Author Topic: Fundamental vs. cap-weighted indexing  (Read 3618 times)

Herr Schnurrbart

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Fundamental vs. cap-weighted indexing
« on: February 01, 2014, 03:16:07 PM »
I've been following this forum for a while and find the discussions and information exchanged here very valuable.

I just read a piece in FORBES about Wisdom Tree ETF's.  Wisdom Tree adheres to the theory that weighting stocks by market capitalization inevitably causes a drag on performance since markets are inefficient and market prices stray from their fair values in a random fashion.  Market-cap-weighted portfolios  (Vanguard) are skewed towards overvalued stocks. 

Wisdom Tree's portfolios are weighted independent of market values using fundamental variables such as total revenues and book value to measure size instead of market capitalization.

I don't own any fundamental-weighted ETFs, but do have several Vanguard funds in my investments.  Recently I have watched with some alarm as cloud computing stocks have climbed into the stratosphere absent any fundamental rationale.

Anybody have any thoughts on the merits of fundamental indexing?

kyleaaa

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Re: Fundamental vs. cap-weighted indexing
« Reply #1 on: February 02, 2014, 07:43:47 AM »
Fundamental indexing is just another value strategy. Their argument that markets are inefficient and that market-cap weighted index funds are dominated by overvalued stocks defy current economic thought as well as the empirical evidence. Buying a fundamental index is functionally equivalent to buying a value index, so just do that instead. It's cheaper.

Besides, how do you know cloud computing stocks have climbed into the stratosphere absent any fundamental rationale? What do you know that everybody else on the planet doesn't? You can't know a stock is overvalued unless you know the future.

c12mintz

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Re: Fundamental vs. cap-weighted indexing
« Reply #2 on: February 02, 2014, 09:50:08 AM »
There have been some significant back testing of results for both cap-weighted and equal-weighted indexes.

From all that I've read, equal-weighted has strongly outperformed over the past 20 or so years, but it's hard to tell if that's a pattern.

In regards to the virtues of the EMH- I can tell you there are a lot of dumb people doing dumb things with their investments. Certain stocks, for example Tesla (TSLA) and Twitter (TWTR) attract a lot of people from 2 categories promoted by a 3rd:


1--- Retail investors who think they are investing in an 'awesome story,' but have no idea about the underlying. They couldn't tell you the difference between items on an income statement or balance sheet if their life depended on it.

2--- 'Pro investors' who are focused on strong 1 year returns who simply chase the popular stocks in efforts to ride the train. This is known as the "greater fool theory," essentially, I know the company is worthless, but the stock is popular, so I'm going to ride the elevator up!

3--- News media operates with stocks similar to "the squeaky wheel gets the grease." Essentially JCPenny, Blackberry and others get bashed almost daily while Netflix, Twitter, Tesla, etc get daily pumping from the news media due to their exploding stock prices.

The combination of #1-#3 can lead to massive short-term run ups in stocks that have no business being worth say $1-$5B, let alone $20-$40B.

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For those who believe in the EMH, I have to ask them about the 90s crash? The 2008 housing bubble/crash? The 1990-1991 oil crisis crash?

Lots of smart people were screaming about the housing bubble as early as 2006, but the market kept on surging. Same thing with tech stocks in 1998. People were mocking Warren Buffett on a daily basis back then.

EMH has been presented and pseudo 'proven' based on a few methods:

1- Dartboard vs. Indexing -- on average the two perform very similar.   // Response: Duh, the dartboard is just a smaller sample of the index, so of course if you add enough dartboard portfolios together the performance is close to the index.

2- Backtesting with ratios -- this has shown that historical P/E and P/B don't really matter, as the 1y returns are almost always similar on average  // Response: This critique fails to account for 2 things: 1) Studies have shown that long-term 'value' stocks have trumped 'growth' stocks even though y/y fluctuations can be wildly different. Check out the Fama/French study 2) It only focuses on ratios, not forward estimates or industry prospects. Lots of companies with higher P/E that are just having a 1-off year like Johnson Johnson 2 years ago, also companies with lower P/Es that are  clearly dying such as Blackberry 2 years ago with a P/E of like 7.

