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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 }
  • 1 robhwales April 22, 2015, 10:18 am

    So if I am reading this correctly then Lars is suggesting that what has recently been done to the Slow and Steady Portfolio is not Rational?

  • 2 magneto April 22, 2015, 11:34 am

    At the end of year Global Tracker ETF IWRD showed following top country allocations :-

    Dec 2014 (PE) [Dec 2009]

    USA 58.34% (18.21) [47.77%]
    Japan 7.90% (21.35) [9.72%]
    UK 7.87% (15.70) [10.30%]
    Canada 3.93% [4.83%]
    Eurofirst 300 (20.02)
    France 3.63% (25.66) [5.24%]
    Switzerland 3.52% [3.70%]
    Germany 3.45% (17.34) [3.86%]
    Australia 2.75% (19.82) [3.97%]

    As investors put up the valuations in any particular region the weightings in the global trackers then increase.
    Is this logical or do regions mean revert?
    Has Lars at some point addressed the issue of overweight Japan 1989 in a global tracker?
    Maybe we have to compromise, and just accept weightings whether reasonable or not? and just carry on with IWRD/VWRL as the only sensible option?
    Just get this feeling we are following the lemmings.

  • 3 Phillip Weston April 22, 2015, 12:37 pm

    I agree with the logic of this article but cant bring myself to invest in the US at the moment.
    Is it possible to buy a World Tracker excluding just the US?

  • 4 Rob April 22, 2015, 12:43 pm

    Three points are relevant here.

    In no other walk of life do we allocate resources simply by price using no other measure.

    As the Barclays Equity Gilt Study shows us every year dividends are far more important to returns than capital growth. So allocating capital by capital will be sub-optimal. £100 invested in the UK stock market in 1945 would have risen in terms of capital only, i.e. ignoring dividends, to £9,148 by the end of 2014.l With dividends reinvested it would have increased to £179,695.

    Finally, the bet. Keynes told us that markets can remains irrational far longer than you can remain solvent.

  • 5 dearieme April 22, 2015, 1:14 pm

    “Do you really think that the trillions of dollars that follows companies like Google and Apple is somehow poorly informed?” No, but it could be poorly motivated. I can imagine a world where fund managers are scared of not being one of the crowd, of not holding Google and Apple, so that their investment is not a triumph of reason, but a result of abject fear of stepping out of line: dedicated followers of fashion, eh? But if that’s so (if!) does it not make sense to find some alternative tracking technique that is also diversified, also cheap, but less irrational? Why follow the herd over the cliff?

    I’m all for people trying out new tracking models: let’s see how they perform. Meantime, I want more income than a global tracker will pay, and I’m frightened of all but short-dated bonds, so what shall I do?

  • 6 BigPat April 22, 2015, 1:17 pm

    An interesting and pertinent article Lars. I personally, like many here I imagine, am a fan of Vanguard lifestrategy – as lazy as possible. However, I do not like the home bias of their funds. Everytime, I read an article about the Japan crash I shudder.

    I know this has occasionally been mentioned on monevator and there are some good articles online explaining the principle. However, I wondered what your personal view would be? Would you tar it with the same brush as other biases, e.g. smart beta?

    Open to opinions from others too.

  • 7 Greg April 22, 2015, 2:14 pm

    What about bonds? What’s a sensible weighting methodology there? Weighting by total amount of debt doesn’t seem very sound to me…

  • 8 oldie April 22, 2015, 5:40 pm

    I am glad this discussion continues because I find it interesting and relevant. It provides a basis for investing globally and the country proportions using a market capitalisation model.
    It sort of implies that the “crowds” know best.

    But these “crowds” didn’t see the financial crash of 2008 coming, or plan for the collapse of oil prices. Clever bankers, experts, investors…

    Does this alter the argument?

  • 9 Dan April 22, 2015, 9:43 pm

    What about risk? Fama said that the premium on small cap stocks was due to the higher levels of risk associated with investing in these companies. So I think one is not claiming ‘edge’ by investing in small caps, but taking more risk which should lead to higher returns. This point seems to be missing from the article.

