Indexing--in theory and in practice. Bubbles, market distortions . . .

[samclem]

I believe in indexing. Bogle has made his case, the results are there, and it's what I do (in general).

But, I've come to think that while indexing would always work as intended in a perfect world (free markets, lots of transparency and legit bookkeeping, etc), in our real world things are different.

From a recent Bloomberg article on China's Shenzhen market craziness:

The Shenzhen market is up almost 200 percent over the past year. Its price-earnings ratio stands at a little less than 80. (Standard & Poor's 500 Index is up 9 percent and has a ratio of 19.) Much of the demand for Chinese shares is credit-fuelled and comes from small investors new to the game. In one week in April, according to The Economist, Chinese investors opened 4 million new brokerage accounts -- and, by the way, two-thirds of the country's newcomers to investing left school before the age of 15.
Technology stocks, heavily represented in the Shenzhen index, are especially in demand. (Tech stocks: What could possibly go wrong?) The price of China's highest-flying stock, Beijing Baofeng Technology Co., increased 4,200 percent in the 55 trading days after it went public; on Friday it was valued at 715 times reported earnings.

Great news, indexers! Vanguard has announced that these stocks will soon be in Vanguard's Emerging Market Index Fund. Get 'em while they are hot!

It's not just a typical investor mania, valuations are being driven by Chinese government manipulation and market distortions (those young Chinese with money to invest for the first time can't choose US stocks or other options--the money is captive in China, which drives equity prices up even before foreigners dump money in). It would seem that such a market might be one that US index funds would avoid. Indexing's underlying assumption ("I can trust the prices, because both buyers and sellers are free to seek other options") isn't valid. And this is just an example of a much wider problem. Another one: Bonds given special status (and pricing power) by the US government because of their ratings.--ratings granted by selected "approved" ratings agencies--that were apparently influenced by the payments they received from those they rated. I own bond indexes, so I overpaid for those crummy bonds (as did active managers--but at least they were supposed to be discerning and could choose to buy better ones). When Greece's troubles were clear but their bonds hadn't been officially downgraded, some European govt bond indexes were loading up on Greek bonds as though they were German (hey, Greece is in the Eurozone, these are government bonds, we're just buying what's in the index . . ).

If the index is cap weighted (like almost all are), then you'll be buying more and more of the insanely over-bought stocks as the investor mania continues. Maybe we need a "past 12 months earnings" weighted index. But wait, that's no guarantee of avoiding the madness: Value investors were heavily invested in financial companies in 2008 (their earnings were good--because of a different bubble-inducing government distortion). So, earnings aren't a sure measure of value, since the earnings can be based on distortions.

I remain an indexer, a true believer. But as the markets froth up, I am starting to feel a bit like a Christian Scientist with appendicitis.* I'm looking a little closer at how these indexes are constructed, and am not jumping into any hot new index funds just because they are offered by a big fund company. I'm recognizing that some sectors may not be appropriate for indexing, and probably not even for my investments in any form. And I'm starting to think that, just maybe, the hard, cold, cynical judgement of a mature value-oriented stock picking curmudgeon can be worth something.

Just some thoughts on a rainy morning.


*Apologies to Tom Lehrer

 

[Shanky]

So someone who entered the index when it had a P/E of 40 has doubled their investment. The challenge is, how do I know when we run out of "greater fools". Indexing over time with dollar cost averaging smooths out the noise from both bubbles and panics. Trying to avoid either is akin to Market timing.

I stepped out of equities around s&p 500 @ 1800, and I feel pretty foolish. My reentry point will likely be higher than my exit point.


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[photoguy]

Great post. Here are some of my thoughts as a strong believer in passive investing:

(1) I doubt these financial shenanigans are anything new in emerging markets investing. However given the history of actual performance and correlations in EM with the rest of one's AA, I think it's still a worthwhile slice to have. If one is uncomfortable with EM, one can either downweight or eliminate it from one's AA.

(2) Indexing investing doesn't have to be perfect. It just has to be better than the alternative. Given the drag caused by active MF managers who think they can beat the market, there's a lot of room for a less than perfect implementation.

(3) The specific issue you listed (including stocks in China whose prices may be manipulated) might be considered an implementation failure specific to vanguard's EM fund and not a general flaw of indexing. Price manipulation also happens in developed markets yet there's strong evidence that it is best approach for the majority of investors.

