Author Topic: Are Traditional Index Funds Truly Optimal  (Read 18424 times)

matchewed

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Re: Are Traditional Index Funds Truly Optimal
« Reply #50 on: June 03, 2015, 08:44:49 AM »
It does make you an active investor whether you'd like to admit to it or not. But IMO people need to get away from the dogma of being a passive investor. We're all active investors here apart from those who invest in the global financial portfolio, the only ones arguing against that are those who are committed to the Bogle belief system and have ingrained into their heads that anything with the world 'active' in it is bad, and anything with the word 'passive' in it is good. He's just a man, not an investing god, and we can take the good things he's said and apply them, and throw out what is silly.

Let's all admit we're active investors here making giant macro bets as to what asset classes and what countries are going to do the best going forward. Then let's move on to admitting that cap weighted index funds' main advantage is costs. And then go from there.

You seem to be saying we're active because everyone is active in your mind. How do you define active investing?

People who go with index fund investing call themselves passive because all they're doing is passively following their chosen market. It doesn't matter which market. The market definition is irrelevant. It's the perceived inefficiency and the action upon it which dictates active versus passive. That's my take on it.

I'm not saying active is bad. You're saying that I'm saying that. Active is just fine, there are several people who seem to be able to do it, an awful lot who don't do well at it. It's not a bad v. good situation in my mind. It's an acceptance of risk, costs, and anticipated returns.

hodedofome

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Re: Are Traditional Index Funds Truly Optimal
« Reply #51 on: June 03, 2015, 08:53:33 AM »
Active investing is saying you know something that the market doesn't. By tilting your allocation away from what the market's allocation is, you are making an active bet. Does this not make sense?

Some on this thread say they don't know what's cheap and what's expensive, so they buy the market. But what they are really doing is buying a specific market(s) out of the possible investable ones. So you're really not buying the market, what you are actually doing is saying you do know more than the market and as a result of your analysis this is what you've determined to be the best investment. I don't see that as being any different from an active manager.

mizzourah2006

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Re: Are Traditional Index Funds Truly Optimal
« Reply #52 on: June 03, 2015, 09:04:18 AM »
Active investing is saying you know something that the market doesn't. By tilting your allocation away from what the market's allocation is, you are making an active bet. Does this not make sense?

Some on this thread say they don't know what's cheap and what's expensive, so they buy the market. But what they are really doing is buying a specific market(s) out of the possible investable ones. So you're really not buying the market, what you are actually doing is saying you do know more than the market and as a result of your analysis this is what you've determined to be the best investment. I don't see that as being any different from an active manager.

It's really not, you are just passively investing in the markets you actively chose to outperform.

Even if you are passively investing in just equities you should only have 30-35% of your equity investment portfolio in the US market based off of global market capitalization. I'd be willing to bet most have more than 35% in US equities.
« Last Edit: June 03, 2015, 09:17:37 AM by mizzourah2006 »

matchewed

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Re: Are Traditional Index Funds Truly Optimal
« Reply #53 on: June 03, 2015, 09:09:53 AM »
Active investing is saying you know something that the market doesn't. By tilting your allocation away from what the market's allocation is, you are making an active bet. Does this not make sense?

Some on this thread say they don't know what's cheap and what's expensive, so they buy the market. But what they are really doing is buying a specific market(s) out of the possible investable ones. So you're really not buying the market, what you are actually doing is saying you do know more than the market and as a result of your analysis this is what you've determined to be the best investment. I don't see that as being any different from an active manager.

I'd say yes it doesn't make sense because you're not making an active bet, you're just choosing to passively accept the risk and anticipated returns from a different market. It has nothing to do with the market. I guess it's just two different definitions of market then. You seem to be saying the only market is what you posted earlier (BND, VTI, VXUS, BNDX). That there are no other investments in the world outside of these. I raise my eyebrow at that.

Isn't the market then everything in the whole world? Every single opportunity for investment? How ridiculous can it get? How about a currency index?

In other words isn't a better definition for active versus passive the amount of action one takes on their chosen market rather than if someone has their investments in all available invest-able things?

mizzourah2006

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Re: Are Traditional Index Funds Truly Optimal
« Reply #54 on: June 03, 2015, 09:16:59 AM »
Active investing is saying you know something that the market doesn't. By tilting your allocation away from what the market's allocation is, you are making an active bet. Does this not make sense?