  • 10 SemiPassive April 22, 2015, 9:59 pm

    Don’t really care about trying to be smart enough to beat the world index, and VWRL is after all my largest single ETF holding. But for someone planning to live off the natural yield of my SIPP eventually I echo dearieme. The VWRL dividend yield isn’t high enough, and makes the FTSE 100 and All Share look better, maybe combined with Vanguard’s World High Yield ETF.

  • 11 Passive Investor April 22, 2015, 10:26 pm

    Thank you for a great article. I have been a committed passive investor for 20 years so I am broadly in agreement with the article. For what it’s worth I take a home tilt though and a slight smaller company tilt (mainly because of the over concentration of the ftse 100 and s & p 500 indexes).

    I would be interested though if Lars could clarify what he thinks about sll the evidence for the value factor though. Do you think it is ‘incorrect’ or just that the costs of trying to access it are prohibitive?

  • 12 MouseCatcher007 April 22, 2015, 10:47 pm

    Philip Weston – yes, you can buy world trackers that exclude the U.S. They are generally listed in the U.S. (which has its advantages and disadvantages). Try VXUS on Vanguard’s US Website for starters:


  • 13 Kamil April 23, 2015, 8:19 am

    Good morning guys,
    I wonder why the most favourite world tracker from iShares here is
    IWRD (0,5% TER, distributing, only developed countries)
    and not one of these two:
    SWDA (0,2% TER, accumulating, only developed countries)
    SSAC (0,6% TER, accumulating, developed and emerging countries)
    SWDA has lowest TER, SSAC covers emerging markets as well.

    I want to split my savings between 2 world tracker, from which one is VWRL, and I wonder what to choose from iShares for long terms (on the taxable account, so that’s why I’d prefer accumulating ETF).

  • 14 Gregory April 23, 2015, 10:04 am

    Premiums work in the long run. In the very long run and there is no guarantee. I strongly believe Mr. Fama deserved the Nobel prize. There is another Nobel prize winner as an example: Mr. Schiller doesn’t prefer US stocks now. And Mr. Schiller has a very famous friend: Mr. Siegel who…

  • 15 helfordpirate April 23, 2015, 10:24 am

    “anyone who does so is implicitly claiming that the money invested in these deselected companies is somehow less informed than they are.”

    I don’t agree with the repeated theme in this article that a tilt strategy or smart beta or whatever implies that you think you are smarter than the market.

    The golden rule is more return means more risk. If you tilt to small or value you take more risk (by investing in small unproven companies or in value companies – where value turns out to mean knackered). You would expect to be compensated for that risk by getting more return. Your selection of value stocks from the market universe increases your risk relative to the cap-weighted market. The other investors are not “dumber” than you, they have just implicitly selected less risk. You are not “smarter” you have just taken more risk.

    Of course, some would have you believe that some of these tilts are a free lunch and you get more return than the extra risk you are actually taking justifies e.g. that the market consistently under-values value stocks. While that may have been true before Fama/French published their theories, I feel sure that market advantage must have long time disappeared.

    The point on cost is the key. I used to have Dimensional Funds through an IFA and while the 0.3% TER was not too bad, the 1% IFA fee made accessing this strategy not cost-effective. At the end of the day, if I want more return I will increase my equity/bond ratio and accept that I am taking more risk.

  • 16 Passive Investor April 23, 2015, 10:44 am

    &helfordpirate. That makes a lot of sense to me. I don’t tilt to value partly because of costs as you say partly because I don’t think I could stay steady during periods of underperformance and partl because the new ishares offering is concentrated in big companies and Japan (from memory)

  • 17 Rob April 23, 2015, 11:55 am

    Helfordpirate said:
    if you tilt to small or value you take more risk (by investing in small unproven companies or in value companies – where value turns out to mean knackered)

    But the bull market of the last 6 years has rewarded risk as evidenced by the outperformance of the FTSE 250 over the FTSE 100 by 50%. That is partly due to earnings recovery but also because of a revaluation that has resulted in mid caps now being valued at 10 to 25% more highly than the large caps.
    A value tilt now means a tilt to large caps, which are less risky.

  • 18 dearieme April 23, 2015, 3:39 pm

    To return to the question of an “edge”. Maybe I have two. Let me start from the proposition that passive investing is a cheap way of mimicking the weighted-average active investor. My minor “edge” is that I have no need to bust a gut to try to get first quartile performance every quarter – nor to avoid fourth quartile performance. Yet it’s such people’s decisions that the passive investor is eventually mimicking, is it not?

