The Money Mustache Community
Learning, Sharing, and Teaching => Investor Alley => Topic started by: mizzourah2006 on June 02, 2015, 08:14:29 AM
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There has been some discussion around here regarding index funds and I have mentioned the fact that index funds are market cap weighted may be a detriment to your portfolio. As a company's market cap grows your investment in them becomes even larger. Most S&P Index funds have 31-35% of the portfolio in the largest 20-25 companies in the index and as the companies become larger that % will continue to grow.
IMO it would be similar to owning a portfolio of 10 individual stocks where 1-2 of them drastically outperform the others for 3-4 years and you never bother to re-balance.
I found a recent academic paper on it, where they used monte carlo simulations of random buy and hold portfolios vs. a market cap weighted index fund over 5 year periods.
Here is a quote from the article.
These results imply that 74.8% of the completely random buy-and-hold portfolios beat the market. This is the central result and main take-away message of the paper. It is a result that calls for a fundamental revision in the way we perceive the optimality of the market portfolio.
Another good quote:
The main reason for the market’s inefficiency is that it is a portfolio with a very skewed distribution of weights. The weight of the largest market capitalization S&P500 stock (Apple, market cap of $571.5B, as of July 2014) is more than 100 times larger than the weight of the smallest cap S&P500 stock (U.S. Steel, market cap of $3.9B, as of July 2014). The 10 largest stocks in the S&P500 index account for 17.3% of the total S&P500 market capitalization, and the 20 largest stocks account for 27.6% of the total S&P500 market capitalization. 9 The largest firm is on average 68.1 times larger than the median S&P 500 firm. In contrast, in the random portfolios the largest portfolio weight is only twice the median portfolio weight. The very skewed distribution of weights in the market portfolio makes the diversification in this portfolio not very effective, because most of the portfolio is concentrated in a very small number of stocks. One could obtain a much higher diversification benefit with a more evenly weighted portfolio (such as the random portfolios considered here).
You can download the paper here if you are interested.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2488433
Levy, M. (2014). It's easy to beat the market. Social Science Research Network.
Just curious what others thoughts are. I post this in an effort to begin a discussion. Not an argument over passive vs. active investing.
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I'll have time to read the article later today. But I wanted to point out that I bought Apple in 2004 and 2003 and 2002 and 2005. And each year since then. Because of my index funds. I bought at those really low prices and have made a ton of money since then. If I'd bought some random stocks I would have most likely missed out on Apple.
I don't think a Monte Carlo simulation is a good way to have done this analysis. Instead, take stocks that were actually in existence at a particular time and then calculate the returns for randomly generated portfolios using real data. I've seen analyses doing this exact thing, using real data, and they show that the vast majority underperform the market because you miss out on the huge gainers like Dell or Home Depot back when they were tiny.
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Cap-weighting as absolutely sub-optimal from a total returns standpoint for two reasons:
1. Cap weighting inherently gives more weight to over-valued stocks and less weight to under-valued stocks. You're fighting value.
2. You are over-weighting large-caps at the expense of small caps. In the context of an S&P 500 fund, only the top ~50-100 stocks are actually having a measurable difference on your returns. As the largest companies, these are the ones with relatively lower future potential returns.
You can offset problem #2 above by adding a small-cap fund, although these are usually cap-weighted as well. You can offset #1 and #2 by using equal weight funds. However, equal weight funds are tax-inefficient due to annual re-balancing, so these should only be used in tax advantaged accounts. Fund fees are also typically higher, but should be offset over the long term due to the better index structure.
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I don't think a Monte Carlo simulation is a good way to have done this analysis. Instead, take stocks that were actually in existence at a particular time and then calculate the returns for randomly generated portfolios using real data. I've seen analyses doing this exact thing, using real data, and they show that the vast majority underperform the market because you miss out on the huge gainers like Dell or Home Depot back when they were tiny.
The simulations were based off of stocks that were in existence. I guess monte carlo simulation wasn't the most appropriate term. They randomly selected and randomly weighted stocks in random 5 year periods, but used the actual data from those stocks in those given years and compared them to a market cap weighted index fund from that same time period.
I'll have time to read the article later today. But I wanted to point out that I bought Apple in 2004 and 2003 and 2002 and 2005. And each year since then. Because of my index funds. I bought at those really low prices and have made a ton of money since then. If I'd bought some random stocks I would have most likely missed out on Apple.
Apple's Market Cap in 2002 was ~ 7 Billion. It wouldn't have even been a top 150 company in the S&P that year. So you would have owned virtually none of it had you held a market cap weighted index fund. It didn't even hit 100 billion until 2007, which would have put it in the mid-30s rank as far as market cap goes at that time.
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Well in order to execute any other style, value weighted or equal weighted...etc, you need more buying and selling within that index. That would require more fees being charged. So while you may be able to make an argument that value weighted or equal weighted is more optimal (gl w/ that) factor in fees.
The index itself and how the market performs is the rebalancing mechanism of an index fund. As I DCA I buy as the market fluctuates, as capitalization of various companies change so does the index.
Also the paper mentions five year intervals. I'm not investing for five years. I'm investing for 60.
The paper talks about random buy and hold versus the value weight (traditional index fund). You can view the random buy and hold as some form of equal weight fund. There has been previous discussion about equal weight funds here. (http://forum.mrmoneymustache.com/investor-alley/personalcapital-tactical-weighting/)
I've previously mentioned that in order to do an equal weight portfolio you'll probably need more buying and selling within your defined index. That means more fees. So I'd like to see a longer study with costs associated.
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If I'm buying the total market to receive a share of the profits of the companies in it, why shouldn't I allocate more of my capital to the companies with more profits (i.e. market cap)?
