Index Investing

[maplevalue]

Curious if anyone has recommendations for any papers/articles/etc. about why index investing works (beyond something like the Little Book of Common Sense Investing).

 

I feel like as time passes I am more and more amazed at how well indexing does, while at the same time cognizant that there is more money tied up in index linked products today than at any point in history, and perhaps past performance does not equal future results.

[vinod1]

Read "Four Pillars of Investing" by William Bernstein. 

 

I spent ungodly amount of time from 2001 to 2006 reading up on indexing, including the vast majority of the academic finance papers and every single book published on indexing upto that point in time. This is by far the best book you would find that appeals to the common man and provides the right level of information.

 

Vinod

[backtothebeach]

4 minutes ago, vinod1 said:

I spent ungodly amount of time from 2001 to 2006 reading up on indexing

What was your main takeaway? Are you indexing (part of) your portfolio?

[vinod1]

If you believe in addition, subtraction, multiplication and division, indexing is going to beat the vast majority of the investors over long periods of time. Using elementary math you can deduce that. 

 

Assume companies make $2 trillion of profits per year. These are at the end of the day what investors return would be in the long term. Index investors get their proportion of profits without any costs. But there are about $300 billion to $400 billion in costs incurred by active investors and their share of the profits would be after this and would in aggregate would always be less than index investors. 

 

Do this math over 20 years and it is no surprise index beats 95-99% of investors. 

 

Markets can be utterly inefficient and still the above holds true.

[vinod1]

Just now, backtothebeach said:

What was your main takeaway? Are you indexing (part of) your portfolio?

 

Yes and no because it varies based on opportunity set. Sometimes I am able to find enough to fill out my whole portfolio with stocks I like. 

 

So my approach is this.

 

I assume I have no ideas and there is not much value I can add unless I can make compelling case otherwise.

 

So I start with a 100% index portfolio.

 

If I find a really compelling investment, I would invest upto my position sizing limit for that specific investment risk that I tolerate. I would sell that much of index fund to fund this investment.

 

The more stocks I find, the less I have in index funds.

 

Starting with 100% cash instead of 100% in index funds has many disadvantages.

- It puts pressure on you to find ideas. Many many ideas and really really quick. Not a recipe for patience and acting only when you have overwhelming evidence in your favor.

- If you do not have many ideas, you do not end up making crappy investments. No "I like this, seems pretty good, let me take a 1% stab at this".

- You do not have cash drag 

- You are not tempted to market time or reduce allocation because "markets seems rich" and I cannot find anything in my competence. This is actually the bane of many value investment managers.

 

Vinod

[LC]

One further question - when you do sell individual stocks, do you immediately reposition into the index?

[vinod1]

1 minute ago, LC said:

One further question - when you do sell individual stocks, do you immediately reposition into the index?

 

Yes. I use several index funds - US Total Stock market, International Index, US Value Index (Vanguard) and  US Small Value Index (Avantis). I keep track of their valuation levels and buy ones that I find cheapest. Although I have been pretty wrong on which of them is cheapest for a while. But that is not a whole lot of value add or value destructive either way. Not very scientific either but I like to keep a little bit in International and US Small value. Most of index portion in US Total and US Value.

 

Vinod

[backtothebeach]

43 minutes ago, vinod1 said:

Yes and no because it varies based on opportunity set. Sometimes I am able to find enough to fill out my whole portfolio with stocks I like. 

 

So my approach is this.

 

I assume I have no ideas and there is not much value I can add unless I can make compelling case otherwise.

 

So I start with a 100% index portfolio.

 

If I find a really compelling investment, I would invest upto my position sizing limit for that specific investment risk that I tolerate. I would sell that much of index fund to fund this investment.

 

The more stocks I find, the less I have in index funds.

 

Starting with 100% cash instead of 100% in index funds has many disadvantages.

- It puts pressure on you to find ideas. Many many ideas and really really quick. Not a recipe for patience and acting only when you have overwhelming evidence in your favor.

- If you do not have many ideas, you do not end up making crappy investments. No "I like this, seems pretty good, let me take a 1% stab at this".

- You do not have cash drag 

- You are not tempted to market time or reduce allocation because "markets seems rich" and I cannot find anything in my competence. This is actually the bane of many value investment managers.

 

Vinod

 

Very rational and makes a lot of sense.  Especially the ”avoiding cash burning a hole in your pocket“ aspect.

[Hektor]

@maplevaluegood topic.

