Author Topic: Is the CoffeeHouse portfolio really passive investing?  (Read 9118 times)

joer1212

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Is the CoffeeHouse portfolio really passive investing?
« on: October 24, 2012, 10:38:52 AM »
I'm confused. Why do investors who claim to be "indexers" include "small value"
and "large value" funds in their portfolio?
I just finished reading The New Coffeehouse Investor by Bill Schultheis.
The recommended sample portfolios in this book include--without a hint of irony-- a "small value" stock fund and a "large value" stock fund.
I thought the purpose of passive investing was to purchase whole market indexes, such as a total large-cap index fund, and a total small-cap index fund?
I didn't expect Bill Schultheis to promote funds consisting of "value" companies, because, who decides what are "value" companies?  Right, an active manager does, who tries to cherry-pick those companies that he thinks are undervalued.
So, how is this broad index investing?
Index investing should be about purchasing all the companies of an asset class, both the good and bad ones, not trying to outsmart the broad market, which is exactly what active investors do.

hoppy08520

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #1 on: October 25, 2012, 10:10:55 AM »
joer1212, there are many competing perspectives on this. If you go to Bogleheads.org, there is at least one thread a week on the merits of Total Stock Market (TSM) investing versus "tilters" which are people who might hold a core of TSM but then tilt (also described as "overweight") toward value, or small cap, or REIT, etc. (do a search on "SCV" and you'll find oodles of threads).

The fact that there have been so many heated debates over this, for so many years, leads me to believe that neither strategy is a slam dunk, or else people would no longer need to argue :-)

An index can be on any asset class/sector, not just on TSM. In fact, the first index fund was not TSM but the S&P 500-stock index by Vanguard (VFINX). Were people who invested in VFINX not "indexers" because their index fund was not TSM? Passive investing is simply investing in funds that track an index, which is typically less expensive because it doesn't need expensive management teams of analysts and experts (and therefore will typically have higher returns) than an actively-managed fund which has higher built-in expenses (which means that most, in the long run, will trail index funds).

I think someone who does the Coffeehouse portfolio could still be described as a passive index investor, but with tilts toward certain asset classes (value and small) and sectors (REIT).

If you think the Coffeehouse portfolio has too many of these "bets", then just go with TSM for your US Stock portion.

joer1212

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #2 on: October 26, 2012, 12:23:55 AM »
joer1212, there are many competing perspectives on this. If you go to Bogleheads.org, there is at least one thread a week on the merits of Total Stock Market (TSM) investing versus "tilters" which are people who might hold a core of TSM but then tilt (also described as "overweight") toward value, or small cap, or REIT, etc. (do a search on "SCV" and you'll find oodles of threads).

The fact that there have been so many heated debates over this, for so many years, leads me to believe that neither strategy is a slam dunk, or else people would no longer need to argue :-)

An index can be on any asset class/sector, not just on TSM. In fact, the first index fund was not TSM but the S&P 500-stock index by Vanguard (VFINX). Were people who invested in VFINX not "indexers" because their index fund was not TSM? Passive investing is simply investing in funds that track an index, which is typically less expensive because it doesn't need expensive management teams of analysts and experts (and therefore will typically have higher returns) than an actively-managed fund which has higher built-in expenses (which means that most, in the long run, will trail index funds).

I think someone who does the Coffeehouse portfolio could still be described as a passive index investor, but with tilts toward certain asset classes (value and small) and sectors (REIT).

If you think the Coffeehouse portfolio has too many of these "bets", then just go with TSM for your US Stock portion.


But there is a difference between a pure index fund that is based on the market capitalization of the companies in it (e.g. S&P 500; Russell 2000, etc), and an artificially made up "index" (e.g. "value") based on the subjective opinion of what some investment manager believes are undervalued companies, that are, therefore, bargains. That gets into active investing territory, big-time. How is this different from the countless managed portfolios out there that seek to outperform the broad market?
Tilting towards REITs or small-cap is not the same as including a small-cap "value" fund in your portfolio. At least REITs and small-caps are real asset classes, whereas "small-cap value" is entirely fabricated.
« Last Edit: October 26, 2012, 12:34:46 AM by joer1212 »

grantmeaname

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #3 on: October 26, 2012, 06:45:19 AM »
That's not what it does, though. You're misunderstanding it. There's a "value market" index, and VIVAX tracks that index (look in the prospectus, or the table in the bottom left). MSCI is an analytics company that 'makes' indices, and VIVAX passively tracks one of those.

joer1212

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #4 on: October 26, 2012, 10:55:23 PM »
That's not what it does, though. You're misunderstanding it. There's a "value market" index, and VIVAX tracks that index (look in the prospectus, or the table in the bottom left). MSCI is an analytics company that 'makes' indices, and VIVAX passively tracks one of those.

What criteria is used to determine that a company is a "value" company in this index?

grantmeaname

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #5 on: October 26, 2012, 10:58:04 PM »
It could be totally arbitrary. Point is, Vanguard doesn't even produce the index. They just design a mutual fund to track it.

joer1212

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #6 on: October 27, 2012, 12:28:11 PM »
It could be totally arbitrary. Point is, Vanguard doesn't even produce the index. They just design a mutual fund to track it.