Some on this thread say they don't know what's cheap and what's expensive, so they buy the market. But what they are really doing is buying a specific market(s) out of the possible investable ones. So you're really not buying the market, what you are actually doing is saying you do know more than the market and as a result of your analysis this is what you've determined to be the best investment. I don't see that as being any different from an active manager.

I'd say yes it doesn't make sense because you're not making an active bet, you're just choosing to passively accept the risk and anticipated returns from a different market. It has nothing to do with the market. I guess it's just two different definitions of market then. You seem to be saying the only market is what you posted earlier (BND, VTI, VXUS, BNDX). That there are no other investments in the world outside of these. I raise my eyebrow at that.

Isn't the market then everything in the whole world? Every single opportunity for investment? How ridiculous can it get? How about a currency index?

In other words isn't a better definition for active versus passive the amount of action one takes on their chosen market rather than if someone has their investments in all available invest-able things?

If this is the case isn't a buy and hold individual stock investor a passive investor?

matchewed

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Re: Are Traditional Index Funds Truly Optimal
« Reply #55 on: June 03, 2015, 09:20:40 AM »
Active investing is saying you know something that the market doesn't. By tilting your allocation away from what the market's allocation is, you are making an active bet. Does this not make sense?

Some on this thread say they don't know what's cheap and what's expensive, so they buy the market. But what they are really doing is buying a specific market(s) out of the possible investable ones. So you're really not buying the market, what you are actually doing is saying you do know more than the market and as a result of your analysis this is what you've determined to be the best investment. I don't see that as being any different from an active manager.

I'd say yes it doesn't make sense because you're not making an active bet, you're just choosing to passively accept the risk and anticipated returns from a different market. It has nothing to do with the market. I guess it's just two different definitions of market then. You seem to be saying the only market is what you posted earlier (BND, VTI, VXUS, BNDX). That there are no other investments in the world outside of these. I raise my eyebrow at that.

Isn't the market then everything in the whole world? Every single opportunity for investment? How ridiculous can it get? How about a currency index?

In other words isn't a better definition for active versus passive the amount of action one takes on their chosen market rather than if someone has their investments in all available invest-able things?

If this is the case isn't a buy and hold individual stock investor a passive investor?

I guess again it depends on the definition of the market. If you define the market as only those individual stocks (which would be a hard sell given that they will have competitors) then yeah. Given that hard sell though, no. Your active because you perceive an inefficiency and are acting upon it.

mizzourah2006

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Re: Are Traditional Index Funds Truly Optimal
« Reply #56 on: June 03, 2015, 09:27:39 AM »
Active investing is saying you know something that the market doesn't. By tilting your allocation away from what the market's allocation is, you are making an active bet. Does this not make sense?

Some on this thread say they don't know what's cheap and what's expensive, so they buy the market. But what they are really doing is buying a specific market(s) out of the possible investable ones. So you're really not buying the market, what you are actually doing is saying you do know more than the market and as a result of your analysis this is what you've determined to be the best investment. I don't see that as being any different from an active manager.

I'd say yes it doesn't make sense because you're not making an active bet, you're just choosing to passively accept the risk and anticipated returns from a different market. It has nothing to do with the market. I guess it's just two different definitions of market then. You seem to be saying the only market is what you posted earlier (BND, VTI, VXUS, BNDX). That there are no other investments in the world outside of these. I raise my eyebrow at that.

Isn't the market then everything in the whole world? Every single opportunity for investment? How ridiculous can it get? How about a currency index?

In other words isn't a better definition for active versus passive the amount of action one takes on their chosen market rather than if someone has their investments in all available invest-able things?

If this is the case isn't a buy and hold individual stock investor a passive investor?

I guess again it depends on the definition of the market. If you define the market as only those individual stocks (which would be a hard sell given that they will have competitors) then yeah. Given that hard sell though, no. Your active because you perceive an inefficiency and are acting upon it.

But so is a person that is investing more than 35% of his/her stock portfolio in the US market.

So a standard 80/20 stock/bond portfolio should be:

28% US Equities
52% International Equities
20% Bonds

Is that what your portfolio looks like?

matchewed

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Re: Are Traditional Index Funds Truly Optimal
« Reply #57 on: June 03, 2015, 09:50:40 AM »
Active investing is saying you know something that the market doesn't. By tilting your allocation away from what the market's allocation is, you are making an active bet. Does this not make sense?

