Moving Away From Indexing

[slowtraveler]

I'm considering dumping indexing altogether. A half conservative, half aggressive portfolio is something I'm considering.

After looking around some I'm thinking:
50-60% Wellesley(Or Global variant)
20-25% Primecap Odyssey Growth Fund
20-25% Dodge and Cox Global Fund

I'd buy in at 60-20-20 and if markets crash, rebalance to 50-25-25, if not, they'll hit that anyways with the growth.

These are all long term management teams with histories of outperforming the indexes, next to no marketing expense/focus, few funds rather than a fund for every category imaginable, and even have a history of closing off funds once they deem it in their shareholder's best interest.

Is this crazy or reasonable?

With so much talk of all in on VTSAX or 3 fund portfolio, I'm feeling it's almost sacrilege.

[TopHatFox]

I just like the 3 fund index portfolio because it frees up head space to increase income, decrease expenses, and try to be happy

As long as the alpha - fees are consistently higher than an index equivalent and your portfolio is large enough for the difference to matter, I don't see why not.

[arcyallen]

I think the big questions are 1) Why are you considering moving away from indexing, and 2) Why now?

There -are- good funds out there that consistently outperform their indexes, even the sacred VTSAX. The key is that you need to stay the course once you decide, and that's hard to do. Recent performance of funds tend to sway our behavior. American Funds (their US equity funds), for example, typically lag during bull markets. We've been in a bull market for a LONG time, and they indeed have lagged a little. It's hard to stay the course, but seeing as every single time they "catch up" and eventually outperform again it's a reasonable plan to stay steady. Jumping ship due to the jitters (of any kind) historically will not serve you well.

As for "and even have a history of closing off funds once they deem it in their shareholder's best interest.", fund companies rarely close funds for that purpose. Usually it's to cover up horrible fund performance. Those companies certainly might be an exception, of course.

[ThisDinosaur]

How long would you stick with that plan while it underperformed your benchmark? Will you switch to something else when its not working? If you lost money or missed out on profits? I'm not saying it will underperform or that you shouldn't do it, but it is a fact that any actively managed dollar will perform less well than the market portfolio. That's true even if the market portfolio loses money, you're likely to lose more.

Now Jacob has repeatedly made the very valid point that citing this fact is like telling the valedictorian he should stop studying because the average grade of all students will be the average. But this classroom has hundreds of millions of students, some with higher education and better calculators than you. And the people with the right answers get to take the lunch money from the ones with the wrong answers. Buying actively managed funds is like paying the kid with yesterday's right answer to give you tomorrow's right answer.

The main thing that worries me about index funds is their popularity. When the sell off comes it is going to pull everyone down with them.

[slowtraveler]

I've been getting more scared of indexing with the current dogma building around it.

These are companies that have not opened many funds over a course of decades. They are not being closed due to underperformance.

I'm already invested in the Wellesley. It has underperformed it's benchmark YTD but I see no reason to dump it. I think now is a worse time with the current asset bloat to jump ship but I feel steadily more uncomfortable holding index funds.

I feel I'm not being compensated enough for the risk I'm taking. The Primecap Growth fund has a good possibility of giving me 5-15% returns in a 10 year time frame while VTSAX has a smaller chance. To be honest, my VTSAX and VTIAX have beat my expectations handsomely but I can't see this happening for much longer.

I'd like more international exposure than the global fund gives me but their International fund has closed. Primecap seems the most impressive of the bunch to me and I appreciate their sector focus on health care and it.

I'd be willing to stay for 3 years of underperformance. If it goes on longer than that, the funds have failed their performance objective. I want to diversify some of the manager risk I'm currently taking through dumping my index funds since I trust the managers at PrimeCap, Wellington, and Dodge and Cox more to invest for long term than the Standard and Poor Committee (which are the managers of the index). Float-adjusted market cap weighting seems less and less appealing to me and as the index bloats more, more adjustments that lower returns will happen.

@Dinosaur
Do you mean "the average market weighted dollar"?

Also, Wellington, Dodge and Cox, and Primecap make the cut for Bogle's favorite actively managed investment companies.

[arcyallen]

Buying actively managed funds is like paying the kid with yesterday's right answer to give you tomorrow's right answer.

