Equal Parts Small, Mid, Large Cap Indexes

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avalpert
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Re: Equal Parts Small, Mid, Large Cap Indexes

Post by avalpert » Tue Aug 01, 2017 5:34 pm

Doc wrote:
avalpert wrote:For the record, I do tilt to small factor recognizing that it is increasing the risk of my portfolio with the hope that I generate additional return to compensate for that risk - I am under no illusion that I am more diversified than the market weightings
If you follow the arguments presented in "Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns With Less Volatility" by Larry Swedroe and Kevin Grogan, you can get the benefits of the small value overweight without increasing the overall portfolio risk by increasing your bond allocation.
Yes, though I don't think a debate on whether diversifying sources of risks increases return is relevant to this particular thread.

bigred77
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Re: Equal Parts Small, Mid, Large Cap Indexes

Post by bigred77 » Tue Aug 01, 2017 5:43 pm

jbolden1517 wrote:
Alexa9 wrote:I ask this because The Three Fund Portfolio seems to be good enough for most people on here.
The three fund portfolo is a bad portfolio. Now it is a lot better than many other portfolios, but it has serious problems. The bonds don't have enough duration risk to help with correlations. The USA stock portfolio ends up looking too much like a large growth portfolio. The national and international correlate strongly with one another. The satellite aspects are diluted and not rebalanced into enough, for example the small amount of duration risk is muted with so much "better cash" that's it is hard to rebalance in and out of. And then now unlike before, because indexing and quasi-indexing have become so popular in stocks it is becoming more susceptible in the USA (and global bond market) to manipulation by control players who can skim from these funds via. float manipulation.

Indexing a large market is a terrific way, probably the best way to hold down expenses and expenses come off the top. But any idea can be taken too far.

People like to talk about the virtue of simplicity with respect to 3 fund. Simplicity has its costs. All investments aren't equal. CAPM isn't true, the market isn't efficient in pricing for long term returns. Valuations do matter. Diversification among low correlating assets makes a huge difference in serial returns.
I don't think the 3 fund portfolio is a bad portfolio. I think it's perfectly fine for the vast majority of investors, especially retail investors with some 401ks and IRAs, and without a background in financial theory or asset management. My go to advice for almost all novice investors is target date fund, then 3 fund portfolio, then get more advanced ONLY when you can explain why you want to deviate, what you expect will happen, and are commited to sticking to your strategy through long periods of underperformance. Now you've gotten to like 2%-3% of the retail investor population. Is the 3 fund portfolio optimal in terms of obtaining the highest absolute returns, risk adjusted returns, or even reducing fat tail risk? No. But it gets most everyone 90%+ of the way there and that's all that really matters. One could so very easily do worse.

As for the bolded and underlined comment... That's a pretty strong assertion. I don't personally agree with it, but to each there own I guess.
jbolden1517 wrote:
aj76er wrote:
jbolden1517 wrote:because indexing and quasi-indexing have become so popular in stocks it is becoming more susceptible in the USA (and global bond market) to manipulation by control players who can skim from these funds via. float manipulation.
I've seen you mention this before but I'm not sure what it means. Could you please explain it?
Sure. Index funds aim to hold a constant percentage of a stock. Which means the dominant trading strategy excluding increasing the percentage ownership for index funds is to buy dilution (buy stock when control investors or the company sell shares) and sell concentration (sell into buybacks). Between indexing and quasi indexing (funds that in the aggregate act like index funds because they want to track closely to the market) we are at about 70% of the SP500.

If 70% of a stock's float is going to be bought regardless of price it becomes incredibly profitable for a company to create float and sell shares to index funds (I'm including quasi-indexing and passive here) as a way to use index funds as a cheap source of financing. In a normal market investors are rationally pricing stocks based on their future discounted dividends using a discount rate that adjusts for risk. Under normal valuation doubling the number of shares merely cuts the share price in half. Doubling the number of shares should have no impact on market cap. But of course index funds don't rationally evaluate the future stream of dividends. Indexers hold a constant portion of any stock, buying or selling based on float not dividend prospects. So when the number of shares double they have to slowly raise they buy target till they get the shares back in balance. This is the same thing that happens to short investors in a short squeeze. They will end up paying far more than the company is worth. Just imagine a stock with a P/B of 5 doubling its number of shares. The indexers go from holding 70% to 35% and thus have to buy 1/3 of the company or 2/3rds of the new float. If the P/B stays constant (doubtful the control investors would be quite that greedy but it explains the principle) that means the indexers end up with the same 70% of the assets and also a large cash position they paid $5 for every $1 of.

