What's next for passive investing?

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What's next for passive investing?

Postby M B » Mon Sep 26, 2011 4:12 am

It all started when people decided that what they cared about was exposure to a certain market (stocks, bonds, etc.), not the performance of some manager. The basic idea was to reduce costs to pay only for what you cared about. Tracking an index was a means of achieving this (soon to somehow become a goal in itself).

Then came the ETF: it could be traded all day long and gave access to narrow sectors or countries that other funds did not have. Neither characteristic was of great interest to long-term investors: the ETF was mostly a boon for speculators betting on this country or that sector. On the other hand (at least for private investors) they were close-ended, so redemptions did not increase the cost of running the fund. However, they cannot levy front loads, which could be used (even though this is not how they generally are used) as a tax on short holding periods. Also the increased number of intermediaries (broker, market-maker) means that part of the cost (brokerage and spread) is not used to run the fund.

Interestingly enough, none of this is buy-and-hold: all funds buy and sell due to inflows and outflows. Buy-and-hold would mean paying initially to cover trading costs but having no (or barely any) annual fees: if you are rich and have time ahead of you, true buy-and-hold is still cheaper than the cheapest fund. Will funds ever offer genuine buy-and-hold? This would mean that the cost of trading should be borne by those triggering it. Right now if there are outflows on Monday and inflows on Tuesday, the fund must sell then buy back, with the cost paid by all investors. A possible solution is to get your money back as soon as money is available from inflows rather than right now, securities would then seldom be sold.

There are now also funds based on a formula (not the opinion of a person) which are not based on market capitalization but instead on fundamentals: not the market weight but the economic weight, as some put it. Many find these blasphemous, others merely look at their performance (perhaps having some difficulty finding a really suitable benchmark).

What's next for passive investing?
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Postby gotherelate » Mon Sep 26, 2011 12:12 pm

Sounds like a good question to pose to the Bogleheads 10 panel of experts. Mel, are you reading?
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Postby staythecourse » Mon Sep 26, 2011 12:35 pm

Mr. Bogle talks about a dream fund which takes the 40 largest companies and holds it without doing anything to it forever, likely the true "buy and hold" you are describing. He, however, stated any fund company would do it as it is not profitable.

This type of fund would give redemptions in shares of the fund instead of cash when an investor wants to exit the fund to limit forced selling to cover sellers.

If you have the money and time this is a great option. The problem is what do you do about small cap or all the international funds?

The lowest cost portfolio would likely just buy the 30 largest companies and treasury bonds in 60/40 mix. That would be interesting.

Good luck.
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Postby Wagnerjb » Mon Sep 26, 2011 1:17 pm

staythecourse wrote:If you have the money and time this is a great option. The problem is what do you do about small cap or all the international funds?

The lowest cost portfolio would likely just buy the 30 largest companies and treasury bonds in 60/40 mix. That would be interesting.

Good luck.


You just use mutual funds for international and small caps. And - as you say - one can buy Treasury bonds directly. If the investor has a sizable nest egg, one could consider buying Muni bonds directly too, although one must be careful to have enough to achieve decent diversification. (And you need to be careful buying them, to avoid getting fleeced on the cost...and negating any ER savings that you would otherwise achieve).

Best wishes.
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Postby Dieharder » Mon Sep 26, 2011 2:37 pm

staythecourse wrote:Mr. Bogle talks about a dream fund which takes the 40 largest companies and holds it without doing anything to it forever, likely the true "buy and hold" you are describing. He, however, stated any fund company would do it as it is not profitable.

This type of fund would give redemptions in shares of the fund instead of cash when an investor wants to exit the fund to limit forced selling to cover sellers.

If you have the money and time this is a great option. The problem is what do you do about small cap or all the international funds?

The lowest cost portfolio would likely just buy the 30 largest companies and treasury bonds in 60/40 mix. That would be interesting.

Good luck.