(4) I'm not sure why you would be buying more of the "insanely overbought stocks" as an indexer. In decumulation mode, an investor would be either be keeping their AA constant or slowly selling off their most appreciated stocks/indexes. The beauty of cap-weighting is that even if a stock skyrockets in price, no new trades need to be made. In accumulation mode, an indexer should probably be adding to the indexes that have been the most beaten down in recent history (with lowest valuations).

(5) On a stock's entry to an index, the fund would have to make some purchases. However I'd would assume that most well run indexes have a trading strategy to prevent being shafted by front-running/price manipulation. This might involving waiting some time before purchasing, not buying IPOs etc, being unpredictable about the timing. I don't think Vanguard publishes what they do here -- but they might not be the leader here.

(6) Even if a particular slice/sector of the stock market is in a bubble, I think indexing is still the right strategy. Due to cap-weighting, most index investors won't actually be buying any of the insanely overpriced stocks and may actually be selling due to rebalancing.

 

[Totoro]

The trick with worldwide indexing is that it all evens out.

For every market or company that's worth 100 but now valued at 200 there is another market or company that's worth 100 but valued at 50. If (or rather, when) the overvalued bit goes down, the undervalued bit has to go up unless the money leaves the equity market.

With "total" indexing you buy em all. Only thing that really can affect you is capital inflow & outflow in equities as a whole.

But yeah, it feels odd looking into the portfolio and seeing absurd valuations in pockets. I also don't like it one bit. Sometimes I wish there was an easy service that does index-minus: Something that indexes worldwide equities, except for some areas/sectors/stocks you specifically exclude (and then it automatically rebalances for you).

 

[kevink]

Excellent post samclem; thank-you. You articulate and flesh out many thoughts I've had running in the background lately. For me it got started awhile ago looking at how the S&P 500 index has been revised over the years, and then spread to looking at indexes generally.

Here's a link to an article by Steven Evanson, principal of Evanson & Associates, one of the most savvy (and low-cost) advisors in the DFA world. I'm not at all trying to get into the age-old "DFA vs. Vanguard" debate here, but rather sharing what he has to say about the pitfalls of index investing and specifically doing so with ETF's vs. passive funds screened on a more sophisticated basis. Effectively the screens DFA uses, not having to buy and sell when the public indexes do and their independent evaluation of companys in each index may well be the "value-oriented curmudgeon" you talk about samclem - though whether employing said curmudgeon is worth the cost of accessing DFA funds for more than a few folks is another question (though that cost is right on par with the .30-.35% of assets being charged by many Roboadvisors for managment of very generic Vanguard or Schwab ETFs).

Evanson Asset Management - DFA vs. Indexes and ETF's

 

[donheff]

My problem is that, while I can read an analysis like the above and say "yes, that sounds right," I don't have enough other information to effectively react. Maybe we should avoid EM funds, maybe other factors will balance the problems out, maybe over the long term the efficient frontier works about best. No way I am going to become my own active manager so I will just stick with my AA and rise or fall with the vicissitudes of fate.

 

[gcgang]

Are DFA funds only available thru a FA? I went to DFA website, and was asked to provide lots of personal info and send it off into cyberspace before I could even get info on advisors in my area. Anyone have experience with DFA? I like their investment approach.


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[Ed_The_Gypsy]

Gcgang, John Greaney published an article on his Web site a few years ago summarizing the expense ratios of several DFA FAs. There are large differences between firms! Go look.

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[tulak]

I seem to recall that this is one of the reasons Bogle avoids investing in international markets.

But bubbles also happen in the U.S. Your point also bothers me, since I'm a strong believer that valuations matter. The problem is that valuations aren't easy to integrate into a passive index portfolio.

The way I rationalize it is there's an upside to bubbles. If you rebalance yearly or based on triggers, you can catch some of the upside and minimize the risk. IMO, this is a better (and easier) strategy than trying to avoid markets because of valuations.

It's also important to avoid looking at any single allocation in your portfolio. That's hard to do, since many of us like to look at each investment and see how well it's doing. But the key to a good AA is to recognize that any single investment will have both good and bad years. What's important is total portfolio volatility and return.

 

[kevink]

gcgang, to answer your question: yes, DFA funds are only available through an FA and as others have mentioned costs to do so and services provided for that cost vary greatly. Personally I would only consider firms that charge a fixed fee rather than a percentage of assets. As Evanson Asset (link I provided above) points out, it doesn't cost them - or anyone else - more to manage $5 million than it does $500,000. FPL is another fixed fee provider, Scott Burn's AssetBuilder charges .35% a year but is a gateway to DFA with only a $50,000 account minimum - 1/10th of Evanson's and 1/20th of the typical DFA advisor.

