Market cap weighted index mutual funds like VTSMX

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Dog_Papa
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Market cap weighted index mutual funds like VTSMX

Post by Dog_Papa » Sat Aug 24, 2013 9:29 am

I have always wondered if there might be a better way to create a mutual fund. Say, a mix of weight by market cap and simply a fixed dollar amount in all stocks.
That way you would avoid having so much of investment in the very large cap stocks. Like Apple, Exxon Mobil, Google, Microsoft, Johnson & Johnson and GE. I believe
indexing forces the prices of the big caps up. Making them a less attractive stock to own. So, if an index just owned a fixed percentage in as many of the Wilshire 5000
as possible, that would eliminate that problem. They may not be a way to do that, with an index fund. Because most indexes a market cap weighted. See, what happens to a individual stock if it is put in the S & P 500, is it automatically goes up. Wouldn't this indicate indexing changing market forces?

Another problem with indexing as it begins to gain greater acceptance. Is that the market is efficient because we have all these MBA types from Harvard, Wharton and
the U of Chicago, scrutinizing every issue. As more people and institutions, go with index based investing and these MBA types become fewer in number. Won't the
market lose some efficiency? Then index funds won't work as well. In other words, the MBA types are necessary, in that they make the market efficient.

I notice on the web sites I look at, they don't give 10 yr performance on mutual funds. With 5 yr performance info, it appears some mutual funds have performed well.
But, when the 10 yr performance figures are also given, you can see performance regressing to the mean. Media doesn't want that info known, there are a lot of advertising dollars at stake. Index funds don't spend many of those dollars. Just some of my thinking on indexing and investing in index funds.

The Wizard
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Re: Market cap weighted index mutual funds like VTSMX

Post by The Wizard » Sat Aug 24, 2013 9:39 am

Active funds do the sorts of things you mention.
But a lot of folks seem to own a chunk of AAPL directly, as one example, so not just fund ownership pushing that price up.
Better to have various index funds exactly the way they are. If you don't like TSM, then there are MidCap index funds, for instance...
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momar
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Re: Market cap weighted index mutual funds like VTSMX

Post by momar » Sat Aug 24, 2013 9:53 am

You could combine the Rydex S&P Equal Weight fund with a cap weighted fund.
"Index funds have a place in your portfolio, but you'll never beat the index with them." - Words of wisdom from a Fidelity rep

gvsucavie03
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Re: Market cap weighted index mutual funds like VTSMX

Post by gvsucavie03 » Sat Aug 24, 2013 9:55 am

Not sure where you are going with the "MBA-types from Harvard" thought....

Placing equal weight on individual stocks seems like it would create more active management within an index fund. It'd be fairly easy to automatically calculate the weight of the stocks in VTSMX based on their current value. In its simplest form, if you purchased one share of every stock in the Wilshire 5000 index, you would just about have the VTSMX - except you'd have a rebalancing nightmare on your hands when values change the next day.

In this scenario you present, one would own MANY more individual small stocks for every 1 Apple, Exxon, etc. Using your argument, that would drive prices in small caps up faster than large caps.

I don't believe there is an "equal weight" TSM index fund, but I know simply owning 3 index funds of equal weight (34/33/33) of large, mid and small caps would be very close to the same thing in an individual portfolio. It is an interesting thought you bring up, and many investors "tilt" towards mid and small caps for this reason and also because there is a potential for higher returns.

I don't see indexing bringing down market efficiency because the day trading, marketing, and investment "porn" drives people towards hot stock picks and actively managed funds. It'd also be like saying cooking from scratch will drag down the economy when you have a McDonald's on every corner.

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Re: Market cap weighted index mutual funds like VTSMX

Post by pkcrafter » Sat Aug 24, 2013 11:28 am

Another problem with indexing as it begins to gain greater acceptance. Is that the market is efficient because we have all these MBA types from Harvard, Wharton and the U of Chicago, scrutinizing every issue. As more people and institutions, go with index based investing and these MBA types become fewer in number. Won't the market lose some efficiency? Then index funds won't work as well. In other words, the MBA types are necessary, in that they make the market efficient.

