Thought I’d weigh in on the indexing approach to investing.
music selection: “Head Like A Hole” — Nine Inch Nails
There is an entire camp of the investing community (and its the side that the academic Poo-Bahs are on) that insist the best way to invest is to rely on indexing. This is largely driven by a belief in Efficient Market Hypothesis. My leanings are that the markets are in fact largely efficient. But not perfectly efficient. We only have to look at incidents like what happened with Mannotech* to see that sometimes Mr. Market completely loses his ever loving mind.
The most popular form of index investing is ‘market cap weighted’ indexing. This is a very low cost way to run an index as the holdings automatically adjust when individual holdings increase or decrease in price. It is almost completely passive with trades necessary only when companies are added to or removed from the underlying index. We’ll use VOO (the Vanguard S&P 500) to represent this approach. It is ultimately flawed in that it increases the proportion of anything the market is temporarily over-valuing (and will thus decline when it ‘reverts to mean’.) Similarly, if something is being irrationally undervalued, you’d want to own more of it to catch the rebound but market weighting means you hold less of it. Joel Greenblatt did a 20 year back test of this type of indexing and found a 9.1% average annualized return.
It has long been known that simply changing from a market cap weighting to an equal weighting improves returns over long periods of time. We can use RSP (S&P 500 equal weight) to represent this approach to investing. All holdings have the same weight and thus the market mis-pricings should cancel each other out. This approach does however mean that you are exposed in proportion unequal to the surrounding economy to smaller cap stocks. Greenblatt found this type of investing, over a 20 year look back period, had a 11.8% average annualized return. If you had bought this type of index 20 years ago, you would feel a little smarter than the dumbo T.Rex’s that bought VOO.
It is possible to get the benefits of equal weighting to avoid over-allocating to over priced stocks while under-allocating to under priced ones. The secret sauce is to use a ‘fundamentally weighted’ index. This type of index usually takes the net book value (assets minus liabilities) of companies and weights them based on that. You thus end up with an index that is proportional to the economy at large in terms of balance sheet strength and thus is not small cap slanted, without the preference for overloading on anything that is temporarily overpriced by the market. Greenblatt found this type of investing returned on average over the 20 year look back period, 12.2% annualized. That’s 34% better than the approach that is widely held to be ‘best’ by the indexing community. Hungry indexers can get into this type of investing with the ticker PRF.
Academic research suggests there is an even better approach, weighting an index by ‘value’ and ‘cheapness’ criteria. I am unable to find any real world examples of this type of product with sufficient market history to make this idea invest-able. The ticker VLUE looks interesting in this space but I will not be placing in long capital there. Raptors who do so are wandering off on their own.
Devour your prey raptors!
* Mannotech got bid up to an insane multiple during the dot-com boom when it became presumed that the ‘tech’ in their name meant they were ‘some kind of’ internet company. Many excited “investors” were mightily depressed to learn they were actually in the business of manufacturing *laxatives*. Ironic, given their temporarily BS valuation.