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

Lars Kroijer is a former hedge fund manager turned author and occasional contributor [1] to Monevator. His book, Investing Demystified [2], makes the case for index fund investing.

Most Monevator readers will know by now that I think passive investing [3] 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 [4] 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 [5] 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 [6].

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 [7] that have outperformed in the past.

For instance, there is much research that suggests that value [8] (i.e. companies with low price-to-book or price-to-earnings ratios) and smaller companies [9] 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 [10].

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 [11] the broadest and cheapest market.

Lars Kroijer’s book Investing Demystified [2] 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 [12].