If they've given me the right answer for 40-80 years then yes, I'm quite happy with relying on them for their answers.

I'd stay with a lagging investment for a long time, -IF- they continue their management strategy. To me it all comes down to 1) Buying high quality investments, 2) Being diversified, and 3) Holding them for the long term. It's critical to stick to the plan especially when you don't want to. No one wanted to be diversified or buy quality, established comanies in 1999, they wanted tech. Many were concentrated in high dividend paying bank stocks in 2006, right before the crash. If someone actually does these three things, they historically come out OK. What Berkshire does comes to mind.

I don't think three years is enough time to judge the performance of an investment. To me ten years is the minimum. I'd never put money in a fund because of the last three or five year numbers. I think that's a recipe for disaster. Hot, crappy funds can look great for 3-5 years. It's much harder to do that for a decade. Or eighty years (see AIVSX as an example).

In Jim Collin's book he talked about how something like 99.8% of actively managed funds lagged the market over 40 years. He didn't mention that .2%...

[ThisDinosaur]

American Funds (their US equity funds), for example, typically lag during bull markets. We've been in a bull market for a LONG time, and they indeed have lagged a little.

https://www.cfapubs.org/doi/abs/10.2469 ... alCode=faj

Asset allocation explains the majority of a fund's performance over time. If you are comparing a cap weighted total stock market fund to an actively managed fund with, say, small caps or bonds, than the active fund will do worse until bonds or small caps outperform large caps. Paying someone to pick your asset allocation is objectively worse than just looking up their fund's AA and just copying it with low cost index funds.

The problem with the popularity of index funds is systemic risk. When the indexers sell off, it will affect everyone else. The vast majority of people paying advisor fees will be *even worse off* than the indexers. Of course, If you've picked Woebegon funds, where results are always above average, then you have nothing to worry about.

[ThisDinosaur]

@Dinosaur
Do you mean "the average market weighted dollar"?

Here's how I look at it.

The total worldwide return of all available investible assets in any year is a certain number. It could be positive or negative. All those returns are divided up among all the investors like poker winnings/losses at the end of the night.

In order for one guy to win a Lot more than the average of all players, he must have taken those winnings from several individual losers, who did worse than the average.

Before the game starts, you have no idea who's going to win. But you know that many more people will lose(get less than average) than will win. And, in this case, you also have the options to not play (don't invest) or to accept the average return (whether it ends up positive, negative, or zero).

[Mister Imperceptible]

Harry Browne writes (and I agree) that even when you think you are ceding a choice, you are in fact making a choice. If you think index funds are unequivocally best, you are discounting systemic risks like arbitrage and the virtuous/vicious cycles of buying securities based on market cap, irrespective of price. In the long-run, price-insensitive purchases and arbitrage could be every much as detrimental to returns as fees of active management.

I’m not saying active management is definitely better. But there are no guarantees in life. Jack Bogle is just a man.

[IlliniDave]

I don't think the risk inherent to a US large cap index fund (like one that tracks SP500 index or Total US market) is much different than the risk of any other decent sized large cap fund out there. Same is true for any other segment of the market. Active or passive, they are both baskets of stocks drawn from the same pool, one is just managed in a way that is a lot less expensive.

I don't follow Dodge and Cox, but Wellington Mgmt (I'm pretty sure they manage Wellesley) and Primecap both seem to do a good job, as does American Funds (esp. if you can get them without paying a commission). Any fund with relatively low ERs/fees and relatively low turnover has a good possibility of being a strong long-term performer. If you think about it, a non-index fund with extremely low turnover is really a de facto index fund, just with a homemade index rather than one provided by the third-party services (SP, Russell, CRSP, MCSI, etc.). In my view, the real magic of index funds is pushing costs and turnover (essentially another form of cost) as low as they can go. Another thing to look for is funds that are willing to close to new investors (which limits the manager's gross income and hence profits, so not many do it). As the AUM size increases funds necessarily begin to approach the performance of total market style funds, there's no way around that, and it's especially true for funds that operate in small- and mid-cap spaces, and in specific sectors.

Nothing wrong with trying to beat the market by paying a little extra, just spend your fee money wisely. I would caution against expecting that you are eliminating significant portions of risk inherent to equities by owning essentially the same equities under active management. If you really fear the risk of equities, I'd say think about owning fewer equities. That will lower your risk.

