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A Chink in Index Funds’ Armor?

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I got my July 2013 edition of Money Magazine yesterday and on page 43 there is an interesting article about balancing a lopsided index fund. The idea is that many indexes are weighted by market capitalization which means that when Apple was trading was $700 index funds needed to have a ton of it. As we know now that was the wrong time to buy Apple. In fact, this kind process leads to investing in stocks that may be in a bubble and undervaluing stocks that could be buying opportunities.

So Money Magazine asks the question, "Is it time for you to rethink indexing?" They quickly answer it with a no. Their reason is that indexing has proven to be effective over the long haul and few managers beat the average consistently and when they do it is usually by a small amount. It's not like betting on Tom Brady to beat Mark Sanchez, where you feel good about it happening over and over again (sorry New York fans, we were there in the early 90s).

I agree with this. Even with this chink in index funds' armor, I don't see a better alternative, especially because you can keep index funds expenses low. Money recommends a total market index fund (something that matches Wilshire 5000) and specifically goes with Schwab's Total Stock Market Index (SWTSX). I'm a Vanguard ETF guy myself, so I go with VTI the differences here are minimal. The next thing they suggest is Vanguard FTSE All-World ex-US ETF. Their theory is that you can "cover a broad spectrum of domestic and foreign stocks" with just those two.

I respectfully disagree.

I had long thought that it was true, but I found it left me with a whole in emerging markets. I was almost all invested in the US (70%) and had 15% in Europe, and about 8% in Asia (China/Japan mostly). The other 7% was spread around mostly Australia, Canada, and South America. (I'm using SigFig.com geographical classifications which seem to break apart some countries, but leave other continents grouped, hence the inconsistency there.)

In order to correct this very lopsided allocation, I added a significant amount of Vanguard's FTSE Emerging Markets ETF (VWO). It brought my US down to around 55%, my Europe down to about 13% and my Asia up to about 16%. In reality it gave me a lot of exposure to BRIC (Brazil, Russia, India, and China) that I had been largely missing. It wasn't a ton of exposure, I'm still less than 2% invested in India and Russia each.

Interestingly the article points out that today there's a worry that these BRIC economies may encompass too much of emerging market index funds. Considering that the article previous seemed to ignore emerging markets completely, this is still better than nothing. The article suggests looking at iShares MSCI Emerging Markets Minimum Volatility (EEMV) that has a third less in BRICS. I can't think of the appropriate expression off the top of my head, but this I believe this is over-analyzing things. Most people will have BRICs be about 8% of their portfolio, maybe less. If the minimum volatility option moves it to 6%, it's not the biggest deal. Should you really worry about the 2% difference divided amongst 4 very large countries or the 50% that you put in one country (United States)?

Getting back to the problem of Apple representing a big portion of the US stocks. The article mentions that you can go with PowerShares FTSE RAFI US 1000 (PRF), a mouthful, that doesn't weigh by market capitalization. However, it is quick to point out that it had bubble problems itself in the past. The best advice that I see from the article is to augment with Vanguard Small Cap ETF (VB). Personally, I have a good amount of this stock, but for a completely unrelated reason, I've consistently seen research that small caps perform better over the long haul.

The article ends with a section on bond indexes. I believe that to be a bit more complicated than the equities, although the article has some good guidance. Rather than give away the whole store, I'm going to suggest that you buy the magazine or wait for the article to be available online if you are interested in the bond solution. It'll probably be worth a couple of dollars to you.

Posted on June 6, 2013.

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Asset Allocation, Investing

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5 Responses to “A Chink in Index Funds’ Armor?”

  1. The real question is “better than what?”. A cap-weighted index is a very good representation of what the average investor is doing in the market, which means that it will be better than half of them. And since it has a huge fee advantage it gets pushed up even further. So if you buy that index you are better than average, mostly because of the fee advantage (otherwise you would be exactly average). That’s not a bad place to start.

    When you take that view and put cap-weighted indexes at the center of everything, there is not much else that performs better than them (and a lot of that is things you couldn’t have known ahead of time). They won’t warn you of a coming crash, but it’s pretty impressive that they can do so well despite the complete lack of intelligence and foresight.

    Of course you could change things and argue that something else is the true benchmark but again it’s rare to find something better than cap-weighted indexes that you can predict ahead of time. I like the idea of fundamental indexes, and one could even say that those are a better measure of the current investment opportunities (as opposed to the current investments in high demand). On a side-note, cap-weighted indexes are the hardest for management to manipulate because it doesn’t make sense to drive up your stock price by increasing your market cap (but you can drive it up by increasing dividends since a lot of investors are seeking high yields right now).

    Ultimately cap-weighted indexes are the only thing that nearly everyone can invest in without causing a bubble in some specific components of the index. If anything else got popular enough, then eventually it would be the same as the cap-weighted index. This could be good if it’s a solid fundamental index. It would also be very bad if it was a technology-heavy group of weak companies (which is basically what happened in the 90s).

    The biggest argument against cap-weighted indexes is basically complaining that they didn’t load up on Walmart, Microsoft, and Starbucks 30 years ago and then short technology companies in the 90s. That statement applies to many people.

    • Lazy Man says:

      Yeah, that was my thought too, what’s better out there. I guess you could just say make the WilShire 5000 hold .02% of each stock. However as you point out, that would be a big impact in the smallest stock there.

      So what if you did a hybrid of the cap-weighted and the equally-divisible amount?

      I’m not sure I can convince myself that solves a problem. It’s still going to be weighted towards the big market-caps (much like how Congress is still going to be weighted towards the big states with how the House and the Senate are made up).

      In the end, I think any further investigation of it, is solving a problem that really doesn’t need to be solved. The magazine made a better case with bonds where one popular index fund had 70% in U.S. bonds. I could see where that weighting could be dangerous.

  2. Troy says:

    I personally never touched index funds. I don’t like the idea of other people allocating assets – and plus, most of those index fund managers are dodo brains anyways.
    I prefer ETF’s, because they’re more for the purpose of tracking entire industries.

  3. I am not sure about whether they are dodo brains or not, but I agree that ETFs are the preferable choice if you think that you are strong in a particular industry. It is all about making money at the end of the day, however, so I would not mind anyone getting into index funds if they feel strong at it.

  4. […] A Chink in Index Funds’ Armor? — When the market gets frothy, cap-weighted index funds buy the most bubblicious companies at the expense of (potentially) better values. But can you do better? […]

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