This 30 or 40 large companies do not stay there forever in the 30 or 40 large companies. That makes this theory impossible to implement. It is a dynamic group, AAPL and XOM are the the largest companies now I believe. It used to be Cisco at one point during tech bubble, and then it was MSFT. Likewise some of the companies in top 30-40 from 1980 probaby do not exist today. Companies drop off the list due to bankruptcy, mergers, and acquisitions, as well as from drop in share value. New companies join the list, GOOG for instance.
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Postby nisiprius » Mon Sep 26, 2011 7:23 pm

Custom mutual funds, that let you choose from a menu of a hundred or so ETFs that track indices, choose percentage allocations between them, and, if you wish, choose target asset allocations that you want the fund to reach after 5, 10, 15, 20, 25, 30, 35 years. The custom fund invests in them, automatically rebalances, and interpolates smoothly between your target allocations.

Plus a menu of named, premapped choices like "Coffeehouse Portfolio."
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Postby Anon1234 » Mon Sep 26, 2011 7:37 pm

nisiprius wrote:Custom mutual funds, that let you choose from a menu of a hundred or so ETFs that track indices, choose percentage allocations between them, and, if you wish, choose target asset allocations that you want the fund to reach after 5, 10, 15, 20, 25, 30, 35 years. The custom fund invests in them, automatically rebalances, and interpolates smoothly between your target allocations.

Plus a menu of named, premapped choices like "Coffeehouse Portfolio."

Wouldn't it be great if they could take account of external holdings too?
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Postby A Devout Indexer » Mon Sep 26, 2011 8:30 pm

Dieharder wrote:
staythecourse wrote:Mr. Bogle talks about a dream fund which takes the 40 largest companies and holds it without doing anything to it forever, likely the true "buy and hold" you are describing. He, however, stated any fund company would do it as it is not profitable.

This type of fund would give redemptions in shares of the fund instead of cash when an investor wants to exit the fund to limit forced selling to cover sellers.

If you have the money and time this is a great option. The problem is what do you do about small cap or all the international funds?

The lowest cost portfolio would likely just buy the 30 largest companies and treasury bonds in 60/40 mix. That would be interesting.

Good luck.


This 30 or 40 large companies do not stay there forever in the 30 or 40 large companies. That makes this theory impossible to implement. It is a dynamic group, AAPL and XOM are the the largest companies now I believe. It used to be Cisco at one point during tech bubble, and then it was MSFT. Likewise some of the companies in top 30-40 from 1980 probaby do not exist today. Companies drop off the list due to bankruptcy, mergers, and acquisitions, as well as from drop in share value. New companies join the list, GOOG for instance.


http://www.researchaffiliates.com/ideas ... _Noise.pdf

The above paper from Rob Arnott finds that the largest stocks in the market persistently and significantly underperform the market (S&P 500) itself, so I think a no-fee, buy and hold portfolio of the largest stocks would turn out to be very costly.
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Postby Wagnerjb » Tue Sep 27, 2011 9:30 am

Dieharder wrote:This 30 or 40 large companies do not stay there forever in the 30 or 40 large companies. That makes this theory impossible to implement.


If "the theory" is holding the largest 30-40 companies forever and never doing anything....I agree with you. But if the theory is a passive portfolio which holds 30-40 very large companies, it is easily done. Will you have zero turnover forever? No. Will you have lower turnover than your index fund? Certainly. I think the OP's point is that you will be more passive than an index fund.

Best wishes.
Andy
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Postby Dieharder » Tue Sep 27, 2011 11:49 am

Wagnerjb wrote:
Dieharder wrote:This 30 or 40 large companies do not stay there forever in the 30 or 40 large companies. That makes this theory impossible to implement.


If "the theory" is holding the largest 30-40 companies forever and never doing anything....I agree with you. But if the theory is a passive portfolio which holds 30-40 very large companies, it is easily done. Will you have zero turnover forever? No. Will you have lower turnover than your index fund? Certainly. I think the OP's point is that you will be more passive than an index fund.