You're saying I should allocate an equal amount of my investment capital to Apple as I would Jimbo's Gun Emporium in Des Moines (If it was listed)? How does that make sense?
I love when people come up with reasons for why index funds are money-loosing or suboptimal. But somehow the index funds just continue to beat market timers and fancy strategies over and over! To misquote Churchill: "index funds are the worst strategy, except for all the others"
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Well in order to execute any other style, value weighted or equal weighted...etc, you need more buying and selling within that index. That would require more fees being charged. So while you may be able to make an argument that value weighted or equal weighted is more optimal (gl w/ that) factor in fees.
The index itself and how the market performs is the rebalancing mechanism of an index fund. As I DCA I buy as the market fluctuates, as capitalization of various companies change so does the index.
Also the paper mentions five year intervals. I'm not investing for five years. I'm investing for 60.
The paper talks about random buy and hold versus the value weight (traditional index fund). You can view the random buy and hold as some form of equal weight fund. There has been previous discussion about equal weight funds here. (http://forum.mrmoneymustache.com/investor-alley/personalcapital-tactical-weighting/)
I've previously mentioned that in order to do an equal weight portfolio you'll probably need more buying and selling within your defined index. That means more fees. So I'd like to see a longer study with costs associated.
The authors didn't advocate equal weighting. They advocated buy and hold for the 5 year period. They just suggested the random allocation of the portfolio that was selected be more equally balanced than roughly 1/3rd of the weight being attributed to 25 of the 500 companies.
The largest firm is on average 68.1 times larger than the median S&P 500 firm. In contrast, in the random portfolios the largest portfolio weight is only twice the median portfolio weight.
I took a look at the RSP fund that you mentioned in the other thread vs. the SPY. Since June 1, 2005 (10 years ago) the RSP has returned 145%. The SPY has returned 115%.
ER of RSP is .4%, ER of SPY is .09%.
Very interesting. I hadn't heard of RSP before. Thanks for the heads up.
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Well in order to execute any other style, value weighted or equal weighted...etc, you need more buying and selling within that index. That would require more fees being charged. So while you may be able to make an argument that value weighted or equal weighted is more optimal (gl w/ that) factor in fees.
The index itself and how the market performs is the rebalancing mechanism of an index fund. As I DCA I buy as the market fluctuates, as capitalization of various companies change so does the index.
Also the paper mentions five year intervals. I'm not investing for five years. I'm investing for 60.
The paper talks about random buy and hold versus the value weight (traditional index fund). You can view the random buy and hold as some form of equal weight fund. There has been previous discussion about equal weight funds here. (http://forum.mrmoneymustache.com/investor-alley/personalcapital-tactical-weighting/)
I've previously mentioned that in order to do an equal weight portfolio you'll probably need more buying and selling within your defined index. That means more fees. So I'd like to see a longer study with costs associated.
The authors didn't advocate equal weighting. They advocated buy and hold for the 5 year period. They just suggested the random allocation of the portfolio that was selected be more equally balanced than roughly 1/3rd of the weight being attributed to 25 of the 500 companies.
When the argument is stated that an index fund is over-weighted in certain companies compared to the random portfolios then inherently the random portfolios are going to be more equal weighted. Especially when the comparison is against 1000 different random buy and hold portfolios.
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If I'm buying the total market to receive a share of the profits of the companies in it, why shouldn't I allocate more of my capital to the companies with more profits (i.e. market cap)?
You're saying I should allocate an equal amount of my investment capital to Apple as I would Jimbo's Gun Emporium in Des Moines (If it was listed)? How does that make sense?
I love when people come up with reasons for why index funds are money-loosing or suboptimal. But somehow the index funds just continue to beat market timers and fancy strategies over and over! To misquote Churchill: "index funds are the worst strategy, except for all the others"
The market doesn't necessarily care about current profits as they are in the past. They care about future profits. If they just cared about current profits IBM, WMT, MSFT, Apple, etc. would have much higher P/Es and Facebook would have a significantly smaller market cap (and P/E) than 225 billion.
DCF does a decent job of explaining this.
http://en.wikipedia.org/wiki/Discounted_cash_flow
http://www.investopedia.com/terms/d/dcf.asp
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If I'm buying the total market to receive a share of the profits of the companies in it, why shouldn't I allocate more of my capital to the companies with more profits (i.e. market cap)?
You're saying I should allocate an equal amount of my investment capital to Apple as I would Jimbo's Gun Emporium in Des Moines (If it was listed)? How does that make sense?
I love when people come up with reasons for why index funds are money-loosing or suboptimal. But somehow the index funds just continue to beat market timers and fancy strategies over and over! To misquote Churchill: "index funds are the worst strategy, except for all the others"
The market doesn't necessarily care about current profits as they are in the past. They care about future profits. If they just cared about current profits IBM, WMT, MSFT, Apple, etc. would have much higher P/Es and Facebook would have a significantly smaller market cap (and P/E) than 225 billion.
Exactly. The expected future profits are priced in, and reflected in the market cap. So by buying a cap weighted index I'm buying in proportion to future earnings. That seems logical to me. As earnings rise I get more of that company, and as they fall I own less.
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I have only briefly looked over the article and can't yet determine by how much the average "random portfolio" has beaten the market, but it appears that one is taking a 25% chance risk of under-performing in order to secure a slightly larger return. A 75% chance of success is good, but I'm not sure how successful the median portfolio is, when compared to the market at large.
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I have only briefly looked over the article and can't yet determine by how much the average "random portfolio" has beaten the market, but it appears that one is taking a 25% chance risk of under-performing in order to secure a slightly larger return. A 75% chance of success is good, but I'm not sure how successful the median portfolio is, when compared to the market at large.
