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.