Some on this thread say they don't know what's cheap and what's expensive, so they buy the market. But what they are really doing is buying a specific market(s) out of the possible investable ones. So you're really not buying the market, what you are actually doing is saying you do know more than the market and as a result of your analysis this is what you've determined to be the best investment. I don't see that as being any different from an active manager.

I'd say yes it doesn't make sense because you're not making an active bet, you're just choosing to passively accept the risk and anticipated returns from a different market. It has nothing to do with the market. I guess it's just two different definitions of market then. You seem to be saying the only market is what you posted earlier (BND, VTI, VXUS, BNDX). That there are no other investments in the world outside of these. I raise my eyebrow at that.

Isn't the market then everything in the whole world? Every single opportunity for investment? How ridiculous can it get? How about a currency index?

In other words isn't a better definition for active versus passive the amount of action one takes on their chosen market rather than if someone has their investments in all available invest-able things?

If this is the case isn't a buy and hold individual stock investor a passive investor?

I guess again it depends on the definition of the market. If you define the market as only those individual stocks (which would be a hard sell given that they will have competitors) then yeah. Given that hard sell though, no. Your active because you perceive an inefficiency and are acting upon it.

But so is a person that is investing more than 35% of his/her stock portfolio in the US market.

So a standard 80/20 stock/bond portfolio should be:

28% US Equities
52% International Equities
20% Bonds

Is that what your portfolio looks like?

I actually don't perceive an inefficiency in the global market. I have no clue how the global market is going nor do I care. I don't think it's going to under-perform or perform better than the US market. I'm just accepting the US total market return using a passive investment strategy.

The difference between that and picking an individual stock is obvious. An individual stock is rarely the market. While all the companies within a certain set of boundaries can be the market.

mizzourah2006

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Re: Are Traditional Index Funds Truly Optimal
« Reply #58 on: June 03, 2015, 10:14:42 AM »
Active investing is saying you know something that the market doesn't. By tilting your allocation away from what the market's allocation is, you are making an active bet. Does this not make sense?

Some on this thread say they don't know what's cheap and what's expensive, so they buy the market. But what they are really doing is buying a specific market(s) out of the possible investable ones. So you're really not buying the market, what you are actually doing is saying you do know more than the market and as a result of your analysis this is what you've determined to be the best investment. I don't see that as being any different from an active manager.

I'd say yes it doesn't make sense because you're not making an active bet, you're just choosing to passively accept the risk and anticipated returns from a different market. It has nothing to do with the market. I guess it's just two different definitions of market then. You seem to be saying the only market is what you posted earlier (BND, VTI, VXUS, BNDX). That there are no other investments in the world outside of these. I raise my eyebrow at that.

Isn't the market then everything in the whole world? Every single opportunity for investment? How ridiculous can it get? How about a currency index?

In other words isn't a better definition for active versus passive the amount of action one takes on their chosen market rather than if someone has their investments in all available invest-able things?

If this is the case isn't a buy and hold individual stock investor a passive investor?

I guess again it depends on the definition of the market. If you define the market as only those individual stocks (which would be a hard sell given that they will have competitors) then yeah. Given that hard sell though, no. Your active because you perceive an inefficiency and are acting upon it.

But so is a person that is investing more than 35% of his/her stock portfolio in the US market.

So a standard 80/20 stock/bond portfolio should be:

28% US Equities
52% International Equities
20% Bonds

Is that what your portfolio looks like?

I actually don't perceive an inefficiency in the global market. I have no clue how the global market is going nor do I care. I don't think it's going to under-perform or perform better than the US market. I'm just accepting the US total market return using a passive investment strategy.

The difference between that and picking an individual stock is obvious. An individual stock is rarely the market. While all the companies within a certain set of boundaries can be the market.

But you are still actively choosing to ignore 65% of the global market capitalization (or weighting it significantly lower than a true market cap weighted allocation should be).

Sure 1 stock can't be the market (although Apple right now is a pretty decent proxy), but what if you own every stock in the DOW and buy and hold. Is that active or passive? What if you own a sector diversified portfolio of 10-15 stocks and buy and hold? Is that active or passive?

