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Is it rational to invest in alternatively weighted index tracker funds?

Photo of Lars Kroijer hedge fund manager turned passive index investing author

Lars Kroijer is a former hedge fund manager turned author and occasional contributor to Monevator. His book, Investing Demystified, makes the case for index fund investing.

Most Monevator readers will know by now that I think passive investing in index funds is the rational choice for nearly everyone.

That’s because I believe most people have no edge when it comes to the extremely competitive investment markets.

I don’t even think many of us can judge whether one entire country’s stock market is better value than another, let alone pick individual stocks that will outperform.

For that reason, I think the most investors are best off using world equity index tracker funds to get their entire exposure to shares.

A world index tracker enables you to let the global capital markets do the hard work of figuring out where your money will earn the best return – because that is what is reflected in the various regional weightings in a world tracker fund.

International capital has spoken. You can just enjoy the ride.

Cheap and cheerful

Investing in a world tracker is the ultimate admission that you don’t know any better than the market.

By understanding your limitations as ‘dumb’ money and just ‘dumbly’ following the market, you actually make a very smart investing decision.

However an increasing number of firms and pundits are taking passive investing in a different direction.

Whether it goes under the name of Smart Beta, fundamental indexing, alternative weighted indexing, or anything else, fans of these methods claim they can deliver superior returns to vanilla market weighted index funds.

The alternative-weighted funds aim to exploit various return premiums that have outperformed in the past.

For instance, there is much research that suggests that value (i.e. companies with low price-to-book or price-to-earnings ratios) and smaller companies both outperform the general market over the long-term.

Various indices and products to track them have been created to reflect this line of thinking.

But is it rational to invest in them?

Dumber and dumberer

In short, I don’t think my definition of a Rational Investor – that is somebody who knows they have no edge – should buy alternative weighted investments as proxies for their market exposure.

By actively deselecting a portion of the market (that is to say buying alternatively weighted index funds with lower exposure to higher growth or larger companies, as in the example above), anyone who does so is implicitly claiming that the money invested in these deselected companies is somehow less informed than they are.

That is a pretty grand statement, and inconsistent with Rational Investing.

In contrast, I think it is probably fair to assume that those investors in high growth or large companies are highly experienced and informed, have read all the relevant books on investing, and are well aware of all aspects of the historical outperformance of various sub-sectors of the markets.

They are not stupid. In fact they are as much a part of the market as the value or smaller company investors are.

Do you really think that the trillions of dollars that follows companies like Google and Apple is somehow poorly informed?

Do you think that you know more about the markets than they do to the extent that you should deselect those stocks?

Expensive to implement

In my view anyone who suggests an alternative weighting to simply tracking the overall market looks a lot more like an active than a passive investor.

Likewise, the implicit cost of the part of the portfolio that diverges from the general index can easily approach the fee level of an actively managed fund.

Suppose an alternative weighted index has an overlap of two-thirds with the wider market, but it costs 0.3% more per year to implement than the market cap weighted tracker.

In this case you are effectively paying 1% per year on the one-third part of your investment that is different from the general market.

That is a fee level akin to some active managers.

An alternative universe

I think that many of these alternative weighted indices are created to match what has had the best historical performance and thus is easiest to sell.

If stocks with high P/E and growth rates had been the best performers over the past decades, then I think the alternative weighted indices would all consist of that market segment – complete with charts outlining the great reasons why the outperformance of expensive growth companies was expected to continue.

We would then be equally guilty of fitting the product to past returns and essentially saying that we had the insight that the future would be like the past.

And I don’t believe we can rationally say that.

Do you have edge or not?

As well as the active deselection of some parts of the market that it implies, my main issue with small company investing has to do with implementation.

Actively implementing a portfolio of smaller companies is very expensive. The trades required to build up the portfolio are subject to large bid/offer spreads and price movements if you trade in any size.

But even if you could pass the hurdle of costs, you are still left with the same question – do you really know enough about the markets to claim edge to the extent that you over-weight these stocks at the expense of other stocks in the market?

What is it that you know that the wider market doesn’t?

Whether you are picking a North American Biotech index, the Belgian index, or an index of commodities stocks, you are essentially claiming edge and an advantage in the market.

That’s no different from if you were tipping Microsoft shares to outperform.

Yet many passive investors who would scorn the ability of the average person to pick stocks will happily debate the pros and cons of these alternatively weighted indices.

I think that’s inconsistent.

Place your bets

Everyone wants a ‘get rich scheme’, so here is one for fans of alternative weightings.

Buy a fund tracking whatever alternative index you think is sure to outperform and sell short the broader index against it with as much money as you can borrow.

Now wait for the world to prove you right.

This will guarantee you riches, and a constant stream of lackeys from the financial media turning up to write articles about your investing brilliance!

Sounds unlikely?

I agree.

Instead: stick with the broadest and cheapest market.

Lars Kroijer’s book Investing Demystified is available from Amazon. He is donating all his profits from his book to medical research. He also wrote Confessions of a Hedge Fund Manager.

