Squeeze The World

The Hidden Weaknesses of Index Funds – From the Wall Street Journal

Squeeze The World

The Wall Street Journal recently published a series of articles under the title “The Passivists.” Highlighting the merits of a passive investment approach, authors tackle topics such as the fruitless endeavor of trying to pick winning stocks to the “Do Nothing All Day” investment approach taken by Nevada’s $35 Billion pension fund. For each article we provide a synopsis as well as our own additional comments to build upon the great work highlighted in this series.

The general synopsis of this article[1] revolves around some of the pitfalls involved in traditional indexing strategies and offers an alternative; mainly, the fundamental indexing strategy made popular by Robert Arnott of Research Affiliates.

Although we agree that the rigidity involved with following a traditional index strategy poses unnecessary costs to investors, there are also some fundamental issues with fundamental indexing, as we will discuss in this article.

The goal of traditional indexing is to track a particular benchmark, like the S&P 500 or Russell 2000, as closely as possible in order to replicate performance. This involves the portfolio manager buying and selling securities as the indexes reconstitute themselves, leading to potentially buying securities at a premium and selling securities at steep discounts as active traders “front-run” reconstitution dates as they know that traditional index strategies will be buying and selling particular securities on certain days in order to track the index.

But Mr. Arnott believes there to be another basic reason why traditional indexing is not optimal. According to WSJ article, fundamental indexers believe that indexes based on market capitalization leads to eventually owning more overvalued securities (lower expected return) and less undervalued securities (higher expected return) securities. This has become known as the “Noisy Market Hypothesis.” Fundamental indexes address this problem by breaking the link between a securities value and the price and instead build custom indexes based off of fundamentals such as book value, sales, earnings or a combination.

There is a fundamental flaw with fundamental indexing.

As Mr. André F. Perold of Harvard Business School addresses in “Fundamentally Flawed Indexing” in the Financial Analysts Journal almost a decade ago, “the problem arises in going from this assumption [any given stock is likely to be overvalued or undervalued] about market prices to the conclusion that capitalization weighting systematically skews investment toward overvalued stocks.” His reasoning is the following, “the crux of the issue is that the noisy market hypothesis effectively anchors on fair value – holding fair value fixed and using probability distribution of the pricing error to deduce the probability distribution of market prices. To do so is to presuppose systematic reversals in stock prices, an assertion that does not follow from stocks being randomly mispriced.”

The argument can be analogized as follows. Suppose that you are shopping in a jewelry store and you see two different 1-karat diamonds. One sells for $1,000 and the other for $1,500. As far as you are concerned, they both look the same. However, the jeweler tells you that he underpriced one of them and overpriced the other. Based on your intuition, you immediately decide that the $1,500 diamond is the overpriced one while the $1,000 diamond is the underpriced one. However, a few moments of reflection would lead you to the conclusion that there is an equal probability (50%) that the $1,500 diamond is the underpriced one. Since you are not a gemologist, you have no good way of knowing. Investors (and fund managers) who believe that higher priced companies have a higher probability of being “overpriced” are making the same mistake.

Although the logic used by fundamental indexers is faulty, their conclusion about creating a better exposure to the market by focusing on fundamentals is true. We also believe that the market has different dimensions to risk that are being priced into the market. Dimensional Fund Advisors (DFA) has been one of the leading proponents of multi-dimension investing for over 3 decades. Similar to Research Affiliates, they believe there are certain premiums in the market that investors can capture and therefore increase the expected return of their portfolio. These include company size, their price relative to their book value, as well as profitability and capital investment. In short, companies that are smaller, have a lower price relative to their book value, higher profitability, and lower capital investment have higher expected returns.

In reality, an investor who follows an approach like DFA’s or that by Research Affiliates is really gaining exposure to similar securities. DFA believes securities are fairly valued and reflect the risk associated with them while Research Affiliates believes that investors are becoming more exposed to overvalued stocks overtime, which we have already shown is based on faulty logic.

We have done performance comparisons between DFA and Research Affiliates and found no statistical difference in performance between the strategies.

But we still prefer to exercise sound logic.

You can find the original article published in the Wall Street Journal here.

[1] Jakab, Spencer. “The Hidden Weaknesses of Index Funds.” The Wall Street Journal. October 18, 2016. http://www.wsj.com/articles/the-hidden-weaknesses-of-index-funds-1476799335