If a portfolio were truly random, wouldn't it be representative of the market?
Or do you mean a random selection, of a typical investors selected portfolio?
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I have only briefly looked over the article and can't yet determine by how much the average "random portfolio" has beaten the market, but it appears that one is taking a 25% chance risk of under-performing in order to secure a slightly larger return. A 75% chance of success is good, but I'm not sure how successful the median portfolio is, when compared to the market at large.
If a portfolio were truly random, wouldn't it be representative of the market?
Or do you mean a random selection, of a typical investors selected portfolio?
It's a random selection. The term was taken from the paper. I believe that if the weighting is different, then it isn't representative of the market.
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I have only briefly looked over the article and can't yet determine by how much the average "random portfolio" has beaten the market, but it appears that one is taking a 25% chance risk of under-performing in order to secure a slightly larger return. A 75% chance of success is good, but I'm not sure how successful the median portfolio is, when compared to the market at large.
How they defined it was that they took random 5 year periods between 1926 and 2014. In those 5 year periods they selected 10 stocks. They did this 100 times. They compared this against an index fund. This did better than the index fund 75% of the time according to the paper.
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If I'm buying the total market to receive a share of the profits of the companies in it, why shouldn't I allocate more of my capital to the companies with more profits (i.e. market cap)?
An efficient market would have every publicly traded company priced to give the same future risk-adjusted return. So why should you overweight large companies just because they're larger? You are starting from that conclusion without giving a good justification.
One reason is fees - market cap weighted fuss don't have to rebalance, so they have lower fees.
Another reason could be risk - small caps are generally considered higher risk.
Of course, the other side of that coin is the small caps traditionally have higher returns as well to compensate for that risk.
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I have only briefly looked over the article and can't yet determine by how much the average "random portfolio" has beaten the market, but it appears that one is taking a 25% chance risk of under-performing in order to secure a slightly larger return. A 75% chance of success is good, but I'm not sure how successful the median portfolio is, when compared to the market at large.
How they defined it was that they took random 5 year periods between 1926 and 2014. In those 5 year periods they selected 10 stocks. They did this 100 times. They compared this against an index fund. This did better than the index fund 75% of the time according to the paper.
I had a hard time figuring out how much better, though. A median return vs market return would be helpful (and is probably in there). I don't know if I'd take the risk for a marginal improvement on returns.
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I have only briefly looked over the article and can't yet determine by how much the average "random portfolio" has beaten the market, but it appears that one is taking a 25% chance risk of under-performing in order to secure a slightly larger return. A 75% chance of success is good, but I'm not sure how successful the median portfolio is, when compared to the market at large.
How they defined it was that they took random 5 year periods between 1926 and 2014. In those 5 year periods they selected 10 stocks. They did this 100 times. They compared this against an index fund. This did better than the index fund 75% of the time according to the paper.
I had a hard time figuring out how much better, though. A median return vs market return would be helpful (and is probably in there). I don't know if I'd take the risk for a marginal improvement on returns.
Well the paper does discuss the Sharpe ratio.
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I have only briefly looked over the article and can't yet determine by how much the average "random portfolio" has beaten the market, but it appears that one is taking a 25% chance risk of under-performing in order to secure a slightly larger return. A 75% chance of success is good, but I'm not sure how successful the median portfolio is, when compared to the market at large.
How they defined it was that they took random 5 year periods between 1926 and 2014. In those 5 year periods they selected 10 stocks. They did this 100 times. They compared this against an index fund. This did better than the index fund 75% of the time according to the paper.
I had a hard time figuring out how much better, though. A median return vs market return would be helpful (and is probably in there). I don't know if I'd take the risk for a marginal improvement on returns.
Well the paper does discuss the Sharpe ratio.
I've looked back at it and it appears that they're showing about a 1% (annual) average improvement over the market return and a slightly higher average standard deviation. I think that they use a mean average, so I'll have to look again to see if there were any outliers in that calculation that make things look better or worse than they appear (or if I misread and it was a median).
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If I'm buying the total market to receive a share of the profits of the companies in it, why shouldn't I allocate more of my capital to the companies with more profits (i.e. market cap)?
This statement is fundamentally incorrect. You are buying shares with the highest market capitalization, not the highest earnings.
As a hypothetical example (because it's so extreme), let's create a three company portfolio of Uber (currently valued at $50B on the private market), Lockheed Martin ($60B) Market Cap, and Intuit ($29B Market Cap). In a cap-weighted index, you would allocate 36% to Uber, 43% to LMT, and 21% to Intuit. In an equal-weighted index, you would allocate a third to each. Does a company that is losing money (Uber) deserve premium placement in your portfolio just because someone else thinks it's worth $50B? Or does it make sense to allocate an equal amount to each company?
Index's were fundamentally designed for different purposes than they're being used for. They were designed to track economic activity, not to create an effective investing vehicle.
While passive investment as a strategy is a great investment approach, the common underlying index's are not designed to optimize returns over time. They aren't bad, but equal weight is better.
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Cap-weighting as absolutely sub-optimal from a total returns standpoint for two reasons:
1. Cap weighting inherently gives more weight to over-valued stocks and less weight to under-valued stocks. You're fighting value.
2. You are over-weighting large-caps at the expense of small caps. In the context of an S&P 500 fund, only the top ~50-100 stocks are actually having a measurable difference on your returns. As the largest companies, these are the ones with relatively lower future potential returns.
You can offset problem #2 above by adding a small-cap fund, although these are usually cap-weighted as well. You can offset #1 and #2 by using equal weight funds. However, equal weight funds are tax-inefficient due to annual re-balancing, so these should only be used in tax advantaged accounts. Fund fees are also typically higher, but should be offset over the long term due to the better index structure.