OK, they are necessary, and they are immediately ready to pounce on any great opportunity that comes along, so there is no way indexing can become so prevalent that the market becomes inefficient. If it ever did become obviously inefficient, more pro investors would immediately start trading and immediately wipe out any perceived advantage. Then there's the problem is even knowing if it's inefficient or not. Pros already think the market is inefficient, and it is or isn't depending on how it's defined.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Dog_Papa
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Re: Market cap weighted index mutual funds like VTSMX

Post by Dog_Papa » Sat Aug 24, 2013 11:42 am

gvsucavie03 wrote:Not sure where you are going with the "MBA-types from Harvard" thought....

What I have noticed, in the world I have been living in, is that business management seems to reflect academic theory as opposed to real business experience. Not picking on Harvard, just using it as a metaphor for this phenomenon. In my view, an example are customer service surveys. Some, companies seem lost in this concept. Even before you have any interaction, they are trying to get you to fill out a survey. Then after interaction with an employee, you get a phone call, emails and snail mail too.

Seems like a waste of time and money. I also wonder how much real value, those surveys would be to a business. I think the real goal is gathering info to help control employees and reduce labor costs. It also gives management a tool, because they then have a written document, they can use or just discard, depending on the situation and management's goals. I have a strong feeling this concept has an academic genesis. It sure can be a real nuisance.

Over the yrs, I have noticed many businesses don't seem very well run. I have always wondered why. I think using academic theory is part of the reason. People being promoted, not due to competence, but as a reward for performing a difficult job for many yrs, is also a part of the reason.

I do agree with your comments on owning multiple index funds, solves the market cap weighted problem I mentioned. Overall, I just question if market weighting of
a portfolio is the way to go, as opposed to a portfolio based on a different concept.

I do feel indexing is having an effect on the market and many have a vested interest, in keeping the public from better understanding, of the concept and understanding how the markets really work.

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Re: Market cap weighted index mutual funds like VTSMX

Post by gvsucavie03 » Sat Aug 24, 2013 2:41 pm

Dog_Papa wrote:I do agree with your comments on owning multiple index funds, solves the market cap weighted problem I mentioned. Overall, I just question if market weighting of
a portfolio is the way to go, as opposed to a portfolio based on a different concept.


An interesting thought. If it is efficiency you are after and skipping all of the research/theoretical stuff, indexing is definitely the way to go.

What works better... a 3-fund portfolio that owns the entire world markets proportionally based on each fund's different security holdings or having 8-10 funds that "tilt" towards smaller funds and sectors?? That's the question we probably all have! Is there an even better way than what Bogle himself suggests??? :idea:

I think some bigger factors are risk tolerance, asset allocation in multiple accounts that creates as efficient of a rebalancing event as possible, tax efficiency and personal preference. Slicing up all of the various security holdings into their appropriate caps/sectors/styles compounds a portfolio's complexity and a lot of people don't have this in their 401(k)'s or have room in IRAs, so the tax efficiency can really become a hassle.

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nedsaid
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Re: Market cap weighted index mutual funds like VTSMX

Post by nedsaid » Sat Aug 24, 2013 3:58 pm

If you are concerning about having "too many" large cap stocks in Total Stock Market, why not couple Total Stock Market with a small cap index? The exact weightings are up to you.

I personally am overweighted small caps. I have 16% versus 9% for the Total Stock Market Index. I also tilt to Value.

The problem with "smart" indexing and "smart" this and that is that you drift closer and closer to active managment. The concern you have is shared by many. Solve it by buying more small caps.
A fool and his money are good for business.