    My major “edge” is that I have a better chance than those active managers have – and therefore than the passive manager’s computer has – of understanding the purposes for which I am investing. Not the average global investor – me. Certainly I might be happy to use a global tracker as part of my portfolio – yippee, it’s cheap – but I’m damned if I can see why it would be irrational of me to use other equity assets too.

    To show my even-handedness let me add that I don’t currently hold a global tracker but am actively contemplating buying one in one of my pensions – which, unlike my ISAs, is pretty indifferent to dividend yield.

  • 19 Passive Investor April 23, 2015, 4:44 pm

    @dearieme. I don’t see why your minor edge is much of an edge? . It enables you to take a longer view than a fund manager and keep down costs but it doesn’t answer the question “why do I have greater knowledge / better judgement than the person selling the stock I am just about to buy”. I can’t see why you major edge is an edge either? Have I misunderstood some subtlety in your point in which case would be interested to understand more.

  • 20 oldie April 23, 2015, 5:25 pm

    Do active fund mangers have or believe they have an edge?

  • 21 Moongrazer April 24, 2015, 9:08 am

    I can’t help but feel that there is a circular argument to this piece. Yes, passive investment is about accepting you have no edge and you shouldn’t try to second guess or beat the market. However, you’ve (presumably) come from a position that the whole market ultimately moves upwards. I don’t invest in the whole of the market on the basis of returning whatever the market does – I invest in it because history has shown (with a LOT of evidence) that investing in whole of market has yielded a reasonable rate of return in the long run.

    Hypothetically, what if history had shown that the whole market had proven to remain stagnant overall, and that the returns lay in small cap or value (with the research to back it up)?

    I’m not disputing that investing in whole of market is a good idea (given the evidence), simply that we do so because we have history on our side. So if the evidence exists for value or small cap yielding additional risk/return premium, why would you not tilt towards it? Are you saying you know better than the people who have done all the research?

    Or put another way: if history and research had proven that investing in the whole market yielded no return, would you still do it?

  • 22 Passive Investor April 24, 2015, 9:50 am

    @moongrazer. For me it would depend what time period you meant by ‘history’. If you mean only 10-2o years I wouldn’t think that was long enough. It isn’t really plausible to me that you would get a consistent segment of the market that had zero returns over the very long-term. The market may not be completely efficient but there it has a certain wisdom over the very long-term, surely? (Ie investors would leave that segment until prices dropped enough to give a return going forward)

    I do see secular currency trends as a reason for some home bias in a portfolio by the way. But this doesn’t negate the main point of the article for me at least.

  • 23 Moongrazer April 24, 2015, 10:03 am

    @Passive Investor
    I’m talking 200 years of history rather than 10-20, but certainly I feel that the reason we even have this discussion is because history has borne out that the market ultimately moves upwards.

  • 24 magneto April 24, 2015, 11:43 am

    @ Passive Investor
    “I do see secular currency trends as a reason for some home bias in a portfolio by the way.”
    The currency issue bothers me too and I have no ready answer
    Would you kindly expand on your thinking.
    All Best

  • 25 Passive Investor April 24, 2015, 12:04 pm

    @magneto. Over the long-term currency movements balance out. So the (bad) times when you buy foreign stock when the pound is low are balanced out by two things: good times when you are buying with a high pound and the fact that if the pound is low, dividends denominated in foreign currency are worth more (assuming they aren’t being used to re-invest in foreign stocks) . This means that generally it isn’t worth the expense of hedging currency exposure to equities (this isn’t the case for foreign bond exposure which according to Vanguard at least is better hedged).

    My concern about this is that the long-term isnt entirely relevant in the 5-10 years before and at the beginning of the retirement draw down period. It would be a serious problem if the pound was significantly higher during this period than it had been during the previous period of investment accumulation. I see it as a source of risk that I want to manage by having a significant home bias to my equity investments.

  • 26 magneto April 24, 2015, 4:26 pm

    @Passive Investor
    Many thanks for the response.
    We are in mid retirement with 1/3rd stocks domestic.
    Constantly re-thinking this aspect in regard to Lars’ and other opinions.
    Maybe after all we are not distorting allocations unduly but aiming for a sensible compromise.
    Fully realise that there can never be an optimum domestic allocation determined in advance.
    Humility in the face of Uncertainty
    Thanks again, something to chew on.

