Author Topic: If you want to index, Vanguard rules. If you want to tilt....not necessarily.  (Read 8699 times)

milesdividendmd

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It is true that if you want to match the market and keep your costs down, it is very difficult to do better Vanguard.

It is also true that keeping your costs down is the single most important factor in maximizing your returns.

It is also true that if you keep your costs down and match the market and maintain discipline you will beat at least 70% of all investors on a risk adjusted basis long term.

But if you want to capture the size premium or the value premium or the momentum premium or the quality premium, vanguard is often not the best bet.

This is a point made by 2 preeminent passive investing gurus in the past week.

Rick Ferri:  http://www.forbes.com/sites/rickferri/2014/07/31/confessions-of-an-index-investor/

and my favorite, Larry Swedroe: http://www.etf.com/sections/index-investor-corner/22820-swedroe-small-value-funds-not-equal-part-ii-.html?fullart=1&start=2

Buying and holding the whole haystack is awesome, and worthy of praise.

But slicing and dicing and tilting has value too I think...  (And I get my small value exposure from RZV, Guggenheim small cap value.)

pom

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I tilt toward small caps using VB (Vanguard small cap index tracker). It has a 0.09% expense ratio.

The Falcon

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Yep, I'd even consider (shudder!) a mix of index AND active management (with requisite due diligence) for small cap exposure if capital permits....the efficient marker aint so efficient when it comes to the tiddlers. Combined 10-20% of portfolio max depending on risk appetite.

Scandium

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I struggle with this. I believe Bogle said that he thinks tilting to small (or whatever) is just market timing, but what does he know..

The data for the SCV premium looks compelling though. It does have 10-20 years of underperformance, so require an extreme degree of "stay the course". Based on that I'm not sure it makes sense for the money i need day 1 of retirement, in ~20 years. For my funeral fund maybe. Not sure I can follow Swedroe's advice and do an extra 25% to SCV, that seems like a lot of faith in this concept.

Schwab where I have taxable and roth doesn't have their own SCV fund, so for now I've just added the small cap ETF to try to increase return (and risk) some. SCHA is more a mid-small blend though. So far this year it's down 4% so living up to the volatility expectations! I do like simplicity though so sometimes contemplate just doing away with it and sticking to broad market, which does have 9% SCV..

edit: for others at Schwab there is SPRD SLYV which can be traded commission free for a small value tilt. ER is 0.25%
« Last Edit: August 05, 2014, 09:11:32 AM by Scandium »

milesdividendmd

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I struggle with this. I believe Bogle said that he thinks tilting to small (or whatever) is just market timing, but what does he know..

The data for the SCV premium looks compelling though. It does have 10-20 years of underperformance, so require an extreme degree of "stay the course". Based on that I'm not sure it makes sense for the money i need day 1 of retirement, in ~20 years. For my funeral fund maybe. Not sure I can follow Swedroe's advice and do an extra 25% to SCV, that seems like a lot of faith in this concept.

Schwab where I have taxable and roth doesn't have their own SCV fund, so for now I've just added the small cap ETF to try to increase return (and risk) some. SCHA is more a mid-small blend though. So far this year it's down 4% so living up to the volatility expectations! I do like simplicity though so sometimes contemplate just doing away with it and sticking to broad market, which does have 9% SCV..

edit: for others at Schwab there is SPRD SLYV which can be traded commission free for a small value tilt. ER is 0.25%

Advanced apologies for a semantic discussion but...

I can see calling such funds "active" but I can not see accusing  them of "market timing."  Market timing involves changing your allocation based on market conditions in order to exploit perceived inefficiencies.  These funds do no such thing.

The funds mentioned in Ferri and Swedroes articles are actually index funds, they just arent cap weighted index funds.  They are value weighted or size weighted (or both).  Such indices will always be more expensive than cap weighted indexes because the only time you have to trade a fund in a cap index is when it enters or exits the index.  If a value company becomes a growth company in  a cap weighted index the fund manager must do nothing.  If the same happens in a value index the fund manager must sell the stock.

But if you want exposure to the size premium of the value premium in your portfolio, then a smaller and valuey-er is more effective.

Scandium

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I struggle with this. I believe Bogle said that he thinks tilting to small (or whatever) is just market timing, but what does he know..

The data for the SCV premium looks compelling though. It does have 10-20 years of underperformance, so require an extreme degree of "stay the course". Based on that I'm not sure it makes sense for the money i need day 1 of retirement, in ~20 years. For my funeral fund maybe. Not sure I can follow Swedroe's advice and do an extra 25% to SCV, that seems like a lot of faith in this concept.