Now that cheap financing benefits the company and the passive investors own 70% of the company. So 70% of the lost $4 is going from their right pocket to the left pocket the same as if the index fund had directly written a loan to the company and then written the loan off. But the remaining $1.20 just fell on the floor. Its going to go to control investors, other investors, short sellers... That drain is huge. All this can be completely above board and disclosed because indexes don't read prospectus or PR statements. Companies can tell investors openly they are manipulating their float to squeeze index funds and the index funds still buy. Something similar to this happened for a decade (and arguably is still happening) to VPACX. Essentially you are in the business of funding negative interest bonds to SP500 high P/E stocks.

On the low side the opposite things happen to beaten down stocks that are buying back. Control investors can diminish float which forces index funds to sell to them, which allows them to diminish float cheaply, which forces more selling.... So after having the indexers sit for years while a company restructures its debt and is about to take off, control investors can essentially buy back at 2/3rds of the company cheaply from indexers and quasi-indexers. And not only that they can both games serially. Forcing the index funds to buy high, drive the stock down, sell low, let the stock rise, buy high... in an unending cycle.
I'd have to reread your post here a number of times to really wrap my arms around what your trying to say but I see a lot that I disagree with.

TSM is cap weighted, why are you saying they aim to hold a constant percentage of a stock? They change their target percentage of a stock whenever that stocks market cap changes or the market cap of the index itself changes. So when buybacks occur, the share price should go up a proportionate amount to keep the market cap the same less the cash used in the buyback (share price rises, number of shares outstanding decreases, market cap decreases by the amount of cash used. It's simply a way to return cash to the shareholders. No different then if that stock issued a dividend). If the "control investors" sell shares there is no reason an index fund has to buy them. Volume of non-index fund trading is huge. Why should this affect market cap unless a big player is dumping so many shares that they push the stock price down? Presumably another player would come in to pick up those shares (I guess this addresses your belief in inefficient markets). If the company is truly diluting ownership via equity offerings, at least they are bringing in new cash to the company which would ideally support a new higher market cap. Stock splits don't affect market cap or index fund buying/selling.

Lastly, index funds don't really control stock prices. The marginal buyer and seller do, which is going to be active traders. They can fight over the final percentage of volume and determine prices. Index funds simply accept prices. I have more faith in the active investors to keep prices in line than you do perhaps.

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Alexa9
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Re: Equal Parts Small, Mid, Large Cap Indexes

Post by Alexa9 » Tue Aug 01, 2017 6:13 pm

avalpert wrote: To me this smacks of constructing a portfolio based on random thoughts and feelings rather than systemic, rational analysis.
You tilt to small caps yourself. Enlighten us why since you're "systemic and rational."

avalpert
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Re: Equal Parts Small, Mid, Large Cap Indexes

Post by avalpert » Tue Aug 01, 2017 6:23 pm

Alexa9 wrote:
avalpert wrote: To me this smacks of constructing a portfolio based on random thoughts and feelings rather than systemic, rational analysis.
You tilt to small caps yourself. Enlighten us why since you're "systemic and rational."
Because I target a certain exposure to the SmB risk factor. based on my desired risk/return profile. I've found, for my target needs, the most efficient way to get that exposure (and maintain my desired exposure to beta, momentum and value) is using small and midcap value funds domestically and a small-cap fund along with large value internationally.

jbolden1517
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Re: Equal Parts Small, Mid, Large Cap Indexes

Post by jbolden1517 » Tue Aug 01, 2017 6:40 pm

bigred77 wrote: I'd have to reread your post here a number of times to really wrap my arms around what your trying to say but I see a lot that I disagree with.