  • 27 Passive Investor April 24, 2015, 5:03 pm

    @magneto. As you say humility in the face of uncertainty. In the scheme of things the fine tuning between domestic / foreign / emerging / small / value doesn’t really matter at all. What does really really matter is keeping costs down, managing risk (ie having a significant allocation to bonds / cash), and managing your own psychology so as not to panic in a down turn. Like so many things in life, easy to say and difficult to do…..

  • 28 Minikins April 24, 2015, 10:03 pm

    A very persuasive post, thanks.

    Although Keynes may have said that the market can remain irrational for longer than you can remain solvent, I would suggest that markets can remain irrational far longer than you can remain rational.

    It is all about the rational/irrational relationship, maybe even inversely so. We are living with an unknowable, unpredictable and volatile beast that is the market. That would seemingly be the irrational party. But we know that individuals (even in Hounslow) can and do manipulate it. That demands a degree of predictability. Maybe we are the irrational ones living and loving this great ‘beast’, pouring our hard earned money into its greedy jaws hoping for a golden egg to appear from its rear end in time. How rational is that?

    In one of Kipling’s Plain Tales from the Hills there is a line that
    “any woman can manage a clever man, but it takes a very clever woman to manage a fool”. We have to be rational to manage this crazy relationship, or are we the fools being managed by our own monstrous creation?

  • 29 Topman April 25, 2015, 11:55 am

    Morning Mk

    The actual RK words are, “Take my word for it, the silliest woman can manage a clever man; but it needs a very clever woman to manage a fool”. – Wikisource

    My old English teacher would have winced at what he would have felt was an unnecessary semi-colon, and I wonder what kind of woman would be able to manage a motley fool?!

  • 30 hariseldon April 25, 2015, 2:45 pm

    I hold Vanguard All World in combination with Vanguard All World High Yield in a ratio of roughly 2 parts to 1. My thinking is along the lines that the High Yield ( the index methodology is a blend of yield and market cap) has a value bias but holds back on companies and thus markets with below average yield and looking back to a 1989 situation of the tech crash when we had 100+ P/E companies and markets it would have eliminated them from one third of the portfolio.

    I don’t have any edge to call the irrational markets but we may well have an inkling and this method at least caps any such problems and I can resist the temptation to “do something” knowing I have a method that limits the perceived market irrationality.

    A mild home bias to the UK can be justified that the currency represents my liabilities, it’s much cheaper the uk trackers are around 15+ bps cheaper on management ( VWRL vs VMID and ISF) and one avoids the 25 bps withholding taxes on VWRL on the income side and of course as individuals we can do what we like if we are happy that the combination works and it avoids tinkering, over trading and related costs.

  • 31 The Accumulator April 25, 2015, 2:46 pm

    @ Lars – there’s a large body of research that shows that tilting towards certain companies has beaten the broader market over time, geography and asset classes.

    Explanations for the higher expected returns include a bigger risk premium for accepting the perils of investing in riskier companies and ongoing biases in human behaviour that cause investors to overpay for certain glamorous companies.

    It’s not irrational or arrogant to acknowledge this research. As Helford Pirate says you’re accepting greater risk in order to achieve greater return.

    It does seem irrational to me to believe that these styles of investing will outperform in the future just because they have in the past. Or that they won’t nose dive for a hideously long time and break your commitment to them. Or that heavily marketed Smart Beta products are the best way to capture these returns.

    Like a chainsaw or a Hobbit’s ring these are tools best wielded with care.

  • 32 Minikins April 25, 2015, 5:00 pm

    @Topman Yes it’s been a while since I dusted off my old Kipling books, thanks! Although Kipling wasn’t all that popular when I was at school, my dad always read me his stories and then I happened to spend a couple of years at an old Raj hill station, so I had a bit more local understanding and plenty more time to read!
    As for managing a motley fool, I should think Lady Fortune would do a good job : )

  • 33 Topman April 25, 2015, 8:32 pm


    Just so!