Schwab where I have taxable and roth doesn't have their own SCV fund, so for now I've just added the small cap ETF to try to increase return (and risk) some. SCHA is more a mid-small blend though. So far this year it's down 4% so living up to the volatility expectations! I do like simplicity though so sometimes contemplate just doing away with it and sticking to broad market, which does have 9% SCV..

edit: for others at Schwab there is SPRD SLYV which can be traded commission free for a small value tilt. ER is 0.25%

Advanced apologies for a semantic discussion but...

I can see calling such funds "active" but I can not see accusing  them of "market timing."  Market timing involves changing your allocation based on market conditions in order to exploit perceived inefficiencies.  These funds do no such thing.

The funds mentioned in Ferri and Swedroes articles are actually index funds, they just arent cap weighted index funds.  They are value weighted or size weighted (or both).  Such indices will always be more expensive than cap weighted indexes because the only time you have to trade a fund in a cap index is when it enters or exits the index.  If a value company becomes a growth company in  a cap weighted index the fund manager must do nothing.  If the same happens in a value index the fund manager must sell the stock.

But if you want exposure to the size premium of the value premium in your portfolio, then a smaller and valuey-er is more effective.

I'm aware, I think his point was that it is assuming you know one segment will outperform and owning that instead of the total market.

Found his quote. His response is pretty tame.

Quote
John Bogle on tilting:
"Impressed both by the long-term performance (and recent performance) of value stocks and small-cap stocks, some investors hold the all-market (or S&P 500) index fund as the core, and add a value index fund and a small-cap index fund as satellites. I'm skeptical that any kind of superior performance will endure forever. (Nothing does!) But if you disagree, it would not be unreasonable to hold, say, 85 percent in the core, another 10 percent in value, and another 5 percent in small cap. But doing so increases the risk that your return will fall short of the market's return, so don't push too far."
-- The Little Book Of Common Sense Investing, p.206.

Also more comments by Bogle I don't have time to read now.
http://www.vanguard.com/bogle_site/sp20020626.html

Cyrano

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I struggle with this. I believe Bogle said that he thinks tilting to small (or whatever) is just market timing, but what does he know..

The data for the SCV premium looks compelling though. It does have 10-20 years of underperformance, so require an extreme degree of "stay the course". Based on that I'm not sure it makes sense for the money i need day 1 of retirement, in ~20 years. For my funeral fund maybe. Not sure I can follow Swedroe's advice and do an extra 25% to SCV, that seems like a lot of faith in this concept.

Schwab where I have taxable and roth doesn't have their own SCV fund, so for now I've just added the small cap ETF to try to increase return (and risk) some. SCHA is more a mid-small blend though. So far this year it's down 4% so living up to the volatility expectations! I do like simplicity though so sometimes contemplate just doing away with it and sticking to broad market, which does have 9% SCV..

edit: for others at Schwab there is SPRD SLYV which can be traded commission free for a small value tilt. ER is 0.25%

Advanced apologies for a semantic discussion but...

I can see calling such funds "active" but I can not see accusing  them of "market timing."  Market timing involves changing your allocation based on market conditions in order to exploit perceived inefficiencies.  These funds do no such thing.

The funds mentioned in Ferri and Swedroes articles are actually index funds, they just arent cap weighted index funds.  They are value weighted or size weighted (or both).  Such indices will always be more expensive than cap weighted indexes because the only time you have to trade a fund in a cap index is when it enters or exits the index.  If a value company becomes a growth company in  a cap weighted index the fund manager must do nothing.  If the same happens in a value index the fund manager must sell the stock.

But if you want exposure to the size premium of the value premium in your portfolio, then a smaller and valuey-er is more effective.


To quibble, market cap weighted funds must trade to remain on index after a share buyback or a new issue. But the point of it being the index construction with the lightest turnover stands.

milesdividendmd

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Cyrano,

I believe this not case. If there is a share buyback the value of the stock goes up and this is reflected in its capital weighting within the index. From the index fund provider's standpoint nothing need be done. Similarly if more stock is issued the value of the stock decreases image and this is reflected within the index.

This is my understanding of how Capital weighted indexes work. If you have more detailed knowledge, please share.

AZ

Cyrano

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Miles,

To illustrate, consider a simple cap weighted index containing two nearly identical firms. Each initially has a market cap of $10 B, a share price of $100, with 100 M shares outstanding. A cap weighted fund is equally invested in the two.

Firm A pays a $2 dividend. When it goes ex-dividend, its share price falls to $98, it still has 100 M shares outstanding, and a market cap of $9.8 B.