Here is a really excellent and detailed fairly recent comparison of DFA and Vanguard returns and expenses. It's worth it to read the extensive comments, some of which offer real gems:

DFA Vs Vanguard | The White Coat Investor- Investing And Personal Finance Information For Physicians, Dentists, Residents, Students, And Other Highly-Educated Busy Professionals

 

[samclem]

Indexing over time with dollar cost averaging smooths out the noise from both bubbles and panics. Trying to avoid either is akin to Market timing.

But my DCA days are over--I'll be taking money out soon. I suppose rebalancing serves much the same function. As far as market timing--We know that valuations do matter, and that we can tell something about returns for the coming 10 years by looking at PE10 today. But we can't tell anything worth knowing about >next< year. That makes it not too useful for getting in and out of equities--leads to too much time spent out of the market (we're close to h**** territory here).

(1) . . .I think [EM] is still a worthwhile slice to have. If one is uncomfortable with EM, one can either downweight or eliminate it from one's AA.

I liked EM index funds more when they were willing to exclude more countries/companies. The index builders (surely driven by the fund companies) are digging a lot deeper now, and I think it's logical to expect increasing uncompensated volatility as a result.

(4) I'm not sure why you would be buying more of the "insanely overbought stocks" as an indexer. In decumulation mode, an investor would be either be keeping their AA constant or slowly selling off their most appreciated stocks/indexes.

I may keep the number of MF shares constant, but when these crazy inflated stocks enter the index, the MF buys it and then I own it. (E.g. if it's defined as a top 5000 stock index, they add the Lucky Rising Flash company when its market cap (inflated stock price x shares outstanding, probably issued yesterday) makes it the 5000th largest company, and some other dull stock drops out). We end up owning these overbought bubble-babies passively, and pay the price when they pop.

The trick with worldwide indexing is that it all evens out. . .
With "total" indexing you buy em all. Only thing that really can affect you is capital inflow & outflow in equities as a whole.

Yes, I see your point and agree with it. But that one caveat--money flowing in and out of the equity market-- can be a doozy. Like these new Chinese investors borrowing to buy wildly inflated shares. That's money that wasn't owning shares before, now it is puffing up prices. That's fine for us steady indexers if we sell/rebalance--at least we'll mitigate sme of the damage. How much better, though to avoid the problem in the first place.

Sometimes I wish there was an easy service that does index-minus: Something that indexes worldwide equities, except for some areas/sectors/stocks you specifically exclude (and then it automatically rebalances for you).

+1. That would be great. I don't believe I can spot the next Apple or Microsoft, but I'd like to take a stab at being able to eliminate the next Crox.

Here's a link to an article by Steven Evanson, principal of Evanson & Associates, one of the most savvy (and low-cost) advisors in the DFA world.

Thanks, I look forward to reading it.

Regarding the person playing the role of cynical curmudgeon: I used to count on John Bogle to do this, to a degree. No, he didn't try to pick deep value stocks like Munger, but he didn't seek out the latest flashy thing. He built Vanguard's brand on low costs and the meat-and-potatoes that most investors really needed (even if they might have yearned for the something more exotic). I think the new leadership is doing things a bit differently.
[/QUOTE]

. No way I am going to become my own active manager so I will just stick with my AA and rise or fall with the vicissitudes of fate.

That's been my position for decades, and I still haven't changed anything, yet. But change needn't be radical or expensive--maybe just shifting a bit out of equities (or specific regions/sectors) when they are at high PEs by historical standards (treading on DMT /"Tactical Allocation" territory here! But is going from 70% stocks to 60% stocks really a sin if the things are in bubble territory based on PE10 or other measures? I'd still be mostly in stocks). Or, less controversially, take a few dollars out of the passive indexes and put them in Wellington, where adults with a steady hand and a skeptical eye can screen out the craziness at fairly low cost to me.

I appreciate the comments and food for thought. More are very welcome. I'm not a heretic yet, but I do feel myself having [-]doubts[/-] [-]concerns[/-] impure thoughts.

 

[kevink]

I love the way you think and I love the way you write samclem - and that was before the Tom Lehrer reference in your first post!

I hear you on Wellington, and I also looke at its companion fund Wellesley and kick myself repeatedly for not just going all in on it about 15 years ago. This quote from John Bogle from a couple of weeks ago says it all:

"I would say, go into the casino, which is what Wall Street is today. Bet on the entire stock market and then get out of the casino and never show yourself there again," Bogle said.