  • 34 Passive Investor April 26, 2015, 11:33 am

    @kamil. Unfortunately the tax treatment of accumulation and income units is identical. The income from accumulation units has to declared as such despite the fact it is rolled up in the fund. There is a clear explanation on the HMRC website. I thought the same as you until my accountant brought me up to speed a few years ago. The one useful thing you can do of course is to have higher income generating assets in the tax shelter and more growth orientated assets outside the shelter.

  • 35 Kris April 26, 2015, 12:04 pm

    I’m just learning about investment and have a very new and ‘modest’ portfolio put together over the last year. I started off, and am still drawn to passive investing becuase I don’t think I can beat the market and the costs of active funds seem to outweight possible beneifts. I have passive as a core with some actively managed funds where I believe there is value to them (i.e. not excesivly priced and with good track record of above index returns over 5 years).

    But the more research I do and the more I educate myself, the more I am finding myself questioning the whole thing at a very fundemental level.

    Perhaps you will all smile at my naievity but if passive products are tracking the market then are they not following what active investors decide to invest in? And in my year of getting to grips with equity markets it seems to me a lot of investment is based on an assumption that the value of markets will go up (doh – of course I hear you say!).

    Deep down this seems dangerous to me and is akin to basing wealth generation on the assumption that people in the future will just value equities higher than we do now. Surely the basis for investing in a business is that it offers physical growth, sustainability, real returns for investors in the form of dividends from profit, and not just that its share price will go up. It offers something tangible.

    Sorry not even sure what the point of my rambling post is other than to say funds allow me to diversify risk which I could not do if I invested in individual shares. However I worry that my future pension is based on an an idea that ‘markets just go up over time’. From what I can see in hsitoric data of FTSE all-share thats only really true since the 1980’s. I for one would feel much more comfortable investing in something more tangible.

  • 36 The Investor April 26, 2015, 1:30 pm

    @Kris — These are very sensible questions that a new investor should be asking. Your reading of the data is a bit off, however — the long-term (100 years or so) *real* return (i.e. after inflation return) from the UK stock market is about 5%, so it’s not just a post-1980s return. A few countries have done better, more have done worse, and we can’t know which will do better/worse in the future, hence most think it prudent to diversify internationally.

    Regarding your fundamental questions you raise, try reading these two pieces, in this order:



    Hope this helps! 🙂

  • 37 Uncertain April 26, 2015, 1:52 pm

    Kris the basis for people paying more for buisnesses in the future is indeed based on growth and profits increasing in the future. The amount people value those profits fluctuates over time and is somewhat higher now than in the early eighties.
    However the basis for hoping that equity prices will go up over the long term is based on the rationale and historically observed experience that businesses pay out part of their profits in dividends but the rest they reinvest in the buisness so that the business can grow and increase its profits in the future. Whereas there are many hiccoughs on an individual company basis this has been the broad experience for equity markets as a whole.

    I would by the way ignore the observation that the majority of equity returns come from dividends, this is a linguistic distortion of the genuine finding that without reinvesting your dividends you lose most of the potential total return. The return historically has come roughly equally from dividends and growth. You need the growth both to increase the dividends and to make the reinvested dividends worth more than they were when issued.

  • 38 Passive Investor April 26, 2015, 1:53 pm

    @kris. Others can probably answer your questions better than me. Very briefly though, it isn’t investing in the market as a whole that is the zero sum game but trying to beat the market that is zero sum. For every investor who buys a stock there has to be seller. The market is just the sum total of millions of transactions. You are certainly right to believe that as a private investor you can’t (except by luck) expect to beat the market. If you think you can, ask yourself why your judgement / knowledge is superior to that of professional investors who spend their lives analysing companies. (And half of them won’t beat the market either of course).
    There is loads out there about the source of returns from equities. The best analysis draws a distinction between speculative returns (the bit you are worried about that comes from short-term investor confidence) and investment returns (dividends and earnings growth). In the short-term speculative returns can dominate but over longer and longer terms they get cancelled out and it is investment returns which matter. Investment returns arise from companies creating wealth and this fundamental source of return is the reason for investing (rather than gambling). This idea is described in a well known quote from legendary value investor Ben Graham who said that “over the short-term the stock market is a voting machine but in the long-term it is a weighing machine”.
    There is probably lots of good stuff on Monevator but I also learnt a lot from “The little book of commonsense investing” by John Bogle and the Vanguard website (both US and UK sites have excellent stuff on this and historical returns). Other tips are Tim Hale “Smarter Investing” and anything by Rick Ferri or William Bernstein.
    PS I get quite evangelical about this as for the first five years of my investing career I was sucked in by tips from newspapers and I always bought “last year’s best fund”. I could never understand why this didn’t produce the excess returns I expected. By chance I was then lucky enough to come across passive investing around the time that Virgin introduced the first (as it happens now very expensive) index fund to the UK in 1995.