Firm B instead spends the same $200 M on a buyback. If the stock was fairly priced in the first place, and can stretch the buyback over enough time that liquidity isn't an issue, the buyback does not impact the stock price. (Since you assume differently, we'll come back to that in a moment.) Firm B now has 98 M shares outstanding. Now in the beginning, the two firms were nearly identical, and both are now $200 M poorer in cash, so if $9.8 is a fair market cap valuation for firm A, it is also a fair valuation for firm B, implying that $100 remains a fair share price for firm B. So there was no reason for the buyback to have changed the share price in a reasonably efficient market.

So after the two firms have returned money to shareholders by different means, they both have a market cap of $9.8 B, and a cap weighted index would equally weight the two.

But the cap weighted fund is now 50% invested in A, 49% invested in B, and has 1% cash, and needs to buy B or sell A to return to the index's weight.

Insofar as its investors reinvest their distributions, the fund uses the dividend cash to purchase B to return to the index weighting.

But insofar as its investors take their distributions as cash, the 1% cash will be used to pay distributions, and the fund must instead sell A and use the proceeds to buy B to return to market weighting.

Short version: when some firms in a cap-weighted index pay dividends and other firms do buybacks, a fund tracking that index needs to sell shares in the buyback firms and buy shares in the dividend firms to remain on index.







milesdividendmd

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Cyrano,

Your explanation does not quite make sense to me.

If a company performs a stock buyback they purchase their own shares.

When they do this the number of shares outstanding goes down by the exact number of shares purchased by the company.

So now each piece of stock represents a larger piece of the company, as well as a larger amount of future earnings in the company.

This improves the price to earnings ratio for the company,, As well as The earnings per share.

So each stockholder now owns a bigger piece of the company. This is why The stock price goes up upon the announcement of the stock buyback.

The other reason is the impact of the purchase on the price. The more the company purchases, the less the supply, the higher the price of the stock. (Simple economics.)

In a truly efficient market The price per share should go up by the exact amount as the value gained by each share.

In other words, the company is slightly smaller in size, but there are fewer pieces of it. (It's capital weighting is unchanged, but it's capital per-share has gone up.

So a fund manager need to nothing, The company that has bought its own stock has not changed in value at all. Each share is worth a larger piece of the company but the company is smaller by the exact amount of the Buyback.

Similarly in the event of a dividend being paid the net asset value of the company goes down by the exact amount of the dividend. So the pie has shrunk a little bit, but this shrinkage is captured by the lower market price of the stock.

In neither of these instances should the fund manager have to do anything. The changes in capital weighting are already priced into the stock which the index already owns
« Last Edit: August 05, 2014, 10:57:36 PM by milesdividendmd »

milesdividendmd

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Admittedly there is not much written on how to run a market cap index, since so few undertake this endeaver, but the S&P directer did say this about his index...

On an index level, however, the situation is different. The S&P index weighting methodology adjusts for shares, so buybacks are reflected in the calculations. Specifically, the index reweights for major share changes on an event-driven basis, and each quarter, regardless of the change amount, it reweights the entire index membership. The actual index EPS calculation determines the index earnings for each issue in USD, based on the specific issues’ index shares, index float, and EPS. The calculation negates most of the share count change, and reduces the impact on EPS."

I'm not sure that this settles our disagreement one way or another.

But in the end the important take home is that market cap weighted indices are much cheaper, because of their reduced need for transaction costs.

Interesting stuff!


Dr. A

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Cyrano,

Your explanation does not quite make sense to me.
If a company performs a stock buyback they purchase their own shares.

When they do this the number of shares outstanding goes down by the exact number of shares purchased by the company.

So now each piece of stock represents a larger piece of the company, as well as a larger amount of future earnings in the company.

This improves the price to earnings ratio for the company,, As well as The earnings per share.

So each stockholder now owns a bigger piece of the company. This is why The stock price goes up upon the announcement of the stock buyback.


This ignores the fact that the company is spending cash in order to buy the shares back, which goes to the investors that sell their shares to the company. If you assume that the shares were fairly valued at the time of the buyback, then the company has merely exchanged a certain amount of cash (say, $X) for a future earnings stream that was worth $X. So while each shareholder gains a fraction of future earnings, they also give up a fraction of cash with equal value.

This is only true when the shares are fairly priced. A company really can increase it's value by buying back undervalued shares, just as it can lose value by buying back over-valued shares.

I think the reason a stock goes up on buyback news has more to do with psychology than any quantifiable boost in value. Confidence in the future of the company, producing more cash than management knows what to do with, believing that management thinks the company is undervalued, etc.

The other reason is the impact of the purchase on the price. The more the company purchases, the less the supply, the higher the price of the stock. (Simple economics.)

