The DIY investor readers of this blog know the basic argument for low-cost, indexed ETF investing. Basically, professional investors are, pretty much, the market. As Bogle points out, they mathematically are going to achieve, on average, the market return because they are the market. Take out between 1 and 2% management fee, and the average professional investor is going to be behind the market. Many incur, of course, even greater costs because they use mutual funds, which in turn, charge approximately 1.3% on average. For a short period , 1 -3 years, it is possible that many will outperform on an after-fee basis because they are smart people. But as the investment horizon extends, more will fall back because the cost mounts. So, in the end, the evidence shows that 70 to 80% of actively managed, professional money underperforms low-cost indexing. Market timing doesn't work, stock picking doesn't work, and even tactical asset allocation doesn't work.
The low-cost indexed approach focuses on asset allocation, establishing an investment plan and continuing to contribute as markets drop. In fact, falling markets are embraced as opportunities.
There is a potential way to improve on this approach in using "fundamental indexing." The logic goes like this: the indices we are seeking to match when we index the S&P 500, for example, are market cap weighted. This means that, as companies do better, they have a greater weight in the index. For instance, if Best Buy doubled in price, it would have a greater weight.
We know this can be successfully counter traded in rebalancing a portfolio on a sector basis. For example, when rebalancing, we lighten up on the sector that has done the best (become over-weighted) and booster the underperforming sector. In other words, we sell high and buy low, at the margins. Why not do this with individual companies in the index?
Fundamental indexing is the brain child of Rob Arnott, a brilliant researcher and founder of Research Affiliates. His insight was to think about weighting stocks not by market cap but some other fundamental measures. For example, what about weighting on the basis of a company's revenues? This approach has outperformed even the market using both past data and real time data.
Rob Arnott explains his approach in this video:
Wouldn't some of this hypothetical overperformance be eaten up with capital gains taxes as the portfolio is rebalanced each year? Who are the ETF fundamental indexers in the marketplace today? Wisdomtree?
ReplyDeleteYes, some of the out performance would be given up if used in taxable accounts.
ReplyDeleteSchwab indexes are based on this approach :
"Schwab Fundamental Index Funds are passively managed and tracks the FTSE RAFI1 Index, which is based on the fundamental index methodology developed by Rob Arnott and Research Affiliates. Schwab is the exclusive equity mutual fund (non-ETF) provider of the FTSE RAFI Index Series in the United States.".
My question I'm trying to come to grips with is whether using explicit low cap exposure etc. doesn't also negate some of the excess performance.