 

[photoguy]

Samclem -- if your concern is highly valued stocks entering an index (as opposed to a bubble that inflates the stocks already in the index) why not just invest in value indexes. Those companies will never enter by design.

I admit value EM is going to be hard to find, but probably DFA has such a fund.

 

[gcgang]

gcgang, to answer your question: yes, DFA funds are only available through an FA and as others have mentioned costs to do so and services provided for that cost vary greatly. Personally I would only consider firms that charge a fixed fee rather than a percentage of assets. As Evanson Asset (link I provided above) points out, it doesn't cost them - or anyone else - more to manage $5 million than it does $500,000. FPL is another fixed fee provider, Scott Burn's AssetBuilder charges .35% a year but is a gateway to DFA with only a $50,000 account minimum - 1/10th of Evanson's and 1/20th of the typical DFA advisor.

Here is a really excellent and detailed fairly recent comparison of DFA and Vanguard returns and expenses. It's worth it to read the extensive comments, some of which offer real gems:

DFA Vs Vanguard | The White Coat Investor- Investing And Personal Finance Information For Physicians, Dentists, Residents, Students, And Other Highly-Educated Busy Professionals

Thanks, kevink. The article concludes its not worth it to hire an FA just to get access to DFA funds. Even though DFA have outperformed in certain asset classes, it's not much outperformance and the outperformance is not sure to persist.

I'll just continue to build cash, add to stocks if the market comes down, spend it if it doesn't.


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[samclem]

Samclem -- if your concern is highly valued stocks entering an index (as opposed to a bubble that inflates the stocks already in the index) why not just invest in value indexes. Those companies will never enter by design.

Yes, I do some of this (my AA has a value and small tilt), and I appreciate the fact that the value part will be less "bubbly" (and my dividend yield for those indices will be higher). But if we just select for "value" without any human "picking", we can get very high sector concentrations, as happened in 2008 when financials had such great returns (puffed up, at least in part, by another govt-induced asset bubble). In 2008, 23% of the Vanguard Value Index fund were financial services companies. As a result, value indices got slammed pretty well in the crash. Now it is 2015 and--surprise--the dang financials are 22% of the fund again (financials are just 14% of the S&P 500). So, I'd be overexposed to that sector again. I can imagine cases where other sectors could have high representation in a value index. So, I think selecting for value helps (quite a bit), but its not perfect, and it provides limited protection for when the whole casino has gone crazy. DFA might help here--their value indexes tend to be a lot "deeper value" than Vanguard's.

The value tilt takes a bit of the edge off, I admit.

 

[NW-Bound]

Indexing - in theory and in practice?

Is it still the same thing? To buy the largest stocks, in proportion to their market capitalization, P/E be damned?

Indexing has its positive aspects, and it more likely beats jumping in/out of the market at the wrong time. But proponents of indexing often talk as if the above are the only two types of investing. If you do not belong to this particular religion, then you must be a murderer and or rapist.

The market is more than often fair and efficient. But that does not mean we should adopt the "see no evil, hear no evil, speak no evil" attitude and do not even dare questioning the market at times when it acts insanely. Dot-com, real estate bubbles?

I always pay attention to signs of market bubbles or its manic depression. I am usually not smart enough to recognize mass delusion and brave enough to benefit from it, but it does not mean that I give up trying to understand the situation.

 

[clifp]

Great post Sam,and it is one of the primary reason why so much of my portfolio consists of boring and except for Berkshire Hathaway dividend paying stocks.

I am far less concerned with missing the next Apple, Google, than avoiding the next Pets.com, Enron, or Chinese social media, or corrupt construction company. A few times in the last decade I've actually take the time to spend an afternoon and gone through the S&P 500 index and spend 30 seconds or so trying to figure out would I want to own or sell the stock

This was a very superficial analysis; a gut check, plus a quick check with Morningstar, on P/E, P/S. I foolishly didnt keep statistics, but I had no opinion on roughly 300 stocks of the other 200, I only wanted to own 120, and no desire to own the other 80.

Take a company like Comcast CMSA They face significant competition from the internet, DISH/Direct, and perhaps in the future Elon Musk. Customers despise the company. The yield is a low 1.5%, P/E is a market average of 17, and it has 2 star rating by Morningstar. There is almost no chance this is 5 bagger in the next 10 years, and some chance its market cap could be cut from $150 billion to say $30 billion in the same time period.