But from a risk-adjusted total returns standpoint, cap weighting should be effective, if you believe the EMH. The market is saying those are the most valuable companies to own and in that proportion.
The largest firm is on average 68.1 times larger than the median S&P 500 firm. In contrast, in the random portfolios the largest portfolio weight is only twice the median portfolio weight.
I took a look at the RSP fund that you mentioned in the other thread vs. the SPY. Since June 1, 2005 (10 years ago) the RSP has returned 145%. The SPY has returned 115%.
ER of RSP is .4%, ER of SPY is .09%.
Very interesting. I hadn't heard of RSP before. Thanks for the heads up.
Equal weighting essentially just overweights mid-cap stocks relative to a market cap weighting, and at somewhat higher cost. So in periods where mid-caps outperform large caps (like the last 10 years), an equal weight portfolio will provide higher returns. But mid caps also have more volatility. It's not a free lunch.
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Yes that allocation totally makes sense. The market cap is a proxy for earnings. Future earnings! If the market has decided that the future earnings (and earnings growth) of Uber is worth that much I have no reason to believe otherwise. Do you? Why?
The more I think about it the more it seems equal weigh is just a form of market timing, you belive you know better than the collective market.
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Investors favoring equal-weight funds believe that mid-cap stocks will outperform the market. While there have been times in the past that has held true, you could choose different time frames to show sub-par performance. Also, you'll pay higher fees for equal-weight funds.
References:
- http://online.barrons.com/articles/SB50001424053111904651304579608882103786334
- http://www.forbes.com/sites/rickferri/2013/04/29/no-free-lunch-from-equal-weight-sp-500/
- http://www.marketwatch.com/story/equal-weight-etfs-arent-the-most-balanced-2013-03-04
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Cap-weighting as absolutely sub-optimal from a total returns standpoint for two reasons:
1. Cap weighting inherently gives more weight to over-valued stocks and less weight to under-valued stocks. You're fighting value.
2. You are over-weighting large-caps at the expense of small caps. In the context of an S&P 500 fund, only the top ~50-100 stocks are actually having a measurable difference on your returns. As the largest companies, these are the ones with relatively lower future potential returns.
You can offset problem #2 above by adding a small-cap fund, although these are usually cap-weighted as well. You can offset #1 and #2 by using equal weight funds. However, equal weight funds are tax-inefficient due to annual re-balancing, so these should only be used in tax advantaged accounts. Fund fees are also typically higher, but should be offset over the long term due to the better index structure.
But from a risk-adjusted total returns standpoint, cap weighting should be effective, if you believe the EMH. The market is saying those are the most valuable companies to own and in that proportion.
The largest firm is on average 68.1 times larger than the median S&P 500 firm. In contrast, in the random portfolios the largest portfolio weight is only twice the median portfolio weight.
I took a look at the RSP fund that you mentioned in the other thread vs. the SPY. Since June 1, 2005 (10 years ago) the RSP has returned 145%. The SPY has returned 115%.
ER of RSP is .4%, ER of SPY is .09%.
Very interesting. I hadn't heard of RSP before. Thanks for the heads up.
Equal weighting essentially just overweights mid-cap stocks relative to a market cap weighting, and at somewhat higher cost. So in periods where mid-caps outperform large caps (like the last 10 years), an equal weight portfolio will provide higher returns. But mid caps also have more volatility. It's not a free lunch.
It only overweights mid caps if you believe large caps should have higher weights. IMO it treats all stocks in the S&P the same regardless of market cap.
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The more I think about it the more it seems equal weigh is just a form of market timing, you belive you know better than the collective market.
Huh? Where do you get timing from?
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Yes that allocation totally makes sense. The market cap is a proxy for earnings. Future earnings! If the market has decided that the future earnings (and earnings growth) of Uber is worth that much I have no reason to believe otherwise. Do you? Why?
The more I think about it the more it seems equal weigh is just a form of market timing, you believe you know better than the collective market.
You're actually thinking about this backwards. Using cap-weighting means that you are implicitly following active investors by buying overbought markets and selling oversold markets. You're accepting the valuations active managers are using, which is what the EMH cautions against. My example is extreme because I compared Uber (a company with no earnings) to a company with a comparable valuation (Lockheed) and $3.6B in annual earnings. Should these companies have a comparable valuation? Probably not.
Equal weight treats all companies the same, regardless of "hot" companies valuation concerns.
For another way to think about it, cap-weighting will overweight hot-momentum stocks and underweight undervalued stocks. Equal-weighting will do the inverse on a relative basis.
Also remember, per the EMH, small caps will outperform large-caps over time. That is, higher risk equities will outperform lower risk equities when averaged over time.
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Yes that allocation totally makes sense. The market cap is a proxy for earnings. Future earnings! If the market has decided that the future earnings (and earnings growth) of Uber is worth that much I have no reason to believe otherwise. Do you? Why?
The more I think about it the more it seems equal weigh is just a form of market timing, you believe you know better than the collective market.
You're actually thinking about this backwards. Using cap-weighting means that you are implicitly following active investors by buying overbought markets and selling oversold markets. You're accepting the valuations active managers are using, which is what the EMH cautions against. My example is extreme because I compared Uber (a company with no earnings) to a company with a comparable valuation (Lockheed) and $3.6B in annual earnings. Should these companies have a comparable valuation? Probably not.
Equal weight treats all companies the same, regardless of "hot" companies valuation concerns.
For another way to think about it, cap-weighting will overweight hot-momentum stocks and underweight undervalued stocks. Equal-weighting will do the inverse on a relative basis.