If passive is owning it all based on market capitalization because you believe the market knows more than you then any deviation from the global market capitalization is an active decision away from that allocation. I'm not sure how one can argue that.

matchewed

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Re: Are Traditional Index Funds Truly Optimal
« Reply #59 on: June 03, 2015, 10:25:58 AM »
But you are still actively choosing to ignore 65% of the global market capitalization (or weighting it significantly lower than a true market cap weighted allocation should be).

Sure 1 stock can't be the market (although Apple right now is a pretty decent proxy), but what if you own every stock in the DOW and buy and hold. Is that active or passive? What if you own a sector diversified portfolio of 10-15 stocks and buy and hold? Is that active or passive?

If passive is owning it all based on market capitalization because you believe the market knows more than you then any deviation from the global market capitalization is an active decision away from that allocation. I'm not sure how one can argue that.

*snips for brevity*

Easily, depends on the definition of the market. I feel like I've said this before for some reason...

hodedofome

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Re: Are Traditional Index Funds Truly Optimal
« Reply #60 on: June 03, 2015, 10:28:22 AM »
If passive is owning it all based on market capitalization because you believe the market knows more than you then any deviation from the global market capitalization is an active decision away from that allocation. I'm not sure how one can argue that.

Broseph I'm telling you it's because they have an allergic reaction to the word active. At least that's my amateur psychologist opinion.

matchewed

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Re: Are Traditional Index Funds Truly Optimal
« Reply #61 on: June 03, 2015, 10:30:30 AM »
If passive is owning it all based on market capitalization because you believe the market knows more than you then any deviation from the global market capitalization is an active decision away from that allocation. I'm not sure how one can argue that.

Broseph I'm telling you it's because they have an allergic reaction to the word active. At least that's my amateur psychologist opinion.

Congratulations? You get internet points? I'm not sure on the value gained in this anymore. Duck season.

index

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Re: Are Traditional Index Funds Truly Optimal
« Reply #62 on: June 03, 2015, 10:34:01 AM »
The S&P 500 index is not cap weighted, but float weighted. This change came about in 2005 to provide the share liquidity for index tracking funds.

This helps to explain the effects of float weighting:
https://www.virtus.com/vsitemanager/Upload/Docs/6614_Horizon_Kinetics_SP500_Index.pdf

So the S&P 500 index (or Vanguard's Total Market Index for that matter) is weighted by Market Cap minus the capitalization of the company held by insiders and 10% owners. As an example - if Buffet buys 10% of Apple, the allocation to AAPL in the S&P index would fall from 3.94% to 3.54%.

To take the example further. What are the 1, 2, 3, 4, and 5th largest companies by market cap in the US? Apple, Google, Exxon, Berkshire, and Microsoft. Where do they rank in the S&P?

Apple - #1
Google - #4
Exxon - #3
Bershire - #7 
Microsoft - #2

Berkshire Hathaway was not even included in the S&P 500 index until 2010 because there were not enough shares traded everyday for index funds to buy what they needed until the B shares split 50:1. 

Does the allocation make sense? It does if you are trying to sell index products. Make no mistake that the S&P and Vanguard by extension are selling something. Are there better ways to allocate money? Absolutely. Are the better alternatives cost effective? That is up for debate.

hodedofome

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Re: Are Traditional Index Funds Truly Optimal
« Reply #63 on: June 03, 2015, 11:41:04 AM »
http://www.pragcap.com/lets-try-this-again-ending-the-passive-vs-active-distinction

My recent post on the Efficient Market Hypothesis brought about the usual pushback from “passive” index fund advocates. As an advocate of low fee indexing I find this debate incredibly frustrating and it appears as though years of industry misinformation has muddied the waters here. Passive indexing advocates tend to argue that I am just moving the goal posts, but that’s not really true at all. In fact, I’d argue that most indexers don’t actually understand what playing field we’re on. For example, in the Seeking Alpha comments section one reader wrote:

active… passive… whatever. people who say they are “passive indexers” mean that they buy index funds or ETFs and do not trade them. it is a description of their behavior. they purchase them, perhaps dollar cost average, then wipe their hands of it.