 

@vinod1 Thanks for the insights. If/when the market goes down, wouldn’t the index also go down, reducing the amount available to deploy? How do you think about this when deciding not to hold cash when there is a lack of opportunity?

[LC]

Reminds me of the original hedge funds: the idea of being 100% invested in the index, then hedging out (either long or short) individual stocks the manager found under/over valued. 

[learner]

@vinod1 - what have been your learnings in terms of picking the right index? I just buy S&P. I had tried looking into others but realized that it is simpler to use S&P

[Sweet]

5 hours ago, vinod1 said:

 

Yes and no because it varies based on opportunity set. Sometimes I am able to find enough to fill out my whole portfolio with stocks I like. 

 

So my approach is this.

 

I assume I have no ideas and there is not much value I can add unless I can make compelling case otherwise.

 

So I start with a 100% index portfolio.

 

If I find a really compelling investment, I would invest upto my position sizing limit for that specific investment risk that I tolerate. I would sell that much of index fund to fund this investment.

 

The more stocks I find, the less I have in index funds.

 

Starting with 100% cash instead of 100% in index funds has many disadvantages.

- It puts pressure on you to find ideas. Many many ideas and really really quick. Not a recipe for patience and acting only when you have overwhelming evidence in your favor.

- If you do not have many ideas, you do not end up making crappy investments. No "I like this, seems pretty good, let me take a 1% stab at this".

- You do not have cash drag 

- You are not tempted to market time or reduce allocation because "markets seems rich" and I cannot find anything in my competence. This is actually the bane of many value investment managers.

 

Vinod

I have historically sat in a large amount of cash to wait for investments that can take a very long time to appear.

 

I realised about 2-3 years ago that the approach you described is optimal - easier said than done though.

[Sweet]

On indexing in general, you have to choose the right country, the right sector, the right indexing approach.  Some indexing, like buying Europe, has worked poorly compared to US indexes.

 

Someone pointed out one time that the rules of the SP-500 meant that it acted like a giant trading algorithm that cuts losers and allows winners to run.  I thought that was very perceptive and accurate and it helps explain its success.

 

But indexes with a slight rule change, such as equally balanced rather than market cap weight ETFs aren’t as good as cutting losers and allowing winners to run.  Wrt the indexes I’ve looked at, generally equally weight underperforms marketcap weighted.

 

My preferred index would be to hold the Nasdaq but unfortunately you have to get the timing right because valuations can go crazy at times.

[throw123]

I have shifted all my S&p 500 cap weighted index to VBR and RSP. I think the odds are decent for RSP and VBR to outperform cap weighted S&P 500

[thepupil]

1 hour ago, Sweet said:

On indexing in general, you have to choose the right country, the right sector, the right indexing approach.  Some indexing, like buying Europe, has worked poorly compared to US indexes.

 

Someone pointed out one time that the rules of the SP-500 meant that it acted like a giant trading algorithm that cuts losers and allows winners to run.  I thought that was very perceptive and accurate and it helps explain its success.

 

But indexes with a slight rule change, such as equally balanced rather than market cap weight ETFs aren’t as good as cutting losers and allowing winners to run.  Wrt the indexes I’ve looked at, generally equally weight underperforms marketcap weighted.

 

My preferred index would be to hold the Nasdaq but unfortunately you have to get the timing right because valuations can go crazy at times.

 

It's interesting in that I remember distinctly in the early 2010's working at a place that was benchmarking managers against equal weighted indices because equal weighted had done so much better than cap weighted (particularly abroad where indices concentrated, often in banks) over the past decade.

 

I'd also note that the longest term data I have does indeed show that cap weighted beats equal weighted, but it's not by as much as you'd think, and the two approaches were tied at 9.4%/yr for the entire period 1990-2016. 

 

I think it's impressive that the equal weighted basket of 500 US stocks (rebalanced quarterly i believe)  has done as well as it has. Makes a good case for RSP. SPY has about 29% in Mag7. RSP has about 1.75%. 

 

 

1990-1999 Cap weighted: +18.2%/yr , Equal Weighted: +12.5%/yr

2000-2009: -1%/yr vs +3.4%/yr (equal weighted wins)

2010-2019- +13.5% vs +13.55% (cap weighted edges by .05%/yr)

2020-Present: +12.5% vs +9.9% (equal weighted wins)

 

Whole Period 

Cap Weighted: +10.26% , 2693%

Equal Weighted: +9.72%, 2262%

 

 

 

 

 

[Sweet]

1 hour ago, thepupil said:

 

It's interesting in that I remember distinctly in the early 2010's working at a place that was benchmarking managers against equal weighted indices because equal weighted had done so much better than cap weighted (particularly abroad where indices concentrated, often in banks) over the past decade.

