Many investors compare their investment performance to the TSX composite index. This seems to make sense since it is the most widely used benchmark in Canada, and almost all mutual funds compare their performance to the market that way.

But for individual investors, it may not be the appropriate benchmark to use at all. Here are five reasons why you might want to ignore the index.

The TSX is too highly concentrated

The TSX composite is really an index of three sectors: financials, energy and materials and we all know how well the latter two sectors have done recently. 

Most investors probably don't want to have 20% energy exposure, and many do not want any materials exposure. Sure, Canada is made up of rocks, trees, oils and banks, so it makes sense for a representative index to own these sectors. But that does not mean you need to. 

Choose your sector allocations based on your individual objectives.

Indexes do not account for taxes or transaction costs

Indexes regularly add or eliminate companies. They do so without costs, but there are certainly costs involved if you are trying to replicate the index. 

In addition to commissions, there is bid/ask slippage, where you pay a bit more to buy and a bit less to sell. This will impact your performance versus the benchmark. 

If you have a company that is taken over, the index simply replaces it. You, however, have to pay taxes on the sale. A 4% position in a company taken over for cash means you may need to pay 23% capital gains tax (depending on your province and rate). 

Thus, upon reinvesting the proceeds of the deal, you are now almost 1% behind the index, which does not consider taxes in its calculations.

The TSX includes a lot of bad companies

Of course, different investors have different views on what makes a company good or bad. But the TSX composite is a market-weighted and liquidity-based index that includes companies just because they are large. 

Bombardier Inc. (BBD.B/TSX) has been included in the index for decades, but hasn’t made shareholders any money in a very long time. 

Of course, most investors know about Nortel Networks Corp., which at one point made up a whopping 46% of the index prior to its eventual bankruptcy. Sino-Forest Corp., Bre-X and other failed companies have also been part of the index. 

If you ignore the index, you can skip owning the companies you don’t want. The index cannot.

Indexes have survivor bias

In finance, survivorship bias is the tendency for failed companies to be excluded from performance studies because they no longer exist. 

It often causes the performance of indexes to skew higher because only companies that were successful enough to survive are included. The unsuccessful companies, of course, get kicked out of the index. 

This is a case again where an index has an advantage over an individual investor, who may keep their losing investments longer than a regimented index committee.

Good companies are often excluded

Whether it is for size reasons or liquidity reasons, very good companies are often excluded from indexes. 

Evertz Technologies Ltd. (ET/TSX), for example, was recently booted out from the TSX Canadian Dividend Aristocrat Index, which consists of companies that have raised their dividends in each of the past five years. Evertz qualifies there, but did not meet the TSX’s liquidity test, so it was removed. 

This company was punished because insiders own 66% of the company, yields 4%, has $90-million in cash and has more than doubled its dividend since 2009 (it also paid a special dividend of $1.40 per share in 2013). 

To us, that sounds like the definition of ‘aristocrat,’ at least as far as dividends go. Not according to the index definitions, though. 

Individual investors have an advantage here: Unless you are a multimillionaire, you don’t have the same liquidity issues, and can buy anything you want.