  • 39 Grand April 26, 2015, 6:21 pm

    What brilliant comments 😀

  • 40 Tim G April 26, 2015, 7:41 pm

    @Grand “What brilliant comments :D”

    I agree!

    Is there any way of subscribing to the comments even when you haven’t made one? I often don’t have anything to add personally but like to see what other people are saying.

  • 41 Naeclue April 26, 2015, 7:42 pm

    @passive, Virgin were not the first to launch a tracker in the UK. I was invested in L&G trackers before Virgin came along. Virgin were always more expensive than others as well. Someone once said that no-one ever lost money by underestimating the intelligence of the general public…

    @Uncertain, I totally agree with your comment about spurious claims that the majority of equity returns come from dividends. Such claims are either based on a misunderstanding of the historical record or pure marketing spin trying to persuade investors to put their money into active or “smart” beta funds.

    Regarding value/small caps or whatever else has historically beaten the market – these historical facts are now known by active investors and so it is not unreasonable to assume that this information will be taken into consideration in setting current market prices. In future small caps, which may be more risky overall than large caps may beat the overall market. But that cannot be guaranteed, otherwise it would not be a risk and buying small caps whilst shorting large caps would be a source of risk free returns.

  • 42 Kris April 26, 2015, 7:57 pm

    @ The Investor / Uncertain / Passive Investor

    Thanks for your thoughts and the extra material to read. I’ve read the links to the zero game posts and its very enlightening. I’ll look over some of the other mentioned reading.

    My biggest concern in my short investing career is that the market turns out to be made up of speculation, hype and overconfidence like some giant bubble waiting to burst over 20 years. And of course I guess this does happen hence ‘market corrections’?

    Nice to be reminded there is some substance behind it all and wealth is being generated by something tangible!

    My first 6 months of investing I bought active funds before I discovered ETF’s and passive investing. Cant ditch the actives just yet because of trading costs and they are doing well. However for the last 6 months its been passives all the way and am slowly rebalancing.

    Oh well onwards with the learning 🙂

  • 43 Uncertain April 26, 2015, 8:29 pm

    Kris I am not against all active funds and have a few myself (mainly IT’s)
    However I would point out that if you are planning for the long term trading costs will be swamped by ongoing fees and if you are thinking of changing from active to passive the sooner the better from an overall cost point of view. (Assuming you haven’t got either big capital gains or a lock in period with higher withdrawal costs)

  • 44 Passive Investor April 26, 2015, 10:38 pm

    @ naeclue. My mistake as you say L&G, HSBC and others introduced tracker funds in 1989 – early 90’s ahead of Virgin by 5 years or so.


  • 45 Topman April 27, 2015, 12:05 pm

    @Naeclue – “….. no-one ever lost money by underestimating the intelligence of the general public…”

    Often wrongly paraphrased, it was in fact H. L. Mencken, writing in the Chicago Tribune on 19 September 1926, who said, “No one in this world, so far as I know – and I have researched the records for years, and employed agents to help me – has ever lost money by underestimating the intelligence of the great masses of the plain people”. – Wikiquote.

    Without wishing to stray OT, suffice it to say that there many other superb Mencken quotes there, of which one of my favourites is, “Shave a gorilla and it would be almost impossible, at twenty paces, to distinguish him from a heavyweight champion of the world. Skin a chimpanzee, and it would take an autopsy to prove he was not a theologian”.

  • 46 GHDorset April 27, 2015, 12:16 pm

    By coincidence, I was thinking of investing this year’s ISA in a smaller company ETF, on the basis that all my existing ETFs track large/mid sized companies. I also wanted to use a different broker to my current ISA, and a different ETF provider, in order to spread risk around FSCS limits.