This is absolutely not true. And we know it can’t be true because a stock picker can also buy stocks and not trade them. This is essentially what Warren Buffett does. He is as tax and fee efficient as it gets. Being a “passive investor” does not just mean that you’re relatively inactive, low fee and tax efficient.  That is not the differentiating aspect between “active” and “passive”. The correct distinction between active and passive is trying to “beat the market” versus trying to “take the market”. That is, an indexer would tell you that they are just trying to take the market return while the stock picker would say they are trying to beat the market return within which that stock trades. But this clarifies why the passive vs active distinction is precisely wrong and nothing more than good marketing sold by firms who are trying to take assets from high fee stock picking mutual funds.

“Passive investing means taking the market return while active investing means trying to beat the market return. Passive does NOT mean being inactive since a stock picker can obviously also be inactive and tax and fee efficient.”¹

You see, at the aggregate level there is only one portfolio of outstanding financial assets. I’ve said this a million times here and gone into great detail in explaining it (which is why it’s frustrating that so few people get my point – I must be very bad at explaining this). This portfolio is “the market”.  Anything within this aggregate is a micro slice within “the market” just like GE is a slice within the S&P 500. The kicker is, when one chooses to own an “index” like the S&P 500 they are simply picking an index of 500 stocks inside of the global aggregate of financial assets in a more diversified way than the stock picker. US stocks are only 18% of the world’s financial assets so this is hardly the equivalent of owning “the market” of global financial assets.  And no, US stocks are not highly correlated or representative of all of the world’s outstanding stocks.

Indexers invariably deviate from global cap weighting. So, if the global cap weighting of stocks and bonds is 45/55 (as it roughly is at present) then anyone who deviates from that allocation is making an active decision that makes them nothing more than a more diversified version of the stock pickers that so many indexers demonize.  That is because once you deviate from global cap weighting you are essentially saying that “the market” is wrong for some reason. And you are claiming that you can do better than that portfolio.  You are implementing the same type of asset picking inside the global financial asset portfolio that a stock picker implements inside of a more micro index. And as I showed in this study, it’s very common for famous index fund advocates to underperform the GFAP even as they criticize “active” stock pickers.

This simple point shows that there is no distinction in the active vs passive debate as long as we assume that we’re being tax and fee efficient. We are all active investors to some degree. And I would argue that people who use the term “passive investing” do not fully understand the scope of the discussion here. They are, more likely, trying to sell you a product that has been marketed as “passive” because this term has come to be known as being superior to active (thanks in large part to erroneous studies such as the one cited above).  And that’s why this discussion matters. Not only is it important to understand macro portfolio construction for what it is, but it’s important to avoid fund companies and advisors who sell these ideas for a higher fee than you could otherwise obtain through similar portfolio construction approaches.

¹ This research piece has a nice definition that is consistent with my position here:

Active Management – The Practice of picking individual stocks based on fundamental research and analysis in the expectation that a portfolio of selected stocks can consistently outperform market averages.

Passive Management – The practice of buying a portfolio that is a proxy for the market as a whole on the theory that it is so difficult to outperform the market that it is cheaper and less risky to just buy the market.

beltim

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Re: Are Traditional Index Funds Truly Optimal
« Reply #64 on: June 03, 2015, 12:04:23 PM »
hodedofome: I mostly agree with you, but I just can't agree with you that there's only one global market.  In the absence of any intervention, that might be true, but there's intervention all over the world that prevents capital equalizing risk-adjusted returns.  Individual countries set up barriers to overseas investors or companies seeking to invest in those countries.  Corruption and graft, along with inconsistent reporting, auditing, and control, make reported numbers wildly different depending on the particular government, country, or industry.  Certain financial institutions are required to invest in particular assets by law rather than maximizing risk-adjusted return.  Currency fluctuations - unpredictable by definition - can take a great investment in one country and turn it into a terrible investment in another country.

The fact is, there isn't just one global market, and these are just some of litany of reasons that investment in the United States is not at all comparable to investment in China, Greece, or Venezuela.

hodedofome

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Re: Are Traditional Index Funds Truly Optimal
« Reply #65 on: June 03, 2015, 01:23:15 PM »
beltim we're not in disagreement. I'm simply making a philosophical argument against most 'passive' investors' actions. If someone truly said "I don't know enough, the market knows best," then they would buy what the market is offering. They wouldn't say "US stocks return the best over the long term so I'll invest in that," because you really don't know if that will be the case in the future. There's no law that says it should be so. You wouldn't say "stocks have the best return so I'll put all my money in that" because you don't know that the future will be like the past. Just because the stock market posted a higher return than the bond market over the past 200 years doesn't mean that it will be the case over our lifetime. You can come up with a million reasons why stocks should post higher returns, or why this country or why that country is a better/worse investment, but the true passive investor shouldn't be answering those questions. They should just admit that the market knows best and go with that.