Also remember, per the EMH, small caps will outperform large-caps over time. That is, higher risk equities will outperform lower risk equities when averaged over time.
Huh? What does "the EMH caution against"?
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The index strategy has never been *optimal*. It's just superior to the vast majority of real-world, professional investors' returns.
Yes, there are some exceptions like Warren Buffett, which has fantastic returns in his past (and present). But if you were an investor when he opened his first private fund, you could not have differentiated him from any average manager.
Anyway, to create an optimal strategy, you would have to get some advance knowledge of future events, by crook or by cunning modelling. All financial models have broken down in time, some catastrophically. Market-timing works well, except when your timing is off. Hedging works well, if your hedge really counter-balances the rest of the portfolio at all times. You can't count on that. Even "strategic" allocation (meaning timing the market with portfolio composition changes) mostly relies on soothsaying.
IF you have the chops to jump in and do the financial equivalent of getting an olympic gold medal, go for it; I do not have the drive, talent or deep pockets needed so buying the market and getting "average" returns is perfect for me.
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I don't understand the point of the simulations. If you plot Sharpe ratios and show that the median stock selection does not have a Sharpe ratio of zero, your conclusion is already set. If your goal is to beat the cap-weighted index, it doesn't make sense to select 10 stocks, it makes sense to take them all. At that point we are back at a RSP vs VIIIX discussion. (No matter how many stocks you select, 10, 50, 499, the N+1 stock still has the same percentage chance to beat the cap-weighted index. With that as a stated goal, it makes sense to keep selecting because you will otherwise introduce variance and decrease return.) Reducing portfolio size has the expected impact (same median as RSP, more variance than RSP) and I don't think anyone would make the reasonable recommendation that a dartboard approach is superior to selecting RSP.
(edit: there would be deviation if you are only "rebalancing" every five years versus quarterly, which is an argument in itself.)
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No, I believe the market is efficient. It has efficiently priced in the differences in future earnings. I don't believe in over or under- sold. Or at least not in my ability to tell.
You talk as if there is no value in the market price. You ignore all the aggregate information in the market. If company A's earnings double while company B's are cut in half you would not want to own more of A and less of B?
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No, I believe the market is efficient. It has efficiently priced in the differences in future earnings. I don't believe in over or under- sold. Or at least not in my ability to tell.
You talk as if there is no value in the market price. You ignore all the aggregate information in the market. If company A's earnings double while company B's are cut in half you would not want to own more of A and less of B?
i see market inefficiencies almost every week. I guess it just depends on how closely you are looking.
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No, I believe the market is efficient. It has efficiently priced in the differences in future earnings. I don't believe in over or under- sold. Or at least not in my ability to tell.
You talk as if there is no value in the market price. You ignore all the aggregate information in the market. If company A's earnings double while company B's are cut in half you would not want to own more of A and less of B?
i see market inefficiencies almost every week. I guess it just depends on how closely you are looking.
I assume that means you're posting this from your own tropical island then?
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No, I believe the market is efficient. It has efficiently priced in the differences in future earnings. I don't believe in over or under- sold. Or at least not in my ability to tell.
You talk as if there is no value in the market price. You ignore all the aggregate information in the market. If company A's earnings double while company B's are cut in half you would not want to own more of A and less of B?
i see market inefficiencies almost every week. I guess it just depends on how closely you are looking.
I assume that means you're posting this from your own tropical island then?
Yes because I have clearly been able to accumulate enough assets in 3 years in the workforce to buy a tropical island, I always poor every dime into the position, and it only takes a few hours for me to make my money. Market inefficiencies often take 6-12 months to correct.
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Interesting. I didn't see any obvious holes in the research, though I also don't feel like I'm a very good judge. If it holds up, what's the takeaway? Just invest in 10 randomly-selected S&P 500 companies, hold them forever, and you're likely to outperform the index? It doesn't seem like this was difficult research to perform, so why is 2014 the first time anyone discovered this?
In terms of equal-weight indexes, the thing I always bring up (and never get a response on) is the inelegance that come from splits and mergers. If a company who sells 2000 cars a year splits into two companies who each sell 1000 cars a year, why would I suddenly want to own twice as much of those companies as I did before (and less of every other company?) And conversely, if a company that sells oats merges with one that sells wheat, I suddenly get only half the share of the profits I was getting from oats and wheat before?
Using cap-weighting means that you are implicitly following active investors by buying overbought markets and selling oversold markets. You're accepting the valuations active managers are using
It seems that you aren't familiar with the beliefs of that support the theory of passive investing? Those of us who buy into it believe that "the market" (which includes the votes of all the active investors) knows better than we do what the true value of a company should be. Thus, there is no concept of "overbought" or "oversold" markets, and accepting the valuations of active managers is exactly what we intend to do.
So yeah, your hypothetical market makes total sense to me. If everyone else thinks Uber is worth $50B, then who am I to tell them they're wrong? (though in this case I might be a bit more skeptical since the "everyone else" valuing Uber is smaller than the "everyone else" valuing the publicly-traded companies).
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Something can be inelegant and still be a better investment strategy.
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Interesting indeed. I'm having trouble following the methodology described in the paper. Is what matchewed described above ("they took random 5 year periods between 1926 and 2014. In those 5 year periods they selected 10 stocks. They did this 100 times.") what the researchers actually did? The paper says "[f]or each 5-year sub-period we draw 10 random passive portfolios" (not 10 individual stocks). It then talks about randomly assigning initial portfolio weights for the stocks in the portfolios -- it sounds to me like they constructed portfolios containing all 500 of the stocks in their selected universe, but just randomized the weighting. But it's not clear to me -- how are others interpreting their methodology?