Best wishes.


I was responding to this comment:

Mr. Bogle talks about a dream fund which takes the 40 largest companies and holds it without doing anything to it forever, likely the true "buy and hold" you are describing.


It is nearly impossible to do nothing forever since companies go out of business sometimes. It is certainly possible to build a customized passive portfolio with very low turnover and very low costs. However, index funds are super cheap these days, for instance some retirement plans offer Vanguard Institutional Plus share class. It is possible to Index Total Stock Market for 0.02% and Total Bond Market for 0.05% through such plans.
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Postby lazyday » Wed Sep 28, 2011 7:42 am

Buy and hold forever has been tried before, I believe with unit investment trusts(?), perhaps many decades ago.

Merrill got into something like this around the turn of the century with their "HLDRS". Interesting, but never very popular. One complaint was all the annual reports IIRC. You actually have ownership of underling shares, including voting rights.

Over time, some of the problems mentioned here came to pass, as holdings became lopsided from corporate restructurings or resource conversions, and just from years of companies growing and shrinking.

http://www.holdrs.com
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staythecourse

Postby larryswedroe » Wed Sep 28, 2011 7:49 am

Something close to that already exists and has for long time

http://www.bridgewayfund.com/IN/strategies/bluechip35index/index.html

And BTW-Enron was once the 5th largest company and I would guess that many others that are no longer around or much smaller once fit that top 30-40 profile (perhaps some like Digital Equipment for example).

Note that of the original Dow 30 only one single one still exists, GE.
Last edited by larryswedroe on Wed Sep 28, 2011 7:51 am, edited 1 time in total.
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Postby lazyday » Wed Sep 28, 2011 7:49 am

I'm interested in passive funds that don't hold tightly to an index. Tracking error is allowed. Costly trading might be reduced, or kept to a minimum.

Already Bridgeway and DFA have passive funds that don't need to closely follow an index. But I'd like to see more: a fund that both minimizes internal trading costs and passes all those costs onto those who cause them.

This would be especially beneficial in illiquid markets such as microcap, emerging, deep value, or a combination.

Trading will already be reduced because the fund doesn't need to follow an index. However, internal trading may still be required for customer trading of the fund, and to avoid style drift.

I wonder if an ETF could be designed with different baskets for creation units and "destruction units." These baskets would change as needed to avoid style drift.

When fund is popular and many people are buying, shares would trade at a premium.

Similarly, when many are selling the fund, it would sell at a discount. The premium and discount are needed to pay for the creation and destruction of fund shares. This should happen automatically. Management could also dynamically adjust fees charged with basket creation/destruction if needed, such as charging double on the side with too much activity, and no fee on the other side.

A frequent trader might pay high costs, indirectly through premium and discount. A Boglehead might indirectly pay costs when first purchasing, and when selling, but would avoid all internal trading costs during the entire holding period.
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Postby Snowjob » Wed Sep 28, 2011 7:58 am

The uncontrolled inflows and outflows have pushed me further into the buy and hold individual stocks style of investing.
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Re: staythecourse

Postby Wagnerjb » Wed Sep 28, 2011 9:00 am

larryswedroe wrote:Something close to that already exists and has for long time

http://www.bridgewayfund.com/IN/strategies/bluechip35index/index.html

And BTW-Enron was once the 5th largest company and I would guess that many others that are no longer around or much smaller once fit that top 30-40 profile (perhaps some like Digital Equipment for example).

Note that of the original Dow 30 only one single one still exists, GE.


For those who are concerned about the "15 stock diversification myth", note that the 35-stock Bridgeway fund has matched the S&P500 (its benchmark) over the past 14 years since inception.

The fund actually beat the S&P500 by around 30 basis points, but the time period is probably too short to draw any conclusions. But part of this advantage is likely due to front-running of the S&P500, which a passive (non-index) portfolio doesn't suffer from.

Best wishes.
Andy
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