BTW I'm not saying people should invest in the GFP, we're just talking theory here.

beltim

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Re: Are Traditional Index Funds Truly Optimal
« Reply #66 on: June 03, 2015, 01:28:07 PM »
So would someone who says, "I have heard bad things about financial controls in other countries, so I'm going to stick with US-domiciled assets" and then invests in a total-US stock fund be an active or passive investor?

mizzourah2006

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Re: Are Traditional Index Funds Truly Optimal
« Reply #67 on: June 03, 2015, 01:36:06 PM »
So would someone who says, "I have heard bad things about financial controls in other countries, so I'm going to stick with US-domiciled assets" and then invests in a total-US stock fund be an active or passive investor?

Well you are actively steering clear of equities that you think may be toxic, whether because of the country of origin or business concerns. Similarly someone who invests in the S&P 500 is actively ignoring the other 5k+ stocks in the US market. Purposeful or not it is still a decision as an investor you are making.

brooklynguy

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Re: Are Traditional Index Funds Truly Optimal
« Reply #68 on: June 03, 2015, 01:45:32 PM »
beltim we're not in disagreement. I'm simply making a philosophical argument against most 'passive' investors' actions. If someone truly said "I don't know enough, the market knows best," then they would buy what the market is offering. They wouldn't say "US stocks return the best over the long term so I'll invest in that," because you really don't know if that will be the case in the future. There's no law that says it should be so. You wouldn't say "stocks have the best return so I'll put all my money in that" because you don't know that the future will be like the past. Just because the stock market posted a higher return than the bond market over the past 200 years doesn't mean that it will be the case over our lifetime. You can come up with a million reasons why stocks should post higher returns, or why this country or why that country is a better/worse investment, but the true passive investor shouldn't be answering those questions. They should just admit that the market knows best and go with that.

I agree with matchewed's point that this is just a form of "no true Scotsman" argument, and with his line of reasoning that it's just about how you define "the market."  We had the same discussion here in the dual momentum thread:

Just depends what "market" you want to match.  If you set the parameters broadly enough, you can further expand the market (and its associated breakdown) to include beanie babies, alpacas, tulip bulbs, cannabis plants, etc.

If perfectly matching the "global financial market" is your goal, then the asset allocation for your passive index investments currently needs to match the breakdown you provided (but in that case the associated costs are going to go up).

My goal is for 80% of my portfolio to match the U.S. stock market, and for 20% of my portfolio to match the international (ex-U.S.) stock markets, because I believe that is a reasonable exposure (only one of many possible reasonable exposures) to capture the gains that the worldwide equity markets will probably provide in the long-run for the reasons stated above.

Your argument has no logical end-point:  you can keep ratcheting up the "no true passive investor would invest that way" reasoning to higher and higher (and more and more absurd) levels, forever, past the point where we're still talking about investing.  "No true passive spender would allocate his capital any differently than the global market of purchasable products and services" would be one of the stops along the way.

YoungInvestor

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Re: Are Traditional Index Funds Truly Optimal
« Reply #69 on: June 03, 2015, 04:15:03 PM »
The market is saying that people believe Apple will provided twice the risk-adjusted gains going forward as Microsoft. So it's going to cost twice as much to buy 1% of Apple as to get 1% of Microsoft. Cap-weighted indexing is just getting a certain share of each company based on it's expected future profits. If we believe, but aren't certain, Apple is going to provide twice the risk-adjusted gains going forward, we'd want twice as much of our money going into it. This is using the market to allocate our dollars.

No. If the market is planning the same risk-adjusted return from each company, you will have the same expected risk-adjusted return on your investment whether you weigh equally or weigh by cap.

Your statement implies that for 1$ invested in any company, the market assumes the same return. Investing the same amount in each company is the best way to keep the same expected return while decreasing the variance of the outcome.

