Free-quent Flyer
Blogger
I like market-capitalization-weighted passively indexed mutual funds for a lot of reasons:
These funds are more expensive than the market-cap-weighted funds mentioned above, but not by that much. Charles Schwab offers a "Large Company" fundamental-weighted fund for 0.32% (+0.27% compared to Vangaurd's passive fund), a "Broad Market" fund for 0.32% (+0.27%), an "International Large Company" fund for 0.32% (+0.2%).
If you believe in your heart-of-hearts that cap-weighting is the Wrong Way To Index, and that fundamental-weighted funds will outperform cap-weighting by more than the amount of the increase in the expense ratio, that seems like a perfectly reasonable position to take. Good luck.
What I've noticed more and more in the podcasts I've been listening to is an obsession not with the correct way of designing a low-cost, passive index fund, but with simply magical thinking.
Magical thinking usually takes one of two forms. The first is the argument for "magic by necessity." This argument says something like, "it would be great if passive indexed investing could give you the results you need, but unfortunately with price/earnings ratios well above the historical average, you need magic to generate the necessary returns in your portfolio." Meb Faber is one of the biggest advocates for this brand of magical thinking.
The second form could be called "magic by regression analysis." This argument says, "if you are willing to accept higher volatility in your portfolio, you can generate higher risk-adjusted returns." In other words, if you are willing to follow the sorcerer's system through all market ups and downs, you will generate returns that more than compensate for the increased volatility in your portfolio.
Specifically, I'm talking about so-called "trend-following" strategies. This magical thinking takes the following form: "While you might expect to get higher returns by buying low and selling high, in fact you get higher returns by buying things that are going up and selling things that are going down, as long as you put complete faith in the strategy."
The reason I call this "magical thinking" is that it relies entirely on faith — specifically, faith in the design and implementation of the strategy.
But if you both believe in momentum and believe you can identify the correct subset of that subset of manager, you're indulging in magical thinking.
- They're cheap! Vanguard offers a S&P 500 and total US equity fund, each with a 0.05% expense ratio, a total international stock fund with a 0.12% expense ratio, a total US bond fund with a 0.06% expense fee, and a total international bond fund with a 0.14% expense ratio. That's cheap!
- They don't trade much! Market cap-weighted funds don't have to trade in and out of stocks very often to meet their investment objectives, keeping trading costs to a minimum.
- They are practically guaranteed to meet their investment goals! If you make regular contributions to a market cap-weighted passive index fund, you will buy in at the average price during your investing lifetime. If you make regular withdrawals from a market cap-weighted passive index fund, you will sell your investments at their average price during your withdrawal lifetime.
- They buy expensive stuff when it's expensive!
- They make investments based on the popularity (market cap) of companies instead of the quality of their business operations!
These funds are more expensive than the market-cap-weighted funds mentioned above, but not by that much. Charles Schwab offers a "Large Company" fundamental-weighted fund for 0.32% (+0.27% compared to Vangaurd's passive fund), a "Broad Market" fund for 0.32% (+0.27%), an "International Large Company" fund for 0.32% (+0.2%).
If you believe in your heart-of-hearts that cap-weighting is the Wrong Way To Index, and that fundamental-weighted funds will outperform cap-weighting by more than the amount of the increase in the expense ratio, that seems like a perfectly reasonable position to take. Good luck.
What I've noticed more and more in the podcasts I've been listening to is an obsession not with the correct way of designing a low-cost, passive index fund, but with simply magical thinking.
Magical thinking usually takes one of two forms. The first is the argument for "magic by necessity." This argument says something like, "it would be great if passive indexed investing could give you the results you need, but unfortunately with price/earnings ratios well above the historical average, you need magic to generate the necessary returns in your portfolio." Meb Faber is one of the biggest advocates for this brand of magical thinking.
The second form could be called "magic by regression analysis." This argument says, "if you are willing to accept higher volatility in your portfolio, you can generate higher risk-adjusted returns." In other words, if you are willing to follow the sorcerer's system through all market ups and downs, you will generate returns that more than compensate for the increased volatility in your portfolio.
Specifically, I'm talking about so-called "trend-following" strategies. This magical thinking takes the following form: "While you might expect to get higher returns by buying low and selling high, in fact you get higher returns by buying things that are going up and selling things that are going down, as long as you put complete faith in the strategy."
The reason I call this "magical thinking" is that it relies entirely on faith — specifically, faith in the design and implementation of the strategy.
- Market cap weighting requires no faith whatsoever: you will buy the entire market at its current price, and you will sell the entire market at its current price.
- Fundamental weighting requires faith in the design, but not implementation, of the strategy: you have to trust that the fund managers are using the correct fundamentals to weight their fund, but then they are supposed to rebalance the fund "automatically," although they'll incur some trading costs while doing so.
- Trend-following requires not just belief in so-called "momentum," but also faith that the fund managers are using the correct measures of momentum, and also that they'll implement their momentum strategy correctly.
But if you both believe in momentum and believe you can identify the correct subset of that subset of manager, you're indulging in magical thinking.