of rules, it kind of sounds like an actively managed mutual fund, doesn’t it? In other words, they can add (buy) and delete (sell) investments whenever they want, just like a mutual fund manager. That’s a pretty important difference from a standard definition of an index. But before we look at this impact, let’s first look at the stats.


The numbers

Today, the S&P/TSX Composite Index includes 256 companies. However, just two years ago, in 2009, there were 204 companies. Two years before that, in 2007, the answer was 269; compare that number yet again in 2005 when there were 213 companies, and in 2003 when there were 223 in the S&P/TSX Composite Index. In other words, that’s quite a change from one period to the next.

Here’s a simple graphic illustration of how much the TSX Composite has changed over the years with its new management.

Note: The chart lists the number of companies in the S&P/TSX Composite Index, in two-year intervals, since 1993. (Remember, the transition from the TSE300 Index managers to the new Index managers was completed by December 2002.)


Index vs. mutual fund

It used to be that when an investor or advisor studied a mutual fund’s past performance and current asset allocation, we would mentally ask, “Is this fund actively managed, or is it simply a closet indexer?” In other words, we tried to figure out whether the fund’s past performance was good because the managers were good or were the managers simply mimicking the index – what we call closet indexing.

Which brings us back to our original question - Is the Toronto Composite Index a closet mutual fund?

Consider this. If a mutual fund manager had to hold an investment for at least a full year before they were permitted to sell it, how would this impact their investment decision? Do you think they would be more careful about their purchases? Probably.

Would the mutual fund manager think differently about their investment choices if they knew they could sell the investment at any time after they bought it? Probably.

Most investors and mutual fund managers will make more conservative investment choices if they know they are locked into their decision. If an investor can sell an investment at anytime, they are much more likely to buy riskier investments.

So if the Index managers can add (buy) and delete (sell) companies out of the index at anytime, how much risk are they happy to take on in the process, more or less?

Since the Standard & Poors began managing the Index, the volatility in the number of companies represented has increased dramatically. An index that goes from using 300 companies in one year to 213 in another and then shoots back up to 269 in another and then back down to 204 and then back up to 256, demonstrates the same behavior you might expect from an actively managed mutual fund.

 Number of companies within each sector also changes dramatically

In addition to the constant change in the number of companies represented in the S&P/TSX Composite Index, the number of companies within each of the 10 stock market sectors also seems to change dramatically each year.

As the chart below demonstrates, within the individual stock market sectors, the number of companies appears to also be actively managed. For example, in 2005, there were 40 companies within the Index’s Energy sector. By 2007 the number was increased 85% to 74 companies. So, it appears that as the price of crude oil climbed the S&P/TSX Composite Index manager ramped up the number of oil and gas companies.


Then, as crude oil’s price declined, the Index manager decreased the number of oil and gas companies from 74 to 50, at 32.4% decrease. Then, it appears the number of companies again increased as the price of crude oil recovered.

If one looks at the activity within the other stock market sectors, it’s easy to arrive at the conclusion that the S&P/TSX Composite Index is no loner a representative Index, but rather an actively managed Index, not much different than any other mutual fund.

 Apples to apples: The result of a volatile Index for you and me?

If the new Index is an actively managed index, then maybe we shouldn’t give it the same respect we did the old TSE300 Composite Index. Maybe we should no longer beat ourselves up (and our investment advisors) if our investments do not recover and perform as well as the Index. Because if we’re not willing to mimic the index manager’s activity, then it’s not fair to expect the same investment results as the Index. (It’s only fair to compare apples to apples.)

For example, you would only want to compare how well your investments were doing against the S&P/TSX Composite Index, today, if your current portfolio hold investments in the same three stock market sectors as theirs (Financials (28.00%), Energy (26.52%) and Materials (23.45%). If you don’t, then don’t expect the same results as the Composite Index.

If you are using the S&P/TSX Composite Index as a quick proxy for your own investment portfolio, then you better closely monitor the changes made by the their Index committee, and just as with any mutual fund, you’ll need to monitor the changes in the individual managers of the committee as well.

 How useful is the S&P/TSX Composite Index today as a historical ruler?

Given the changes in the Composite Index, you have to wonder if studying its historical performance and drawing conclusions from it is really still relevant for today’s investors. Why?

Well, ask yourself this question. If a mutual fund has a 10-year average annual performance of say 10.0%, but the current managers have only been managing the fund’s investments for the last 3 years, is it right to give them credit for the performance in the first seven years?

I don’t think so, and the S&P/TSX Composite Index should not be credited with the performance of the TSE300 Composite Index prior to 2002. The new S&P/TSX Composite Index is not constructed and managed with the same criteria and guidelines as the old TSE300 Index. Just like a mutual fund, today’s index managers had no connection with the TSE300 Index’s previous performance and, thus, have no claim to its history.

So, if the S&P/TSX Composite Index is now a closet mutual fund, its performance history began in 2002, no earlier. The TSE300 Composite Index ‘s performance during past demographic trends, economic and stock market cycles can no longer be used as a reference by investors, advisors and money managers.

This also implies that all of the historical data (1977 to 2002) and technical indicators (Index Price-to-Earnings Ratios, Index Highs and Lows, Trading Volumes, Moving Averages, etc.) cannot be used to compare and assess today’s S&P/TSX Composite Index values. Investors can only use the data and technical information from 2002 onward.


Today's Composite Index is not the index it once was and hasn't been for almost 10 years. Even most experienced investors, however, are unaware that the structure and management of the Index has changed so substantially. But these two very important changes to the very fabric of the Index must be considered.

What are we to conclude about all this? Well, the next time you read, hear, or watch a commentary about the ups and downs of the S&P/TSX Composite Index you should stop and ask yourself the following questions:

  • Is it relevant to my investment portfolio?
  • Do I manage my investments with the same frequency and guidelines as the Index committee?
  • Is it relevant as a gauge for the overall stock market?
  • Is the Index’s performance any more useful than the performance of any other mutual fund?
  • Are the Index’s current data and technical indicators useful when evaluating my investment options?

If you answered no to any of these questions, then maybe the Toronto Composite Index has become no more than a closet mutual fund and, as such, it really shouldn’t hold any relevance for investors today.

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