The only reason index funds are cap-weighted is because smaller stocks are not liquid enough for the smaller companies. I'm sure that 1/500 of the total money in S&P500 index funds is a very significant part of the market cap of the smallest company in the S&P 500 index.
« Last Edit: June 03, 2015, 04:16:52 PM by YoungInvestor »

YoungInvestor

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Re: Are Traditional Index Funds Truly Optimal
« Reply #70 on: June 03, 2015, 04:32:06 PM »
The market is saying that people believe Apple will provided twice the risk-adjusted gains going forward as Microsoft. So it's going to cost twice as much to buy 1% of Apple as to get 1% of Microsoft. Cap-weighted indexing is just getting a certain share of each company based on it's expected future profits. If we believe, but aren't certain, Apple is going to provide twice the risk-adjusted gains going forward, we'd want twice as much of our money going into it. This is using the market to allocate our dollars.

No. If the market is planning the same risk-adjusted return from each company, you will have the same expected risk-adjusted return on your investment whether you weigh equally or weigh by cap.

Your statement implies that for 1$ invested in any company, the market assumes the same return. Investing the same amount in each company is the best way to keep the same expected return while decreasing the variance of the outcome.

The only reason index funds are cap-weighted is because smaller stocks are not liquid enough for the smaller companies. I'm sure that 1/500 of the total money in S&P500 index funds is a very significant part of the market cap of the smallest company in the S&P 500 index.

I actually decided to give the last part a try:

Based on a list of the S&P 500 I found out there, the smallest company there is Diamond Offshore Drilling Co., with a market cap of 4.3B$.

0.2% of the following funds is:

VFNX/VFIAX : 419M$
SPY: 354M$
FUSEX: 183M$
VOO: 65M$

That's about 1/4 of the company, and I only looked at 4 funds, with countless more out there, and even more that would include it (total world, anything including all of the US, world large caps, etc.) That's enough to significantly distort the price.

forummm

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Re: Are Traditional Index Funds Truly Optimal
« Reply #71 on: June 04, 2015, 07:51:59 AM »
The market is saying that people believe Apple will provided twice the risk-adjusted gains going forward as Microsoft. So it's going to cost twice as much to buy 1% of Apple as to get 1% of Microsoft. Cap-weighted indexing is just getting a certain share of each company based on it's expected future profits. If we believe, but aren't certain, Apple is going to provide twice the risk-adjusted gains going forward, we'd want twice as much of our money going into it. This is using the market to allocate our dollars.

In nominal terms, yes.  But in percentage terms Apple and Microsoft should return the same risk-adjusted returns. 

Furthermore, your comment doesn't make sense - why do you stop at market cap weighting if you think that market cap is proportional to future return?  Why wouldn't you just buy the largest stock and be done with it?  Or the largest 30 for sufficient diversification?

Risk-adjusted return. You get lower returns on less risky companies like JNJ, MSFT, AAPL, etc. So you could certainly buy the top 30 and expect lower risk and lower return. But you'll miss out on all the speculative companies that could blowup and get huge, along with the speculative ones that don't do much. A link I posted earlier looks at one scenario of how missing out on companies like Dell makes you lag the S&P 500 with randomly selected B&H of a subset of the 500. I don't know how that analysis would have differed if they used more time periods like the OP's originally posted study in this thread.

beltim

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Re: Are Traditional Index Funds Truly Optimal
« Reply #72 on: June 04, 2015, 09:30:27 AM »
The market is saying that people believe Apple will provided twice the risk-adjusted gains going forward as Microsoft. So it's going to cost twice as much to buy 1% of Apple as to get 1% of Microsoft. Cap-weighted indexing is just getting a certain share of each company based on it's expected future profits. If we believe, but aren't certain, Apple is going to provide twice the risk-adjusted gains going forward, we'd want twice as much of our money going into it. This is using the market to allocate our dollars.

In nominal terms, yes.  But in percentage terms Apple and Microsoft should return the same risk-adjusted returns. 

Furthermore, your comment doesn't make sense - why do you stop at market cap weighting if you think that market cap is proportional to future return?  Why wouldn't you just buy the largest stock and be done with it?  Or the largest 30 for sufficient diversification?

Risk-adjusted return. You get lower returns on less risky companies like JNJ, MSFT, AAPL, etc. So you could certainly buy the top 30 and expect lower risk and lower return. But you'll miss out on all the speculative companies that could blowup and get huge, along with the speculative ones that don't do much. A link I posted earlier looks at one scenario of how missing out on companies like Dell makes you lag the S&P 500 with randomly selected B&H of a subset of the 500. I don't know how that analysis would have differed if they used more time periods like the OP's originally posted study in this thread.