In any event, like matchewed, I'm confused about why they used 5-year time windows. Why not examine longer time horizons that are actually representative of a typical stock investor's time horizon? Still, over any time period, you wouldn't expect more than half of a large number of randomly selected portfolios to beat the market index, so these results are interesting.
I'm also confused about this portion of the paper:
More formally, consider a portfolio that has the exact same portfolio weight distribution as the market portfolio (i.e. it has the diversification drawback due to a skewed weight distribution, as discussed above), but it is not tilted toward large stocks.
I don't understand what this means. How can a portfolio have the same weightings as the market cap weighted index and not be tilted towards large stocks? Doesn't the former by definition imply the latter?
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Two thoughts:
1 - If one truly believed in equal-cap indexing, then shouldn't it naturally follow to apply that to country allocation as well? Assuming every country was equally tax efficient, then a equal-cap indexer should buy each country in equal amounts, with US the same allocation in % as Japan, Brazil, and all other countries. Another viewpoint would have all companies equal everywhere, and you would allocate your country % simply based on the number of companies each country has.
2 - There was the point earlier of buying Apple (and companies like it) while it was cheap, and not overvaluing them when they are overly large. However if you are equally cap weighted, as Apple became its huge rise, you would be constantly selling it to keep the allocation to Apple the same as every other company. So while you would have owned virtually none of it if it was market-cap weighted while it was small, you would still own a very small amount of it when it was large, and I don't think (however I didn't do the math) you would have made any more profit off it.
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Two thoughts:
1 - If one truly believed in equal-cap indexing, then shouldn't it naturally follow to apply that to country allocation as well? Assuming every country was equally tax efficient, then a equal-cap indexer should buy each country in equal amounts, with US the same allocation in % as Japan, Brazil, and all other countries. Another viewpoint would have all companies equal everywhere, and you would allocate your country % simply based on the number of companies each country has.
No. Each country has it's own risks and most of them do not have the historical returns the US does. In principal one would expect a higher reward because of traditionally higher risk , but historically that hasn't been the case.
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it sounds to me like they constructed portfolios containing all 500 of the stocks in their selected universe, but just randomized the weighting. But it's not clear to me -- how are others interpreting their methodology?
Ah, yes, I was just influenced by matchewed's interpretation. It's really 500 stocks selected in 10 portfolios for each 5 year period. Because in the "Robustness" section he re-runs the simulation with 1000 stocks instead of 500 stocks. Interestingly, while the randoms still beat the market, the success rate is reduced from 75% to 66%. Makes me wonder if the outperformance is somehow an artifact of using the antiquated S&P500 to represent "the market" rather than an actual all-cap index.
I'm also confused about this portion of the paper:
More formally, consider a portfolio that has the exact same portfolio weight distribution as the market portfolio (i.e. it has the diversification drawback due to a skewed weight distribution, as discussed above), but it is not tilted toward large stocks.
I don't understand what this means. How can a portfolio have the same weightings as the market cap weighted index and not be tilted towards large stocks? Doesn't the former by definition imply the latter?
The set of weightings is the same as the actual index, and the set of stocks is the same, but the two are mixed up. For example, in the real index, Apple's weight is 3.5% or whatever. In his example, that 3.5% is instead assigned to Chipotle, and Chipotle's actual weight is assigned to CarMax, and so on...
In that example, he actually demonstrates the opposite of mizzou's belief: "it is not the tilt toward large stocks that hurts the market portfolio", since the portfolio with random companies getting the big weightings performs even worse than the real one where the big companies get the big weightings.
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If I'm buying the total market to receive a share of the profits of the companies in it, why shouldn't I allocate more of my capital to the companies with more profits (i.e. market cap)?
You're saying I should allocate an equal amount of my investment capital to Apple as I would Jimbo's Gun Emporium in Des Moines (If it was listed)? How does that make sense?
I love when people come up with reasons for why index funds are money-loosing or suboptimal. But somehow the index funds just continue to beat market timers and fancy strategies over and over! To misquote Churchill: "index funds are the worst strategy, except for all the others"
The market doesn't necessarily care about current profits as they are in the past. They care about future profits. If they just cared about current profits IBM, WMT, MSFT, Apple, etc. would have much higher P/Es and Facebook would have a significantly smaller market cap (and P/E) than 225 billion.
Exactly. The expected future profits are priced in, and reflected in the market cap. So by buying a cap weighted index I'm buying in proportion to future earnings. That seems logical to me. As earnings rise I get more of that company, and as they fall I own less.
That's not very logical at all. What matters is how much you pay for that profit, not the total quantity the company is making.
If company A makes 15 billion dollars a year in profit but has a market cap of 450 billion dollars (P/E = 30) and company B makes 1 Billion and has a market cap of 10 Billion (P/E = 10), I want company B's shares, all else being equal.
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A different study with imperfect methodology
http://www.efficientfrontier.com/ef/900/15st.htm
In order to investigate this problem, I looked at the stocks constituting the S&P 500 as of 11/30/99, and formed 98 random equally-weighted 15-stock portfolios for the 12/89-11/99 10-year holding period. Below is a histogram of the annualized portfolio returns:
.....
the TWD of these 15-stock portfolios is staggering—three-quarters of them failed to beat "the market."
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If I'm buying the total market to receive a share of the profits of the companies in it, why shouldn't I allocate more of my capital to the companies with more profits (i.e. market cap)?
You're saying I should allocate an equal amount of my investment capital to Apple as I would Jimbo's Gun Emporium in Des Moines (If it was listed)? How does that make sense?