 

I'd also note that the longest term data I have does indeed show that cap weighted beats equal weighted, but it's not by as much as you'd think, and the two approaches were tied at 9.4%/yr for the entire period 1990-2016. 

 

I think it's impressive that the equal weighted basket of 500 US stocks (rebalanced quarterly i believe)  has done as well as it has. Makes a good case for RSP. SPY has about 29% in Mag7. RSP has about 1.75%. 

 

 

1990-1999 Cap weighted: +18.2%/yr , Equal Weighted: +12.5%/yr

2000-2009: -1%/yr vs +3.4%/yr (equal weighted wins)

2010-2019- +13.5% vs +13.55% (cap weighted edges by .05%/yr)

2020-Present: +12.5% vs +9.9% (equal weighted wins)

 

Whole Period 

Cap Weighted: +10.26% , 2693%

Equal Weighted: +9.72%, 2262%

 

 

 

 

 

 

 

Yeh its not by much for sure.

 

I am not cap weighted indexed right now because the Mag7 are just soo much of the index.

 

I think there are times when it is better to be equal cap weighted and now might be one of them.

[throw123]

25 minutes ago, Sweet said:

 

 

Yeh its not by much for sure.

 

I am not cap weighted indexed right now because the Mag7 are just soo much of the index.

 

I think there are times when it is better to be equal cap weighted and now might be one of them.

agree

[james22]

5 hours ago, Sweet said:

On indexing in general, you have to choose the right country, the right sector, the right indexing approach.  Some indexing, like buying Europe, has worked poorly compared to US indexes.

 

With the exception of BRK (and a sliver of MSTR), I hold only indices (SV, IT, Energy).

 

But market timing various sector funds is very different than buy-and-holding the S&P500 or a Global index.

 

That's why I'm here rather than Bogleheads.

[Vish_ram]

Subject close to my heart. (disclaimer: I'm a RIA and my firm's objective is to outperform S&P 500 and have done it as well). Over time I've realized the beauty of cap weighted indices. 

 

1) The index (SPY in context) just rebalances more often than a typical fund manager

2) The index doesn't bring in the emotions, biases, valuations into account. Fund managers do

3) Index is quick to embrace new companies, concepts, ideas. if world moves towards a paradigm where tech companies rule the world, index automatically readjusts itself. The idiot fund mgr are stuck in the old paradigm.

4) Index doesn't worry about macro, cash position etc. It is fully invested all the time

5) Index reflects truth, the economy, sum total of people's preferences & actions, reflects the effect of macro/micro policies, reflects total effect of collective R&D, policies of govt etc. Most folks can't price them all in fast enough in the long run

6) Index is the most efficient in kicking out losers, reducing exposure to future losers and relentlessly adding to winners. Fund managers fail to do this big time. 

 

The only soundest advice I can get behind is what Buffett gave to his wife. All rest is garbage to a varying degree.

“Put 90% in S&P 500 and rest in US treasury”. 

 

Edited January 29 by Vish_ram

[maplevalue]

18 hours ago, Sweet said:

Someone pointed out one time that the rules of the SP-500 meant that it acted like a giant trading algorithm that cuts losers and allows winners to run.  I thought that was very perceptive and accurate and it helps explain its success.

 

This is one of the key reasons I have warmed to the idea of indexing. In my trading career, or experience picking individual stocks, I found the most success in having a few big winners, while keeping the losses on the non-winners manageable. With indexing a stock can quadruple and the index still holds the same position, versus an actively managed fund which would be likely to sell part of a position to not become too concentrated.

[ICUMD]

Thanks for the above posts.

 

I certainly understand the rebalancing and exposure rationale for indexing.

 

For discussion, I note the PE ratio of the S&P 500 to be averaging around 25.  The tech sector is arguably loftily valued currently and the index is heavily weighted in this sector.  PE of 25 doesn't seem like a value proposition currently.

 

As a value investor, how does one seek value in an ETF?  Or do you just average in?

 

[valueventures]

I view conglomerates as a "semi-passive" approach. I've been putting new capital into FFH, NNI, etc. since I view them as more attractively valued at the moment, but I don't need to worry so much about the idiosyncratic risks associated with stocks that only operate a single business line, product, etc.