In contrast two stocks I own are General Mills (GIS) and UPS they both yield about 3%. Although neither stock is bargain they are exactly the kind of companies I want to in my retirement. In the case of General Mills it has 116 year history of raising dividends. I think it has virtually no chance of increase 5x in the next 10 year, but I also think the chance of it dropping by 80% is also very slight.

UPS has an even wider moat that General Mills, and while there is no guarantee that some Chinese firm doesn't become that dominate global logistic firm, in the next decade there is a reasonable chance that UPS will the winner, and may even be a 5 bagger in the next decade. I find it extremely unlikely that UPS markets cap will drop 80%.

So I am happy to own both General Mills,and UPS not much risks of having their core business dramatically distributed, and the 3% dividend, with a long history of increasing faster than inflation, provides me all the income I need. Comcast has both too low yield 1.5% isn't enough and too much too risk. I still own Comcast via VTI, but at least my exposure is lower because I own a decent chunk of General Mills,and UPS.

And of course compared to many of those Chinese company, Comcast is a model of customer service, (they don't after all poison their customers) with transparent accounting, and very reasonable valuation.

I suspect that overall International stocks are undervalued compared to the US, but these stories really scare me. All of my international stock holding are in index funds, but I do long for a fund where the managers are free to avoid the buying the bubble stocks.

 

[ERD50]

.... A few times in the last decade I've actually take the time to spend an afternoon and gone through the S&P 500 index and spend 30 seconds or so trying to figure out would I want to own or sell the stock

This was a very superficial analysis; a gut check, plus a quick check with Morningstar, on P/E, P/S. I foolishly didnt keep statistics, but I had no opinion on roughly 300 stocks of the other 200, I only wanted to own 120, and no desire to own the other 80. ... .

But isn't this exactly what so many actively managed mutual fund managers are doing, with lots of research and computer algorithms at their side, and plenty of motivation to 'beat the market'? Yet, stats keep showing that they can't do it reliably, but you think you can? Granted, some of that is due to fees, but IIRC the number is something like 80% don't make it in 5 years, and the ones that do are unlikely to be in the next 5 year group. I'm estimating that if you take out fees, you'd still be around 50% (monkeys and darts?)?

Take a company like Comcast CMSA They face significant competition from the internet, DISH/Direct, and perhaps in the future Elon Musk. Customers despise the company. The yield is a low 1.5%, P/E is a market average of 17, and it has 2 star rating by Morningstar. There is almost no chance this is 5 bagger in the next 10 years, and some chance its market cap could be cut from $150 billion to say $30 billion in the same time period.

So maybe buy the index and short the few that you can identify as having poor prospects? Might be cheaper than buying 120 stocks?

-ERD50

 

[samclem]

Here's a link to an article by Steven Evanson, principal of Evanson & Associates . . .
Evanson Asset Management - DFA vs. Indexes and ETF's

Here is a really excellent and detailed fairly recent comparison of DFA and Vanguard returns and expenses. It's worth it to read the extensive comments, some of which offer real gems:

DFA Vs Vanguard | The White Coat Investor- Investing And Personal Finance Information For Physicians, Dentists, Residents, Students, And Other Highly-Educated Busy Professionals

The comments in the second link were very useful. Looking at DFAs approach, they pretty much meet the definition of a "Quantitative" ("Quant") fund, don't they? Of course, they were doing their thang before that term was used. They aren't index funds (since they don't use an external index to build their holdings) and they actively screen holdings in/out using quantitative measures.

I don't see DFA as being worth the price of admission for the largest areas of the equity universe (developed world large cap, etc). I can see DFA adding value in areas/subsectors where the assumptions underlying indexing are questionable. But I wonder if the very factors that make indexing troublesome (e.g. low liquidity markets, reduced transparency and available information, sketchy adherence to GAAP, etc) make those relatively "exotic" sectors unsuitable for my investment dollars anyway? If I had a $10M portfolio it might be worth the time and relatively low cost (with a fixed-price FA) to gain access to them for niche areas of a portfolio, but that ain't me--well, not right now. If I decide I want to have exposure to those niche areas, I'd be inclined to either buy a (relatively) low-cost managed fund or use an indexed ETF or MF warts and all.

So, that's one indexing/MPF issue left unresolved (for me)-- if/how to invest in sectors/areas where indexing may be problematic.

My other question is about the wisdom of adherence to an unchanging AA in the face of market valuation changes. I know >volumes< have been written on this, so I need to do my homework.

 

[Lsbcal]

My large cap international is in VEU so not too much EM there. For small cap international I use VINEX which is active but low ER. So I avoid narrowly focused funds.