I love when people come up with reasons for why index funds are money-loosing or suboptimal. But somehow the index funds just continue to beat market timers and fancy strategies over and over! To misquote Churchill: "index funds are the worst strategy, except for all the others"
The market doesn't necessarily care about current profits as they are in the past. They care about future profits. If they just cared about current profits IBM, WMT, MSFT, Apple, etc. would have much higher P/Es and Facebook would have a significantly smaller market cap (and P/E) than 225 billion.
Exactly. The expected future profits are priced in, and reflected in the market cap. So by buying a cap weighted index I'm buying in proportion to future earnings. That seems logical to me. As earnings rise I get more of that company, and as they fall I own less.
That's not very logical at all. What matters is how much you pay for that profit, not the total quantity the company is making.
If company A makes 15 billion dollars a year in profit but has a market cap of 450 billion dollars (P/E = 30) and company B makes 1 Billion and has a market cap of 10 Billion (P/E = 10), I want company B's shares, all else being equal.
We are talking past each other because you, and others here, believe you can tell what is a "good price" and a "bad price" for a stock (i.e. future earnings). I'm simply throwing up my hands and saying I can't. If the P/E =30 there's a reason for that (higher future growth for example). If it's 10 there's also a reason. If the P/E was 1 would you jump all over it? Do people really believe there is no reasoning in the market, and prices are set totally haphazardly?
I may agree that a P/E for 300 (or whatever it is) for netflix is a bit crazy, but I have no better guess so I trust the market, for good or bad.
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The set of weightings is the same as the actual index, and the set of stocks is the same, but the two are mixed up. For example, in the real index, Apple's weight is 3.5% or whatever. In his example, that 3.5% is instead assigned to Chipotle, and Chipotle's actual weight is assigned to CarMax, and so on...
Ah, got it. Thanks.
Because in the "Robustness" section he re-runs the simulation with 1000 stocks instead of 500 stocks. Interestingly, while the randoms still beat the market, the success rate is reduced from 75% to 66%. Makes me wonder if the outperformance is somehow an artifact of using the antiquated S&P500 to represent "the market" rather than an actual all-cap index.
Shouldn't it be the other way around? That is, the broader-market simulation (not using the antiquated S&P 500 stock universe) should have had greater outperformance, no? (In each case, the S&P 500 market index was still serving as the benchmark for comparison.)
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If you got a few million+ to invest, you could make your own equal weight S&P 500 index. I'd put money on that outperforming the standard index over the long term, not to mention your fees could be lower.
http://blog.alphaarchitect.com/2015/05/18/what-drives-the-sp-500-equal-weight-return-premium/
Sent from my iPhone using Tapatalk
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it sounds to me like they constructed portfolios containing all 500 of the stocks in their selected universe, but just randomized the weighting. But it's not clear to me -- how are others interpreting their methodology?
Ah, yes, I was just influenced by matchewed's interpretation. It's really 500 stocks selected in 10 portfolios for each 5 year period. Because in the "Robustness" section he re-runs the simulation with 1000 stocks instead of 500 stocks. Interestingly, while the randoms still beat the market, the success rate is reduced from 75% to 66%. Makes me wonder if the outperformance is somehow an artifact of using the antiquated S&P500 to represent "the market" rather than an actual all-cap index.
I'm also confused about this portion of the paper:
More formally, consider a portfolio that has the exact same portfolio weight distribution as the market portfolio (i.e. it has the diversification drawback due to a skewed weight distribution, as discussed above), but it is not tilted toward large stocks.
I don't understand what this means. How can a portfolio have the same weightings as the market cap weighted index and not be tilted towards large stocks? Doesn't the former by definition imply the latter?
The set of weightings is the same as the actual index, and the set of stocks is the same, but the two are mixed up. For example, in the real index, Apple's weight is 3.5% or whatever. In his example, that 3.5% is instead assigned to Chipotle, and Chipotle's actual weight is assigned to CarMax, and so on...
In that example, he actually demonstrates the opposite of mizzou's belief: "it is not the tilt toward large stocks that hurts the market portfolio", since the portfolio with random companies getting the big weightings performs even worse than the real one where the big companies get the big weightings.
I'm not sure where you got the idea that the only reason I believe a market cap weighted fund is sub-optimal is because it weights the highest the best. I think that is one reason, it is rewarding past performance for expected future performance. But I would also expect randomly assigning an S&P company a weighting of 300x another S&P company to be equally as poor with more volatility. I actually am not totally against a market cap weighting strategy, but I think a more balanced strategy makes sense.
Perhaps something like this:
Stocks 1-25: 3x median
Stocks 26-100: 2x median
Stocks 101-250: median
Stocks 251-400: 2x smaller than median
Stocks 401-500: 3x smaller than median
I just find it odd that people who are devout index fund investors that are essentially saying "we don't know, so the best thing to do is own it all" are comfortable with an allocation that is essentially taking strong guesses that Apple will outperform any other stock every year and that "guess" continues to grow.
As someone else already mentioned the S&P 500 and Dow Jones Industrial average were designed to be indicators of economic movement. Our goal should be capital appreciation, not to track economic trends in the US.
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it sounds to me like they constructed portfolios containing all 500 of the stocks in their selected universe, but just randomized the weighting. But it's not clear to me -- how are others interpreting their methodology?
Ah, yes, I was just influenced by matchewed's interpretation. It's really 500 stocks selected in 10 portfolios for each 5 year period. Because in the "Robustness" section he re-runs the simulation with 1000 stocks instead of 500 stocks. Interestingly, while the randoms still beat the market, the success rate is reduced from 75% to 66%. Makes me wonder if the outperformance is somehow an artifact of using the antiquated S&P500 to represent "the market" rather than an actual all-cap index.
I'm also confused about this portion of the paper:
More formally, consider a portfolio that has the exact same portfolio weight distribution as the market portfolio (i.e. it has the diversification drawback due to a skewed weight distribution, as discussed above), but it is not tilted toward large stocks.