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JoMoney
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Re: Market cap weighted index mutual funds like VTSMX

Post by JoMoney » Sat Aug 24, 2013 7:50 pm

There may be issues with massive amounts of money being indexed, converging correlations, poor valuations, etc... Cap-weighting may exacerbate it (if it truly is a problem). During the dot-com boom there was a "large-cap effect" that seemed to coincide with indexing. There have been many papers outlining problems of passive indexing (usually put out by those who have an interest in promoting active investing).
Despite any issues that may or may not exist in passive cap-weighted indexing, I find it hard to believe there is a "better way to create a mutual fund".
There are some simple truths that make it irrelevant for the majority of equity investors. If anyone has good arguments against these PLEASE EDUCATE ME :happy

1. The universe of investors can't achieve more than the market creates. Effectively half the investments will earn more, half less than whatever the market does. The market is cap-weighted. Tilting to any particular stock, sector, style, alternate weighting, etc... doesn't change the zero-sum nature of trying to outperform the market.

2. VTSMX is (for most people) the cheapest most effective way to broadly cover the market (U.S.). You may be able to out-perform by tilting in some direction, but you also might under-perform. The net result of under-performing to out-performing the market will be zero-sum. The one certainty is you'll probably have to pay more in expenses to speculate.

3. In order to justify actively investing or tilting toward anything you have to believe you have information other people don't have (or that they're just wrong in their beliefs about the information). Speculating against the market creates additional risks.

4. Dr.Bernstein's paper ( http://www.efficientfrontier.com/ef/900/15st.htm ) shows pretty clearly that although you may be able to diversify by just picking a group of stocks, there are relatively few "Superstocks" that perform above-average. If you diversify widely enough you can hope to garner some of these above-average gains. If you miss out on whatever is hot at the moment, you risk under-performing the overall market.

5. Wall Street makes their money through activity and encouraging active trading and management fees. Investors do better by keeping expenses low.

6. You may be able to out-perform the market by timing it (simply being out the market before it drops). This creates a whole new series of problems. It looks very simple in hindsight, but the reality is much different. The probability that you can guess a good time to enter or exit the market may be 50/50. But that's just one time, when you reverse and re-enter/exit you have to be correct in your timing again. The odds of your consistent guessing get worse and worse. If you feel you're not guessing but are basing it on market valuations it creates other problems: You have no idea how high valuations can go - "Markets can remain irrational longer than you can remain solvent.", and getting back in to the market is even worse - trying to catch a falling knife is emotionally taxing, the valuations always look bad (that's why the market is falling), you have no idea how far down the market may "over-react", and if you wait until everything is cheerful and "hear the robins sing" spring time is over and you've missed the best prices. Despite all the smooth charts and graphs and the momentum of stocks on the rise, the market is not serially correlated. At any given moment the stock can suddenly jump from one price to a much higher or lower price. Typically this only happens going down when liquidity drys up and nobody wants to buy. There is no guarantee you can time your selling to get out at any given price.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Market cap weighted index mutual funds like VTSMX

Post by pkcrafter » Sat Aug 24, 2013 8:39 pm

Dog-pa, you can apply your theory because equal-weighted indexes and fundamental indexes are available. Equal-weighting overweights stocks that the consensus of investors do not believe should be overweighted, and there is no rationale to overweighting stocks the cap-weighted index does not weight more. Fundamental indexing is a value and mid/small tilt. Go for it.

The S&P500 did rise to incredible heights in the late 90s because it was tracking what investors were doing, which was acting irrational. But in the crash, the NASDAQ lost ~80%, the S&P500 lost ~50%.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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JoMoney
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Re: Market cap weighted index mutual funds like VTSMX

Post by JoMoney » Sat Aug 24, 2013 9:08 pm

pkcrafter wrote:The S&P500 did rise to incredible heights in the late 90s because it was tracking what investors were doing, which was acting irrational. But in the crash, the NASDAQ lost ~80%, the S&P500 lost ~50%.


To add my speculations - part of the "large-cap effect" that played out in '99-2000 showed a high premium on the price investors were paying for S&P500 earnings over small and mid-sized companies. This premium is no longer apparent. If anything, investors are currently paying a premium on earnings to buy small-cap stocks and high-dividend stocks.

I am biased in that 99% of my equities are focused around the S&P500. Not because I chose to speculate it will out-perform some other index, it was simply the best option available to me. But I do find myself finding information to justify my prior actions. Whatever you decide, you need a plan, understand why you chose the strategy you did, and "stay the course" :happy
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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