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{ 57 comments… add one }
  • 51 Lars Kroijer April 30, 2015, 8:25 pm

    Hi @Passive Investor
    Agree with you that there is overwhelming evidence that this (like many other) sector has outperformed in the past. But in my view that we can’t conclude from that that this would be the case going forward. If life was only that easy – we could buy what has outperformed in the past. But many, many things have systematically outperformed since the start of stock markets, and many billions of dollars with huge and complex computer systems look to see if those anomalies can drive performance going forward. Perhaps they can, but it is a massive claim of having an edge over the markets which I think is unrealistic for most people. I think we as individuals are hugely guilty of recency and finding patterns where none necessarily exist, but that is another issue.

    I agree with you that sometimes this almost blindly following the market means that you do things that sit oddly with you, like weighting companies/sectors/countries that you are not crazy about highly (yes – you would indirectly buy more Apple after it has gone up massively). But besides being an expensive headache to de-select those things it also implies an edge over the market.

    Sorry to be long-winded again. It’s funny that less than 5 minutes ago I was asked to comment on the relative merits of two different hedge fund strategies. I’m feeling slightly bipolar…

  • 52 Passive Investor April 30, 2015, 9:45 pm

    @Lars. Thanks I basically agree with you. Although it’s interesting to discuss fine tuning an investment strategy / portfolio construction it isn’t the main point. Keeping costs right down with a cheap broad-based tracker, avoiding market timing and having an appropriate proportion of bonds is pretty much all its about.

  • 53 hariseldon May 1, 2015, 10:24 pm

    It is interesting to compare the ‘average’ investment trust to a global index and this can be done here http://www.theaic.co.uk/aic/statistics/aic-stats

    Select the relevant month and there is a set of size weighted average performance figures of different sectors, I believe the NAV performance is most useful and the gearing is shown and also the overall average performance.

    A set of indices are shown below the Investment Trust performance table including The FTSE All World tracker, whilst the trust performance figures are net of charges, the 10% or so typical level of gearing will roughly equal the low charges of a good ETF.

    Whilst at a sector level there are always some examples of exceptionally good and poor performance, the overall average is pretty similar to a Global Tracker by and large which supports the hypothesis that the Global Index approach is going to be good enough for most investors.

  • 54 Passive Investor May 2, 2015, 4:53 am

    @hariseldon. I hadn’t seen the AIC website before. It looks like a great resource for IT enthusiasts. . I am much more sceptical of the benefits of Investment Trusts than some of the people who comment here though.

    In some respects certainly they are better than open-ended funds (eg lower ocr, very long history of consistent dividends in some cases).

    Negatives are gearing and discounts to nav which add volatility. The OCR doesn’t include quite a lot of expenses involved in trading. So even a fund with an OCR figure of say 0.7 % is likely to have an additional o.5% of hidden costs which drag on performance. It is virtually impossible to compare risk adjusted performance with any particular index. On an individual fund level the fact that managers will inevitably vary the proportion of their holdings in different sectors makes a fair comparison impossible. On a group level (ie comparing all the funds in a sector with an index) there is no practicable way to take account of survivorship bias.

  • 55 newbie January 19, 2016, 5:00 pm

    Could we argue that, adding a global small cap index fund alongside our world equity index fund would be a worthy addition.

    After all the market capped index is very heavily weighted towards the biggest companies (even if there share prices drop somewhat). We cant know small caps will under perform large caps. Would the ultimate passive fund be an equally weighted index?

  • 56 The Investor January 20, 2016, 2:56 pm

    @newbie — Well, that’s the essence of the debate as outlined above. Lars believes you should just hold global market cap weighted index — that is the ultimate expression of how people have bet their dollars/pounds/rubles, whatever, and he argues that as you have no reason to believe you’re smarter than them you should not deviate from that.

    In contrast, those who overweight say small caps or value shares or quality shares or what not point to historical evidence that (for some reason) these tranches have outperformed in the past as suggesting they might in the future. Lars argues that you can’t make that leap. It’s up to you to make your own mind up — you’ll find people who call themselves passive investors on both sides of the fence (and sitting on it!)

    Equal weight isn’t ultimately passive because you’re asserting that you know that, say, the market cap of a giant like Apple is too large versus a smaller company that you are allocating more money towards.

    Note that equal weight has done better than market weight in recent history. That’s said to be down to the small cap effect mentioned above.

    Hope that clears up some of the confusion. 🙂 The best I can suggest is that you keep reading around the site, as we can’t really restate all these things every time someone asks unfortunately, just for sheer workload reasons. 🙂 It’s all here though.

  • 57 Gregory January 20, 2016, 5:04 pm

    @The Investor & newbie — “I was actually going to call the book The EDGELESS INVESTOR, because that’s what I really think the book is about, but the publisher disagreed and thought that has negative connotations — the idea that you’re without something — so this was our compromise.r” Lars Kroijer http://www.fool.co.uk/investing/company-comment/2013/11/05/trancript-the-edge-less-investor/

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