I don't understand what this means. How can a portfolio have the same weightings as the market cap weighted index and not be tilted towards large stocks? Doesn't the former by definition imply the latter?
The set of weightings is the same as the actual index, and the set of stocks is the same, but the two are mixed up. For example, in the real index, Apple's weight is 3.5% or whatever. In his example, that 3.5% is instead assigned to Chipotle, and Chipotle's actual weight is assigned to CarMax, and so on...
In that example, he actually demonstrates the opposite of mizzou's belief: "it is not the tilt toward large stocks that hurts the market portfolio", since the portfolio with random companies getting the big weightings performs even worse than the real one where the big companies get the big weightings.
I'm not sure where you got the idea that the only reason I believe a market cap weighted fund is sub-optimal is because it weights the highest the best. I think that is one reason, it is rewarding past performance for expected future performance. But I would also expect randomly assigning an S&P company a weighting of 300x another S&P company to be equally as poor with more volatility. I actually am not totally against a market cap weighting strategy, but I think a more balanced strategy makes sense.
Perhaps something like this:
Stocks 1-25: 3x median
Stocks 26-100: 2x median
Stocks 101-250: median
Stocks 251-400: 2x smaller than median
Stocks 401-500: 3x smaller than median
I just find it odd that people who are devout index fund investors that are essentially saying "we don't know, so the best thing to do is own it all" are comfortable with an allocation that is essentially taking strong guesses that Apple will outperform any other stock every year and that "guess" continues to grow.
That's the key mis-perception of index fund investing. We're not saying we know or don't know. We're saying the market is a representative force of everyone's knowledge of the market. And that this aggregate knowledge of the market provides the best returns considering cost and risk.
If the market (meaning active traders and the like) tomorrow thinks that Apple is a poor investment regardless of the reason and start selling which brings about a drop in the price of the stock then so be it.
We're more saying that the idea of "knowing" is already there present in the price. If you think you're detecting some inefficiency in the market because of capitalization and can act on it then so be it. We're saying that that inefficiency probably isn't there or cannot be acted upon in a cost efficient manner without taking on some risk we're unwilling to take on.
Consider that (more) equal weighted portfolio will be weighted (more) heavily towards small and mid cap companies. That portfolio will have more turnover, forcing more trades, thereby increased costs.
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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.
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If you truly believed the market knows best, then you should have a global allocation to roughly 43% stocks and 57% bonds. Any deviation from that and you are making an active bet against 'the market.' - Cullen Roche
(http://z822j1x8tde3wuovlgo7ue15.wpengine.netdna-cdn.com/wp-content/uploads/2015/01/GFAP2.png)
I'd almost put money that nobody on this thread advocating passive investing has this allocation. All of you are active whether you admit it or not. You're just using index funds as your vehicle of choice.
To argue against non-cap weighted indexes while not going with the market's asset allocation is irrational, IMO.
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If you truly believed the market knows best, then you should have a global allocation to roughly 43% stocks and 57% bonds. Any deviation from that and you are making an active bet against 'the market.' - Cullen Roche
*snip*
I'd almost put money that nobody on this thread advocating passive investing has this allocation. All of you are active whether you admit it or not. You're just using index funds as your vehicle of choice.
To argue against non-cap weighted indexes while not going with the market's asset allocation is irrational, IMO.
Eh that's been discussed before, and is closer to a no true scotsman argument than anything.
I think the difference between active and passive investing is just intrinsically linked to how much you as an individual investor believe in the efficiency of the market you're investing in. You could be passive in one market and allow yourself to have market level returns or you could be actively pursuing what you think is exploitable inefficiencies and well be active...
The market itself is rather irrelevant to whether it is active or passive. It is the level which you are trying to take advantage of perceived inefficiencies.
Now in the article the claim is being made that the global index is the "only true passive benchmark" which is further reinforced with the conclusion -
In summary, investors are starting to acknowledge the overwhelming evidence that active security selection is a loser’s game. This realization has caused a massive exodus from traditional mutual funds and Separately Managed Accounts and into passive Exchange Traded Funds. Investors who choose to follow this trend face a new set of challenges related to the expression of a passive view in their asset allocation. The Global Market Portfolio represents the most coherent expression of this view, and any deviation from this portfolio represents an active bet. Thus most investors who think they are passive are actually active; worse, they are making large concentrated bets unintentionally.
Now I think the difference is that the conclusion is assuming I don't know that using VTSAX tilts in a particular asset class and ignores other asset classes. And this somehow means I'm "active". The thing is I don't think there is some mysterious inefficiency I'm exploiting. I'm just comfortable with the level of risk and anticipated (conservatively) return. That doesn't make me an active investor and I'm no more active than someone who would be buying into that global market ETF strategy that the author is proposing.
Maybe the company behind the post have an interest in global ETF's? (http://bpgassociates.com/strategy.php) :) Not that that is a bad thing. It just sounds a little silly to say "I'm more passive than you because I choose X asset class."
Note that this is also from a similar discussion of "you're not truly a market investor unless you invest in X market".
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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.
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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?
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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.
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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.
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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.
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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?
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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?
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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.
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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?
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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.
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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.
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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...
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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.
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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.
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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 (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.
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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.
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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.
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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.
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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?
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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.
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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 (http://forum.mrmoneymustache.com/investor-alley/dual-momentum-investing/msg643933/#msg643933) 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.
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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.
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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.
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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.
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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?
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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.
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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.
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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 (http://www.forbes.com/sites/rickferri/2013/04/29/no-free-lunch-from-equal-weight-sp-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.
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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.
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.