I think you've realized your original error?  So you realize that EMH predicts that Apple will provide the SAME risk-adjusted return as Microsoft, not double, right?

forummm

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Re: Are Traditional Index Funds Truly Optimal
« Reply #73 on: June 04, 2015, 02:18:19 PM »
Sorry, I was responding to your second paragraph. Yes, I meant in nominal terms. In percentage terms, they should be the same. I thought my original 2nd sentence made that clear (more $ to buy 1% APPL than 1% MSFT). Yes I understand that. Otherwise you should put 100% in Apple. Perhaps I could have worded more clearly.

sarajeanne

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Re: Are Traditional Index Funds Truly Optimal
« Reply #74 on: June 06, 2015, 11:17:37 AM »
No Index funds are not truly optimal. They tend to be a good way to get the masses to invest though which is why they are so widely used. My point is I don't want to buy the whole index at any given time. I want to buy whatever sector is in a cyclical downturn and I want the best run company in that sector. So individual stocks are a better choice. Plus the management fee is zero.

a1smith

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Re: Are Traditional Index Funds Truly Optimal
« Reply #75 on: June 06, 2015, 03:00:20 PM »
Well, so much for the OP's wish to not start an argument about passive vs active!  :-D

Here is an interesting Forbes article by Rick Ferri:

No Free Lunch From Equal Weight S&P 500

To summarize the article - equal weighting the SP500 provides a higher return than cap weighting the SP500.  However, equal weighting the SP500 also comes with higher risk.  Figure 3 shows the capital market line for 23 years of data and both cap and equal weighted SP500 are on the CML.  Hence, no free lunch.

Indexer

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Re: Are Traditional Index Funds Truly Optimal
« Reply #76 on: June 06, 2015, 04:51:40 PM »
Anytime variables are manipulated and information is presented in a very non-standard way I ask why.

Just to make sure I'm getting this right the study measured the 500 largest companies in random weights against a value weighted index of the 500 largest companies over 5 year periods.  The returns, standard deviation, and sharpe ratio are all then reported in average 'monthly' intervals.

Why?

A major conclusion of this study is that value weighted indexes are too heavily dependant on the largest companies, but then they study only looks at the 500 largest companies.  I can rationalize this away that 3800 companies might be too big of a data set to work with so I don't have a huge problem with this.

5 year periods.  Why?  Why not 10 year periods or 20 year periods?  It could be that some companies they wanted to include hadn't been around 10 years, but the study goes pretty far back in time so that doesn't hold a lot of weight.  Playing devil's advocate using a 5 year period normally limits you to less than 1 full business cycle.  Larger more established companies are better at surviving all the cycles where smaller companies can do well during fads and normally thrive in bull markets, but they don't handle bear markets as well.  69% of the time this did better than the market.  Would that number be lower if we used 10 year periods?  Bull markets on average last 97 months(8.08years).  If you measure over 5 year periods a large portion of your data set won't include any bear markets.

Why are returns and standard deviation reported in average 'monthly' intervals?  Why?  I can't wrap my head around this. NO ONE does this.  It doesn't make sense.  Even when they do report annual returns in one section it is figured by multiplying the average monthly by 12.  When you are dealing with this many variables and some of them can be negative you wouldn't do that.  Average returns =/= actual returns over time because of compounding.  Even looking at average annual returns VS geometric returns yields VERY different results.  If you then shrank this down to a monthly interval you might get a lot of distortion.


EDIT:  Final thought.  I'm willing to bet that if the study was rerun using 10 year periods, and the returns & standard deviations were reported over the ENTIRE 10 year periods we would get vastly different results.  The random portfolios would likely still outperform in pure returns BUT with much higher volatility.


Quote from: a1smith
To summarize the article - equal weighting the SP500 provides a higher return than cap weighting the SP500.  However, equal weighting the SP500 also comes with higher risk.  Figure 3 shows the capital market line for 23 years of data and both cap and equal weighted SP500 are on the CML.  Hence, no free lunch.

Exactly!   And if you do want more exposure to small caps just buy a total market index instead of a 500 index.
« Last Edit: June 06, 2015, 05:22:31 PM by Indexer »