3- Performance of managers vs. indexes -- this has shown that something like 90% of managers underperform in 5 years, and 95% in 10 years. // Response: This fails to account for the massive twisted incentive structure most managers operate under. 1y results are all that really matter for flows of funds, so many managers are chasing each other around and are more focused on momentum than value. 

If mutual funds are ignored, and hedge funds and private equity (think Icahn, Einhorn, Buffett, Blackstone, etc) are studied instead, the results are shockingly in favor of active management.

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I really got off topic here, since your first question regarded cap-weighted vs. equal-weighted. In essence I favor the latter. Personally I actively manage my IRA and trading accounts, but my 401k is all passively indexed. For investors not wanting to spend the time or who don't get enjoyment out of stocks, I fully recommend indexing.

The #1 thing to focus on is the expense ratio. Vanguard offers many options with .05-.2% expense ratios. If the equal-weighted is say, 0.2%, it sounds fair, but if it's really high like 0.5%-1%, than avoid it.

Unfortunately for investors some of the most stable ETFs and Mutual Funds that focus on value stocks with stable/growing dividends also have scary expense ratios of 0.5-0.8%. These expense ratios will probably sap away a lot of the extra returns despite what I perceive as a safer/superior investment.


kyleaaa

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Re: Fundamental vs. cap-weighted indexing
« Reply #3 on: February 02, 2014, 04:10:05 PM »
Speculative bubbles are not an argument against the efficient market hypothesis since the EMH doesn't argue that prices are correct at all times, just that all information is priced in. It DOES argue that you can't know whether or not the price is correct until after the fact, though. Plenty of people "predicted" the tech bubble, but the odds of that crash happening weren't actually anywhere near as high as what those people thought. Things could have very easily turned out differently. Ditto for the real estate crash. The people bidding for properties at the height of the bubble weren't necessarily acting irrationally and it's difficult to logically interpret the bubble and subsequent crash as violating the EMH.
« Last Edit: February 02, 2014, 04:12:33 PM by kyleaaa »

c12mintz

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Re: Fundamental vs. cap-weighted indexing
« Reply #4 on: February 02, 2014, 09:41:12 PM »
The people bidding for properties at the height of the bubble weren't necessarily acting irrationally and it's difficult to logically interpret the bubble and subsequent crash as violating the EMH.

People buying houses for the purpose of 'flipping' weren't necessarily irrational if they thought they could get away with it. However people buying houses as long-term investments, if they understood the financial markets and underlying cap rates, were indeed being very irrational.

Many of the tech bubble stocks were complete shams and had negligible information in their pre-IPO public filings. Again- traders perhaps overly greedy, but not necessarily irrational (suckers everywhere!), but the average guy looking for long-term profits was just a pure sucker.

Then again, hindsight is 20/20.

I believe the larger and more visible the company and its underlying operating model are, the more efficient the stock price gets. There are very few stocks in the S&P 500 that are obviously over or under priced after incorporating all available information. However, there are dozens of companies, mostly under $500M, that are priced in wild disconnect to either their business prospects or their underlying assets.

We've gotten off track a bit though as the original post was about cap-weighted versus equal-weighted: it looks like EWI has outperformed by a small amount (1.5% annualized) based on a recent study, but then again expense ratios are important:

http://www.investopedia.com/articles/exchangetradedfunds/08/market-equal-weight.asp

Herr Schnurrbart

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Re: Fundamental vs. cap-weighted indexing
« Reply #5 on: February 03, 2014, 06:46:12 AM »
Interesting study.  The CWI outperform the EWI during bull markets since they are skewed to overvalued stocks.
If we believe that valuations are about to fall back to more reasonable levels then it could be time to shift into EWI funds.

c12mintz

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Re: Fundamental vs. cap-weighted indexing
« Reply #6 on: February 03, 2014, 10:23:33 AM »
Personally I have my full 401k in index funds, and I actively manage my Roth IRA and trading accounts.

I 'hedge' my Roth with puts on high fliers and occasionally buy SPY puts as a general market hedge.

I don't personally believe in the EMH, but I do believe investment 'skill' is few and far between. Therefore I hedge against myself with index funds as I learn the ropes.

If you are interested in market commentary and deeper investment stuff, seekingalpha.com is a great resource.

AdrianC

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Re: Fundamental vs. cap-weighted indexing
« Reply #7 on: February 06, 2014, 08:15:39 AM »