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Why market cap investing still works

Are chimps making chumps out of trackers? In a trial of the fittest run by academics at Cass Business School, traditional market cap weighted indices were beaten by indices picked by 10 million monkeys (or rather by their randomly generated computer simulations).

Market cap indices are the spine of the vast majority of index trackers. News that they’re apparently taking a beating from primates therefore caused some consternation here at Monevator’s Passive Investing HQ.

So should we be pounding the earth like Charlton Heston and preparing to worship our new masters in a passive investing version of Planet of the Apes?

Er, no.

Market cap index investing still works

The Cass Business School’s two-part paper is called An Evaluation of Alternative Equity Indices (here’s part one and part two).

The research reveals that investment strategies with the power to capture return premiums like small cap, value and low volatility have historically delivered more OOMPH! than you got from the regular old market.

But this is no surprise. Academics have been telling us this for 20 years and we cited similar revelations a month ago on Monevator.

Broad market indices are designed to capture beta – the return of the market. But there are other sources of return out there.

Essentially, this paper shows that other types of index can angle their satellite dishes so they receive some of the beta channel, and also the small cap and value channels, too.

We’ve previously discussed how you can invest in some of those approaches – like the fundamental indices – by putting money into value-tilted passive funds.

Mind the cap

The standard argument for market cap indices is that they are transmitters for the wisdom of the crowd.

The gestalt human investment brain allocates capital efficiently to the firms who will make best use of it, and this is reflected at light-speed in the index.

The case against market cap indices is pretty clear, too. They are passive victims of the misjudgments of the market. For instance, they are mechanically forced to accept overvalued equities that balloon in the index with the smiley face of irrational exuberance painted on.

You’ll often see passive investors challenged in heated comment threads about how their portfolios would have been swamped with Japanese equities in 1989 or tech stocks in 1999, like a council landfill site crammed with trash.

These accusations fail to account for the sheer global diversity of a passive portfolio. Nor do they acknowledge just how many active investors get trapped in expanding bubbles.

Active investors are the ones making the active decision to chase the bubble higher, after all.

The pros of market cap index tracking

There are still good reasons for holding funds that track market cap indices. It’s worth reflecting on those as an antidote to getting too clever by half:

Simplicity – Market cap indices are easy to understand. The bigger a company is relative to the rest, the greater its presence in the index. That’s it, bar common-sense rules to guard against over-concentration in the event we all go bananas and back SnakeOilSystems.com to take over the world.

One of the issues with the alternative, so-called Smart Beta indices is they are often presented in the language of a black box. Too often proprietary strategy jargon and marketing pseudo-science seems designed to lacquer on an extra layer of fees and play to our desire to believe in magic rather than to promote understanding and transparency.

Without transparency we break the first decree of the DIY investor: ‘Never invest in something you don’t understand’. Without transparency we risk investing in complexity rather than efficiency, and paying extra for Advanced Methyl Ether Rejuvenator Balm when we just need creosote.

Low costs – Broad market cap indices contain the most liquid equities and have low turnover which is why they can cost 0.10% to own in fund form.

Academic research rarely takes the actual cost of implementing alternative strategies into account. It deals in a frictionless world where equities can be freely traded and there isn’t a maze of middlemen to dash through.

The Cass Business School paper demonstrates that some alternative indices beat the market cap approach by around 2% per year. In the UK, you’ll be subtracting 0.3 to 0.5% from that in higher Ongoing Charge Figures (OCF) plus bid-offer spreads and any tracking error that creeps in.

Costs are nailed on. Potential returns aren’t.

Availability – We’re now served by a wide range of market cap index trackers that encompass both the weird and the wonderful.

In contrast, many of the indices cooked up in the academic labs just aren’t available as funds you can buy into in the UK.

No guarantees – Debate rages as to why the return premiums exist. Are they rewards for extra risk (in which case they should persist) or the behavioural errors of flawed humans (therefore erodible through exploitation)?