I think you are correct about this in the short term, at least for large, aggressive buybacks. In the long-term though, the shares must revert to intrinsic value. That said, I could see a company that thought it's shares were significantly undervalued engage in a large, aggressive buyback with the goal of triggering a permanent move back to intrinsic value by shaking loose the short-sellers or something.

milesdividendmd

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Cyrano,

Your explanation does not quite make sense to me.
If a company performs a stock buyback they purchase their own shares.

When they do this the number of shares outstanding goes down by the exact number of shares purchased by the company.

So now each piece of stock represents a larger piece of the company, as well as a larger amount of future earnings in the company.

This improves the price to earnings ratio for the company,, As well as The earnings per share.

So each stockholder now owns a bigger piece of the company. This is why The stock price goes up upon the announcement of the stock buyback.


This ignores the fact that the company is spending cash in order to buy the shares back, which goes to the investors that sell their shares to the company. If you assume that the shares were fairly valued at the time of the buyback, then the company has merely exchanged a certain amount of cash (say, $X) for a future earnings stream that was worth $X. So while each shareholder gains a fraction of future earnings, they also give up a fraction of cash with equal value.

This is only true when the shares are fairly priced. A company really can increase it's value by buying back undervalued shares, just as it can lose value by buying back over-valued shares.

I think the reason a stock goes up on buyback news has more to do with psychology than any quantifiable boost in value. Confidence in the future of the company, producing more cash than management knows what to do with, believing that management thinks the company is undervalued, etc.

The other reason is the impact of the purchase on the price. The more the company purchases, the less the supply, the higher the price of the stock. (Simple economics.)

I think you are correct about this in the short term, at least for large, aggressive buybacks. In the long-term though, the shares must revert to intrinsic value. That said, I could see a company that thought it's shares were significantly undervalued engage in a large, aggressive buyback with the goal of triggering a permanent move back to intrinsic value by shaking loose the short-sellers or something.

Right, but from the standpoint of a cap weighted index this shouldn't matter.

After the buyback there are fewer more expensive shares outstanding of a slightly less valuable company.

The number of shares times the value of shares determines the capital weighting. The intrinsic value of the company is totally irrelevant. I.e. in the setting of a bubble a cap weighted index will own overpriced companies in proportion to their price x shares outstanding, not in proportion to the actual value of the underlying company.


RyeWhiskey

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All tilting and slice-and-dice is fundamentally some form of speculation: You are essentially betting that one sector/cap will outperform the overall market. It's also added complication and hence violates the goal of simplicity. Personally, all my equity holdings are in a single fund: Vanguard Total World Stock Index. I'd be willing to bet that it outperforms every single other index over the long haul.

milesdividendmd

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All tilting and slice-and-dice is fundamentally some form of speculation: You are essentially betting that one sector/cap will outperform the overall market. It's also added complication and hence violates the goal of simplicity. Personally, all my equity holdings are in a single fund: Vanguard Total World Stock Index. I'd be willing to bet that it outperforms every single other index over the long haul.

I want a piece of that action. I'll take small cap value.

Tilting is not speculation anymore than buying the total world index is.

You are betting that the value, size, momentum, and quality factors will cease to exist. You are also betting that stocks will outperform bonds, real estate, and commodities.

It's not a bad bet and it is quite simple. But it is speculation nonetheless since you are betting that some patterns of return will continue, and some will not.

In one light tilting is less speculative since you are betting on the continued outperformance of all of the factors which have outperformed in the past.

RyeWhiskey

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I want a piece of that action. I'll take small cap value.

Deal. Mark it dude. You want the Vanguard Small Cap Value Index?

Tilting is not speculation anymore than buying the total world index is.

Sure it is, it's just a fancied-up term to make you feel better about the fact that you're making sector/cap specific bets on outperformance based upon a selection of historical data. The truth is that the overall market is guaranteed performance (barring SHTF scenarios). "Out"performance is, by definition, a form of speculation as it posits above and beyond the base.

You are betting that the value, size, momentum, and quality factors will cease to exist.

I don't think it's fair to say that any of those have been proven to exist at all.

You are also betting that stocks will outperform bonds, real estate, and commodities.

Assumption on your part and irrelevant to the discussion as we were purely discussing equity investing.

In one light tilting is less speculative since you are betting on the continued outperformance of all of the factors which have outperformed in the past.

Also not proven. One can cherry pick any set of data to prove outperformance.

milesdividendmd

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I want a piece of that action. I'll take small cap value.

Deal. Mark it dude. You want the Vanguard Small Cap Value Index?

Tilting is not speculation anymore than buying the total world index is.