I was specific to US above but the same is essentially true wrt overseas stocks.

I own some of one of the Primecap-managed funds at Vanguard (Capital Opportunity) and I like it. I'm waiting to pounce on an opportunity should one of the other closed Primecap-managed Vanguard Funds open up to new investors again. Usually it takes a market crash/panic for that to happen. I have a couple other low-fee active funds in my 401k (though the roster of options is > 75% index funds). In the one place where an index and an active fund overlap (small-cap) I put an equal amount in both. So far after ~4 years the performance is extremely close, but the index fund leads by a nose. Interstingly, the lead is is nearly identical to the difference in ERs.

[IlliniDave]

Before the game starts, you have no idea who's going to win. But you know that many more people will lose(get less than average) than will win. And, in this case, you also have the options to not play (don't invest) or to accept the average return (whether it ends up positive, negative, or zero).

Actually the one consistent winner is "the house". The asset managers essentially always win though the amount of their winnings vary as the value of the assets of their clients (who bear all the risk) varies. The exception is an outfit like Vanguard that is essentially a non-profit (though not per the formal legal definition).

[Farm_or]

The economical impacts of so many people indexing always peaks my interest. This is unprecedented. What do we know about the majority of said investors? How is this going to be a unique effect on future market swings?

Maybe I have not been looking in the right places, but I haven't seen a whole lot of data on this subject. I am assuming that most are employed and too busy to decide to all pull out at the same time.

I have a unique perspective for my reason to favor indexes. Once in awhile, a rock star money manager comes along and slays the benchmark for awhile. But most of the managers are average. Compare them to the CEO's of an index. The top 500 CEO's know a whole lot about their sector and especially their company. Those are the money managers that I prefer to employ.

[IlliniDave]

Farm_or,

If there were no index funds, what would all the people invested in index mutual funds (traditional mutual funds or ETFs) have done instead? The vast majority almost certainly would have invested their money in mutual funds anyway. A few might have spun up their own stock portfolios. The amount who would have never invested in the stock market were it not for the invention of index mutual funds is probably negligible. So in that scenario, when the inevitable next serious swoon/panic occurs, what would all those investors do and what would be the economic impact? Whatever it is, I'd bet it is pretty much the same net outcome as it will be the next time it happens IRL with index funds out there. Without index funds all the stocks currently in index funds would still be owned by the same people (in the aggregate), mostly in other mutual funds. So when everybody wants out of the market, they'd still get sold. I think a few years back Vanguard published some data that showed their clients tend to have somewhat lower portfolio turnover than the industry overall, but most people have a breaking point, even those who genuinely believe in pure buy and hold. So I don't think the indexers can be counted on to have a substantial mitigating effect on a crash, though I'd be happy to be proven wrong.

[ThisDinosaur]

That's a good point, IlliniDave, about if there were no index funds. Only counterpoint I'd say is that cap weighted indexes tend to exacerbate the large caps getting larger for no other reason than they're there first. Hypothetically a society of stock pickers and fund managers would be looking for inefficiencies and good deals.

[slowtraveler]

Slowly moving away from Dodge and Cox as a result of the higher turnover. Primecap really has my attention though and may take the Dodge and Cox portion, or maybe I'll just hold my VTIAX till I find a better alternative with that low turnover.

Comparing the index from 1970-2002 is different than the index after but there is no disclaimer for this. In 2002, all foreign companies got kicked off the S&P 500 even though they were among the best performers and it triggered extra taxes from the increased turnover (Unilever, Shell..), a few years later-float adjustment occured so index shareholders increase their stake when inside ownership decreases (ie-buying Microsoft stock at the peak of the bubble when Bill Gates is selling some shares), also there was another move later to include REITs in the index which are debt instruments and not stock.

But the worst move of all was when the S&P committee sold ratings. They allowed their reputation to deteriorate when junk bond debt obligations be sold as investment grade with the S&P approved rating. To allow a committee that has clearly changed and has committed fraud for profit to be responsible with deciding the rules of weighting my portfolio seems foolish at best. To compare the index after the new rules to before the new rules sounds naive at best. They have been corrupted by money and I've kept trying to find a better alternative.