So far the return premiums have stood up to the scrutiny of the markets, but you have to be prepared for the possibility they could evaporate in the future. As Vanguard founder John Bogle says in The Little Book of Common Sense Investing:

I’m skeptical that any kind of superior performance will endure forever. (Nothing does!)

Personal risk factors – If you work for a small cap firm then a good deal of your future returns (i.e. your salary) are dependent on the fortunes of that part of the market. Tilting your portfolio in favour of small cap funds would concentrate your risks rather than diversifying them.

The same principle could apply to some extent to most of us. Consider how your earning power correlates to the economic cycle before tilting your portfolio in favour of, say, value strategies that generally take a beating during recessions.

Performance chasing – Different strategies work best in different time periods, as shown in the Cass paper. Even market cap has beaten all-comers during a raging bull market. Strategies will be declared ‘hot’ based on recent performance – witness the flurries over low volatility and high dividends recently – reducing their likelihood of outperforming in the future.

Johnny-come-latelys will swarm in, then dump the funds when they fail to make ‘em rich. As ever we must resist the temptation to jump on board a bandwagon.

Tracking error regret – How will you feel when your alternative strategy eats the market’s dust for five years straight?

When returns soar we take it as confirmation that we’re as brilliant and blessed as we always thought we were. But when our high-cost strategy is left billowing black smoke in a lay-by as the rest of the market whizzes by, how happy will we be then? That’s not a pain you’ll ever have to feel when you simply invest in the market.

Hard evidence – Twenty years is a reasonable amount of time to judge a strategy’s performance. Ten will do, five is barely acceptable. Anything less is irrelevant.

It’s hard enough to get ten years of performance data for a market cap index fund. We’ll have to wait years for useful numbers on the latest financial products.

Back-testing is used to fill the gap, but be aware that many strategies that glitter in the data mine have lost their lustre in the cold light of day. As ever, investors are wise to be cautious and wary of products with insufficient miles on the clock.

Enough monkey business

I say all the above as an investor who’s convinced by the arguments for factor investing, smart beta, fundamental indexing – whatever you want to call it.

But I know it’s a risk and so I won’t be entirely abandoning market cap investing.

Both approaches will work in tandem in my portfolio because, although I’m prepared to take a chance on the extra reward, sometimes you just can’t beat the tried-and-tested.

Take it steady,

The Accumulator

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{ 59 comments… add one }
  • 51 The Accumulator May 1, 2013, 6:45 pm

    Being influenced by the verdict of the market is at least as reasonable as trying to guess what effect ‘this factor’ or ‘that factor’ may be having – which is nigh on impossible. It may be less fun but it is simple and it is reasonable.

  • 52 ivanopinion May 1, 2013, 9:58 pm

    So are you saying you have more than 50% of your portfolio in US equities?

  • 53 ivanopinion May 1, 2013, 9:58 pm

    And only 10% of it in UK equities?

  • 54 Passive Investor May 1, 2013, 10:19 pm

    @acc @ivan.

    I follow and would argue for a half way position. Foreign equities make sense because they offer diversification, some degree of non-correlation (though not enough when you need), access to more dynamic economies than the UK and I agree that ‘the wisdom of the market’ is not to be dismissed lightly.

    The disadvantage is exchange rate risk. Over the long- term this is actually fairly low but the trouble for the near-retiree is that you could hit a major appreciation of sterling in say your last 5 years of accumulation / first five years of draw-down. If that happens it won’t be much consolation to know that ‘in the long run everything will be all right’.

    The obviois compromise is to put 40-60% in the UK and the rest in non-UK markets. Hopefully this gives the best of both worlds.

  • 55 Grumpy Old Paul May 2, 2013, 7:08 pm

    I didn’t realise that this debate was still continuing but interesting it sure is!