    So I looked at my bank’s stocks & shares ISA and asked them why they don’t trade the ETF I was considering. Their response is ‘some ETFs have been classified as complicated and … resulted in us no longer offering them’. They also no longer trade any ETCs, as they are all classified as complex.

    Perhaps they’ve been reading Lars’ book.

    My current ISA platform and my SIPP platform will happily let me trade in the ETCs and ETFs that my bank won’t. Not sure what message to take from this, other than that I should re-read Lars’ post and book and remember that I don’t have an edge.

  • 47 Lars Kroijer April 30, 2015, 2:46 pm

    sorry it has taken me so long to respond (I’ve been away). I generally agree with the comments. Just to respond to one from @Passive Investor re risk premium, I’ve not explained myself well enough; there is no doubt that certain segments of the market (small cap, etc.) have performed better over the past while, and they were part of the reason for the article. I’d also agree that some of those sectors you would ascribe a higher expected return to than the overall market (small caps an obvious example), albeit at a higher expected level of risk. It is of course no surprise when those segments then often do worse than the overall market in a 2008 scenario (side note: remember the endless number of hedge funds who claimed to be market neutral (i.e. dollar neutral), but still performed extremely poorly because they were long a bunch of small cap names and short an index of large caps against it).

    My point is more that on a risk adjusted basis there is no expected out-performance from the smaller stocks as you can expect the market to re-allocate to the small cap (or other segments) if there was. So unless you want more risk in your equity portfolio than that offered by the overall market (and you can’t/won’t/shouldn’t do it via gearing) you are still better off getting your equity exposure via the overall market, instead of trying to do a mix of various segments other than what is already implied by the market. Part of the reason for this is add’l trading and admin costs, but expenses are also likely to be higher (part of the point of the article) which will matter in the long run. So instead of doing a mix of say 50% bonds / 40% overall equity market / 10% risky equity market I would argue you are better off doing say 45% bond / 55% overall equity market (or whatever that ratio will be in the specific case).

    In the case where you want more risk from equities (for whatever reason really) than implied by the equity market, and can’t get it via gearing it could make sense to invest part of your portfolio in these high beta segments (like small caps, etc.). But in my view it is really in lieu of getting gearing (and perhaps cheaper), and not because you believe that those segments will perform better on a risk adjusted basis. If you thought you could consistently predict that they could you should start a hedge fund:
    1. Buy those segments
    2. Shot the overall market
    3. Adjust sizing to be risk neutral
    4. Get all the gearing you can get your hands on, and get rich.

    I know this is not what you are saying obviously, and actually think we fully agree with each other.

    Sorry I’m being long winded. This is probably as clear as mud.

    On another note I’ve decided to be better about Twitter. Does anyone on this forum know a lot about it and have 5 minutes to spare? Thanks in advance.

  • 48 Passive Investor April 30, 2015, 3:40 pm

    @Lars That mainly makes good sense. A couple of quick points:

    You write :

    My point is more that on a risk adjusted basis there is no expected out-performance from the smaller stocks as you can expect the market to re-allocate to the small cap (or other segments) if there was.

    Are you making the stronger statement that the empirical data show no risk-adjusted out-performance (which is contrary to my previous understanding)? Or are you just saying that there shouldn’t be any risk-adjusted out performance because markets are efficient enough to erode it over time?

    The point about taking more (or less) risk by adjusting bond:equity allocation was very interesting and makes a lot of sense. This is approach is certainly a cost effective way of managing a portfolio.

    I still worry about over-concentration of ultra large cap companies in the FTSE All-share (and to a lesser extent in S & P 500) and see that as a reason to tilt a little to mid and small caps. I suppose it doesn’t make sense in term of managing risk as assessed by volatility but perhaps it does against tail-risks (eg significant underperformance of HSBC or Shell).

    Thanks anyway for an interesting article and comment

  • 49 Rob April 30, 2015, 3:46 pm

    I still worry about over-concentration of ultra large cap companies in the FTSE All-share (and to a lesser extent in S & P 500) and see that as a reason to tilt a little to mid and small caps.

    That is what everyone else does too which is why the big caps are chepaer than the others.

  • 50 Gregory April 30, 2015, 4:23 pm

    I know nobody here but I’m sure most of us will regret to be too bold, “smart” and not follow the brutal simple advice of Lars. I hope I will be the exception that proves the rule:)

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