[mattee2264]

As I understand it when you index invest you free ride on the efforts of active managers to price stocks. So indexing will keep working so long as there are enough active managers who care about fundamentals and do a proper job. Whether it will continue to work when active managers are either losing their jobs or hugging the indices and most of the buying and selling is done by speculators (retail and hedge funds) remains to be seen. 

 

Market cap weighting has the best track record and understandably so because capitalism is based on survival of the fittest and the largest companies have withstood competitive challenges, dominated their markets, and become entrenched in the economy. Also by holding a market cap weighted index fund you are betting that over time the market capitalization of the S&P 500 will increase over time in line with the US and global economy. That is a pretty safe bet to make.

You are also benefiting from efficiencies as there is little need to trade and rebalance and trading costs can eat away quickly at returns. 

 

With the benefit of hindsight there were times when you'd have done better switching into an equal weighted index or favouring EAFE over USA for example or switching into small caps. But that is a variant of market timing and as outperformance of every index comes in short bursts and likewise underperformance the costs of getting it wrong can be severe. Besides for most of the cycle a market cap weighted index will outperform. 

 

Concentration is also a common feature of a market cap weighted index. For the US economy it hasn't been too detrimental because the economy is sufficiently diverse that the top 10 stocks by market cap still offer a range of industries and sectors. Even the current concentration isn't as bad as it looks because Big Tech is involved in other industries e.g. retail/luxury goods/advertising etc. Other economies it can be a bit more toxic for example an FTSE 100 indices would mean owning a lot of financial companies and mining/energy stocks which over long periods tend to be bad investments. 

 

Another thing worth mentioning is that with index investing you do not need to be able to value every stock. Ben Graham used to write about how large growth companies are speculative because so much of their value depends on future prospects. Clearly for most of this market cycle investors underestimated these prospects and perhaps now they are starting to overestimate them. But an index investor would have participated in their dramatic outperformance and probably far more so than the majority of active managers. 

 

It also allows you to be valuation indifferent. Generally in the later stages of bull markets there aren't obvious bargains and even good investors can run out of good ideas and end up with too much cash or unwittingly end up taking on too much risk or lowering their standards etc. An index investor doesn't care as over long periods he knows that it isn't valuations that drive stock markets return (although there has been a helpful long run upward drift in valuations) but growth in earnings and dividends (and latterly the shrinking share count from buybacks). 

 

And maybe one of the reasons that index investing will never catch on to the extent it stops working is that it is hard for intelligent people to accept that all they need to do is hold an index fund through thick and thin with no need to read annual reports, study business economics, read Berkshire letters, follow the news, know any accounting etc. And for short periods of time at least it is possible to beat the market and think you are one of the few who can do so long term.

And the few people who can beat the market over long periods of time get lionised and continue to inspire hope others can do the same. 

 

And another reason is that indexing does not work all the time. You have to suffer through the occasional 50% drop or occasional lost decade and you need a holding period of at least 10 years to reliably outperform bonds. And during those bear markets and lost decades it is a lot easier for active managers to beat the market and gain a reputation for doing so and attract money. 

 

 

 

 

 

 

 

 

 

 

 

 

 

[villainx]

14 minutes ago, valueventures said:

I view conglomerates as a "semi-passive" approach. I've been putting new capital into FFH, NNI, etc. since I view them as more attractively valued at the moment, but I don't need to worry so much about the idiosyncratic risks associated with stocks that only operate a single business line, product, etc.

 

Similar.  Or they enhance with idiosyncratic indexing: exposure to very different industries, markets, etc that a VOO don't often hit.  At the same time, scratches enough of the itch if one likes to keep up with market/investing research.   

[Gmthebeau]

2 hours ago, ICUMD said:

Thanks for the above posts.

 

I certainly understand the rebalancing and exposure rationale for indexing.

 

For discussion, I note the PE ratio of the S&P 500 to be averaging around 25.  The tech sector is arguably loftily valued currently and the index is heavily weighted in this sector.  PE of 25 doesn't seem like a value proposition currently.

 

As a value investor, how does one seek value in an ETF?  Or do you just average in?

 

 

If you are concerned about the extreme concentration at the top of the S&P 500, and PE of them, you could consider Pacer Cash Cows (COWZ) ETF, which has beaten the S&P since it launched in 2017 - pretty impressive really considering how well the S&P 500 has done.  It selects Top 100 companies based on free cash flow yield.

 

https://www.paceretfs.com/products/COWZ