    Having read all of the above comments, I’m still inclined to stick with simple market cap. trackers for the bulk of the equity assets within my portfolio but will, when I next rebalance, tweak it with a nod in the direction of value and small caps. However, I am aware that if this “nod” is, say 20%, of my equity assets, and has an out-performance of 2.5% (after additional charges), then the extra performance of my equity assets as a whole will have been enhanced by, you guessed it, .5%!

    Regarding the weighting towards the US, I think I’d have to look at factors like the turnover, dividend, profits of US companies compared to the rest of the world to help decide how much exposure you feel is appropriate. Also we need to remember that a big chunk of US companies’ business is generated overseas so you’re not just betting on the health of the US economy. But, yes, currency exposure can be a risk.

    Regarding the over-exposure to FTSE top 10 companies resulting from a market cap. tracker, yes it does mean that you get caught up in market bubbles but also, presumably, you also benefit from momentum. If there is a market bubble (anyone expecting that in the next 5 years?), then disciplined rebalancing between equities and other asset classes and between the UK and overseas equities will help reduce the impact of the bubble bursting.

    I would argue that is possible to recognise when equity markets are in “bubble territory”, even at the time. The difficulty, is jumping off the bandwagon early, watching it carry on moving, and enduring the scorn of any acquaintances who know what you’ve done! Bubbles can last a long time with the most extreme case being the UK residential property market.

    “Jumping of the bandwagon early” is of course not passive unless it happens as part of your passive rebalancing strategy. Which leads me to wonder whether limiting market sector allocation should also be part of a passive strategy and, if so, how it could be implemented for UK investors.

    It’s a pity that also there aren’t FTSE 100 decile trackers (top 10, 11-20, 21-30 etc), even if cap. weighted, which would allow a passive investor to very simply restrict exposure to a hand full of elephant cap. companies as they see fit.

    I’m deliberately not attempting to quantify anything (e.g. maximum sector exposure, maximum exposure to one company, maximum exposure to top 10 companies) because different investors would want different targets but I do feel there is a place for a variety of simple cheap cap. weighted trackers for passive investors wishing a greater level of diversification.

  • 56 The Accumulator May 2, 2013, 9:14 pm

    @ Grumpy – good thoughts. One of the things that’s becoming apparent from the debate on this thread is that we’re a bunch of very committed ‘passive’ investors who like to finesse. So I think we implicitly accept a higher than average level of complexity in our portfolios.

    But think one of the great selling in of passive investing is its simplicity. Anyone worried about the concentration of the FTSE 100 or All-Share would be well served diversifying across the standard asset classes – international, emerging markets, fixed income, real estate, maybe commodities, maybe small cap and value.

    After that you could overweight into a FTSE 250 fund. There is no real need to go any further except because you love it. As we clearly do.

    @ Ivan – it’s tough to commit 50% of your portfolio to the US when there are all the asset classes above to fit in plus a home bias because like PI and PC I am concerned about currency risk.

    I am 25% UK – diversified across market cap, small cap and value.

    I am 50% international – same split.

    But my market cap and small cap international funds are both 57% US and I don’t worry about it at all.

    I’m well diversified across the asset classes and sources of return and what metric would I use to change the verdict of the market into a more rational decision?

    As Grumpy says, if I could see a massive bubble inflating then I’d be prepared to take action, but it’s easier said than done. I wonder how many investors got out of Japan in 1989 or tech stocks in 1999?

  • 57 PC May 6, 2013, 5:01 pm

    http://www.thereformedbroker.com/2013/05/06/fundamentally-weighted-vs-cap-weighted-indices/ yet another article on cap weighted. v fundamental indexes

  • 58 Geo May 10, 2013, 8:34 am

    Dimensional has popped up on TD Direct.

  • 59 mucgoo May 25, 2013, 9:11 pm


    TER of 0.35%. The best physical market cap index is 0.3%(HSBC) and the artificial dbx at 0.2%.
    Its artificial.
    Only started in May 2012 so no indication of how good the tracking is. Total of about £60 million so not promising for tracking economics of scale.
    Nearly non existent volume but authorised participant should keep the spread low.

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