The 6-7% really return over spans of 30+ years won't happen anymore with a publicly pooled index mutual fund due to the committee having fundamentally changed the index to accommodate the larger size of aum and their readiness to be bought out.

Vanguard, while known for its subpar customer service relative to Schwab and Fidelity, has no such corruption and has employed both Primecap and Wellington as active management companies.

[wolf]

I think when the people who own index funds panic, which is common, that it will drive down the prices of the stocks in the popular indeces more than stocks that are not tracked in the popular indeces.

In my opinion, there lies also an opportunity in it. When you expect such a behaviour, you could prepare yourself for that scenario, e.g. hoard cash in order to be liquid. When that overreaction happen and Index Funds are sold heavily, you can collect them for underpriced values. I think it is almost the same with value investing. Index Funds and the underlying asset valuations can get pretty "cheap" in a market downturn. So why not participate from that scenario? Index Funds maybe just another vehicel to invest in. Over- and under-valuation could happen to them also, as the same could happen to stocks.

[IlliniDave]

That's a good point, IlliniDave, about if there were no index funds. Only counterpoint I'd say is that cap weighted indexes tend to exacerbate the large caps getting larger for no other reason than they're there first. Hypothetically a society of stock pickers and fund managers would be looking for inefficiencies and good deals.

Without index funds that $4T or whatever would have to go somewhere. I think index funds spread it more evenly than pickers (who are still in the majority anyway, last I knew). And none of that matters much when investors start fleeing.

[IlliniDave]

slowtraveler, S&P the entity and its past failures aside, no one is required to use an SP500 style fund (my own personal preference is total market), but it is really hard to avoid all the companies on their list. And it not like S&P is picking bad companies or tainting the ones they include on their list. The list being an attempt to identify the best 500 companies (a subjective thing to start with) will have some turnover in composition, as does any index, but it will on average be far less than that of the typical professional managers portfolio.

[IlliniDave]

I think when the people who own index funds panic, which is common, that it will drive down the prices of the stocks in the popular indeces more than stocks that are not tracked in the popular indeces.

In my opinion, there lies also an opportunity in it. When you expect such a behaviour, you could prepare yourself for that scenario, e.g. hoard cash in order to be liquid. When that overreaction happen and Index Funds are sold heavily, you can collect them for underpriced values. I think it is almost the same with value investing. Index Funds and the underlying asset valuations can get pretty "cheap" in a market downturn. So why not participate from that scenario? Index Funds maybe just another vehicel to invest in. Over- and under-valuation could happen to them also, as the same could happen to stocks.

I don't think that has anything to do with index funds per se. Without index funds that same money would be spread around the market by the same investors who would engage in the same behavior under whatever conditions prompted a deep sell off. There were great values to be found buying index funds (and many other funds/stocks) in 2002 and 2009 when index funds were much smaller relative to market cap and less numerous than today. I think you can be certain that any massive selloff of index funds will be accompanied by an equal selloff with the other 60% of the money invested in the market. I also think the surge in popularity of index funds lately is in good measure because many investors who experienced both those crashes learned that "active" style management does not protect them under such conditions, so there's no reason to pay for that empty promise. But "bargains after a crash because ... index funds" I don't think adds up. "Bargains after a crash because ... human/investor behavior" is what I think is true.

People seem to want to believe that all the money that's gone into the market via index funds wouldn't have gone in without them, and that's not a premise I can get behind.

[Farm_or]

If I am understanding what you are saying, people investing doesn't much matter if they are indexing or active managed mutual funds. The same monies are ending up in the same companies?

I've read several generalizations about index investing impact and it's effect/ non-effect, but I have yet to see the Gaussian bell curve type of analysis that profiles the typical investors that are driving the 40% bus. It may benefit us to know that?

It may come to be no-thing, because the same human greed and fear creates the same response no matter the tool used for the job? But there might be something different here. For instance: the last dip we went through in February.

Some of the blame went to positive job reports creating anxiety for faster raising interest. Some of the blame went to market manipulation reporting false trades that triggered automatic trades so they could cash in on vix bets. But none of the blame went to vanguard investors, because it was reported that the majority of them did nothing. But the market did move and moved significant enough to be officially called a correction. Was that the tail wagging the dog?