Sure it is, it's just a fancied-up term to make you feel better about the fact that you're making sector/cap specific bets on outperformance based upon a selection of historical data. The truth is that the overall market is guaranteed performance (barring SHTF scenarios). "Out"performance is, by definition, a form of speculation as it posits above and beyond the base.

You are betting that the value, size, momentum, and quality factors will cease to exist.

I don't think it's fair to say that any of those have been proven to exist at all.

You are also betting that stocks will outperform bonds, real estate, and commodities.

Assumption on your part and irrelevant to the discussion as we were purely discussing equity investing.

In one light tilting is less speculative since you are betting on the continued outperformance of all of the factors which have outperformed in the past.

Also not proven. One can cherry pick any set of data to prove outperformance.

Vanguard small cap value?

You didn't read the articles did you? 


kyleaaa

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All tilting and slice-and-dice is fundamentally some form of speculation: You are essentially betting that one sector/cap will outperform the overall market. It's also added complication and hence violates the goal of simplicity. Personally, all my equity holdings are in a single fund: Vanguard Total World Stock Index. I'd be willing to bet that it outperforms every single other index over the long haul.

But the total stock market/total world index funds AREN'T the overall market. They're just 97% of the PASSIVELY INVESTABLE market. They don't represent the overall market any more than small-value does. Actually, they probably represent it a bit less because roughly half of GDP comes from small companies you can't buy on any public market.

Besides, slicing and dicing doesn't add any complication at all. Managing 10 funds is functionally as simple as managing 1. Try it. I bet you won't get even remotely frustrated or spend more than 30 seconds next year dealing with it.

RyeWhiskey

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But the total stock market/total world index funds AREN'T the overall market. They're just 97% of the PASSIVELY INVESTABLE market. They don't represent the overall market any more than small-value does. Actually, they probably represent it a bit less because roughly half of GDP comes from small companies you can't buy on any public market.

If you're not talking about the passively investable market when you're talking about index investing... what, exactly, are you talking about?

Besides, slicing and dicing doesn't add any complication at all. Managing 10 funds is functionally as simple as managing 1. Try it. I bet you won't get even remotely frustrated or spend more than 30 seconds next year dealing with it.

By definition slicing and dicing does add complexity, it's taking one item and turning it into more items, to claim otherwise is absurd. And I have tried it. My conclusion was that I didn't know anything more than anyone else, and hence to claim I do (by betting on a sector or cap) was illogical. Furthermore, it's much easier and simpler to just have one fund.

There's nothing wrong with slicing and dicing, I'm just claiming that it's a form of speculation which should be accepted by those who practice it.

RyeWhiskey

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Vanguard small cap value?

You didn't read the articles did you?

I'm sorry but what articles?

milesdividendmd

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The 2 linked in the OP. ie the whole point of this discussion.

Cap weighted indices are not as useful for tilting as indices aggressively weighted towards the factor that you wish to tilt towards.

This actually wasn't a "to tilt or not to tilt" topic, though the back and forth is certainly interesting.

kyleaaa

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If you're not talking about the passively investable market when you're talking about index investing... what, exactly, are you talking about?

When sophisticated investors say "the market" they mean the entire investable universe, not just the publicly investable markets. A portfolio reflecting the overall economy would contain more small cap value than large cap. We weren't talking about index funds, we were talking about tilting.  Big difference.

By definition slicing and dicing does add complexity, it's taking one item and turning it into more items, to claim otherwise is absurd.

Not in any meaningful sense it doesn't. If you define a total world index as being a 0.1 on the complexity scale where 0 is no complexity at all and 100 is total complexity, then slicing and dicing is a 0.2. Not meaningful enough to even mention. I slice and dice and I have LITERALLY (actually literally, as in I'm not even slightly exaggerating) spent a total of about 7 minutes on it over the past 5 years. There's no complexity there. At all.

And I have tried it. My conclusion was that I didn't know anything more than anyone else, and hence to claim I do (by betting on a sector or cap) was illogical. Furthermore, it's much easier and simpler to just have one fund.

That shows a lack of understanding of what tilting is. It doesn't necessitate or imply knowing more than anyone else.

There's nothing wrong with slicing and dicing, I'm just claiming that it's a form of speculation which should be accepted by those who practice it.

And I'm saying your claim is flat-out wrong. In fact, by the logic you just used, investing in a cap-weighted total market fund would be more speculative than investing in small-value because it's further from the real actual output of the U.S. economy. The stock market is not the economy. The stock market doesn't represent the economy. The stock market is its own thing. Owning the stock market isn't representative of owning the economy.

« Last Edit: August 06, 2014, 08:50:51 PM by kyleaaa »