Yeah, that's the problem that I was talking about-- "it could be arbitrary".

grantmeaname

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #7 on: October 28, 2012, 09:37:14 AM »
In this case, I doubt it's a problem, since it's a relatively broad index and so the criteria, whatever they are, must be loose and not restrictive. Even if they weren't, it would still be an index fund and it would still be passively managed. Tracking an idiotic index is not the same thing as active management.

KingCoin

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #8 on: October 28, 2012, 12:24:13 PM »
There can be good reasons for chopping up your equity portfolio beyond just a market cap weighted index. For instance, small cap stocks have historically had both higher returns and higher volatility than large cap stocks. If you happen to have a long investment horizon and a high risk tolerance, it may make sense to weigh small cap stocks more heavily. I haven't read Coffeehouse Investor, but the author may have a similar rationale for segmenting growth and value.

As an aside, active management isn't an inherently evil thing. Most of these guys are closet indexers anyway. It's the fees that active managers charge that result in underperformance.  So, as always, be especially skeptical about any fund with a expense ratio that exceeds .25%.

joer1212

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #9 on: October 28, 2012, 05:22:49 PM »
There can be good reasons for chopping up your equity portfolio beyond just a market cap weighted index. For instance, small cap stocks have historically had both higher returns and higher volatility than large cap stocks. If you happen to have a long investment horizon and a high risk tolerance, it may make sense to weigh small cap stocks more heavily. I haven't read Coffeehouse Investor, but the author may have a similar rationale for segmenting growth and value.

As an aside, active management isn't an inherently evil thing. Most of these guys are closet indexers anyway. It's the fees that active managers charge that result in underperformance.  So, as always, be especially skeptical about any fund with a expense ratio that exceeds .25%.

Yes, I absolutely agree that tilting a broadly-diversified portfolio a little towards small-caps may be a good thing. In fact, my own portfolio is overweight with a small-cap index fund. I even have about 7% of my portfolio in a REIT index fund.
I'm not arguing the validity of this. I was questioning the inclusion of "value" index funds in an index portfolio.
It's one thing to create an index based on the market capitalization of the companies in it; it is quite another to cherry-pick certain companies, label them "value" companies, and assemble them all in an index. I'm very skeptical of this, and to me seems to defeat the purpose of an index fund in the first place-- to invest in an entire portion of the market (i.e. small companies, large companies, bonds, real estate, etc), not to extract from the entire market the companies that may outperform it.

« Last Edit: October 28, 2012, 05:26:55 PM by joer1212 »

grantmeaname

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #10 on: October 28, 2012, 06:36:48 PM »
Why are value companies an arbitrary portion of the market while small-caps aren't?

joer1212

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #11 on: October 28, 2012, 08:18:12 PM »
Why are value companies an arbitrary portion of the market while small-caps aren't?

Because "small-cap" companies can be quantified.
It is a fact that a company that is worth just 300 million is very "small" compared to one that is worth 100 billion.
But a "value" company seems to hang on the hope that this company is undervalued, which is rather subjective.

maizefolk

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #12 on: October 28, 2012, 08:48:27 PM »
I think I see the problem here. Joer, you're thinking of "value" in the sense of "I think this stock will go up" when in this context it's being used to refer to companies that don't have valuations higher than the hard numbers of their current earning reports and balance sheets justify. Value companies can be defined as being below a specific P/E multiple or by the ratio of market capitalization to "book" value just as quantitatively as selecting companies using a market cap cut-off.

grantmeaname

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #13 on: October 28, 2012, 08:51:04 PM »
No, "value" companies are the opposite of "growth" companies. It's not "undervalued", it's "low PE ratio". Maybe you're misunderstanding the term?

joer1212

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #14 on: October 28, 2012, 09:16:01 PM »
No, "value" companies are the opposite of "growth" companies. It's not "undervalued", it's "low PE ratio". Maybe you're misunderstanding the term?

Yes, I might have used the incorrect term. I apologize.
I know that being "undervalued" and being a "value" company is different. I guess what I was trying to say is that a "value index" consists of companies that have a low P/E ratio, just like maizemen pointed out.

joer1212

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #15 on: October 28, 2012, 09:22:01 PM »
I think I see the problem here. Joer, you're thinking of "value" in the sense of "I think this stock will go up" when in this context it's being used to refer to companies that don't have valuations higher than the hard numbers of their current earning reports and balance sheets justify. Value companies can be defined as being below a specific P/E multiple or by the ratio of market capitalization to "book" value just as quantitatively as selecting companies using a market cap cut-off.

You know, I did want to mention if P/E ratios was one standard by which companies in a value index are judged. I guess by this metric, it is more justified to create an index of such companies, although I don't think a pure indexer would include such a fund in his portfolio. This is more like "dirty indexing", it seems to me.

grantmeaname

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Re: Is the CoffeeHouse portfolio really passive investing?
« Reply #16 on: October 29, 2012, 06:33:31 AM »
Yeah, maybe so. I guess it relies a little less on respect of the efficient market hypothesis than something like a total stock market or small cap fund would.