TSM is cap weighted, why are you saying they aim to hold a constant percentage of a stock?
A TSM fund is trying to track an index of the entire market. To do that it has to hold a constant percentage of the market (call it X), excluding inflows and dividend reinvestment which simply ups the percentage. Since it isn't holding futures but rather stocks for stocks on which it doesn't do selection it is holding them at their market weight. That is to say it holds X% of stock S for all S.
bigred77 wrote: They change their target percentage of a stock whenever that stocks market cap changes or the market cap of the index itself changes.
Nope. If S shares double in price relative to the market then S's dollar percentage doubles. But the number of shares needing to be held doesn't change, it is still X%. Similarly if the market goes up or down relative that can change how much the X% of S impacts TSM it doesn't change the number of shares that need to be held.

Think this through till it makes sense.
bigred77 wrote: So when buybacks occur, the share price should go up a proportionate amount to keep the market cap the same less the cash used in the buyback (share price rises, number of shares outstanding decreases, market cap decreases by the amount of cash used. It's simply a way to return cash to the shareholders. No different then if that stock issued a dividend).
Yes exactly that's what should happen. And when the market was being more or less controlled by investors focused on 6-18 mo earnings that what did happen. A company buys back 10% of their outstanding shares their earnings per share are going to rise 10% and so the stock rises in price 10% keeping the price for those earnings , the market cap, the same.

What's changed is now approximately 70% of the market is controlled by investors tracking to an index (either explicitly or implicitly). Those investors are indifferent to earnings. They only care about holding a constant percentage of the stock. So when the float is reduced by 10% through buybacks they are now 10% overweight and respond by selling. They don't care abut price. They don't care about fundamentals. They care deeply about float.
bigred77 wrote: If the "control investors" sell shares there is no reason an index fund has to buy them.
Yes there is. It has to maintain its fixed percentage of the stock.
bigred77 wrote: Volume of non-index fund trading is huge.
Not according to the people who watch it. If you exclude arbitrage players (who also don't care about fundamentals, and have no intention of being in positions for long) 3/4s of the trades in the SP500 are passive investors.
bigred77 wrote: If the company is truly diluting ownership via equity offerings, at least they are bringing in new cash to the company which would ideally support a new higher market cap.
Yes they are. Which is what I said in my post. But the source of the new cash is index funds (again including quasi-indexers and passive). This is as if you wrote the company a loan and then forgave it. That would justify the higher market cap, but 100% of the cost is born by indexers while only 70% of the gains belong to them.
bigred77 wrote: Stock splits don't affect market cap or index fund buying/selling.
Stock splits don't affect market cap because index funds don't move away from their target percentage. Dilution does move index funds away from their target percentage.
bigred77 wrote: Lastly, index funds don't really control stock prices.
And you know this based on what?
bigred77 wrote: The marginal buyer and seller do,
Who are these "marginal buyer and sellers"? How much money are they managing? What are their volumes of trades?
bigred77 wrote: Index funds simply accept prices. I have more faith in the active investors to keep prices in line than you do perhaps.
You have more faith in active investors than the active investors. They are all saying that indexing the "etf-ication" of the market has destroyed the ability of 6-18 earnings based analysis to function in setting prices for investors with an 18mo horizon. They don't believe stock picking works anymore (at least for the SP500) because index funds (many passive, quasi-indexers) are indifferent to valuation.

All trading strategies have counter strategies that be used against them. Indexing was a counter strategy to the strategies that active managed mutual funds, pension funds and full service brokerages used. It was a successful counter strategy that has eliminated their ability to meaningfully gain return from research. The way it did that was it acted parasitically on the value of that research while not contributing to the cost to perform it arbitraging away the returns on research. The stock pickers no longer believe in stock picking. You convinced them. Congratulations you won! The claim here for years has been accepted, now they agree with you.

The people left now are the ones who weren't trying to stock pick in that sense in the first place. People for whom the research arbitrage had no impact. Control investors don't need to do research and market makers / arbitrage investors are researching entirely different things. You made it to the next round. New players, new strategies. You trade on float, they are happy to take the other side of float trades.
Last edited by jbolden1517 on Tue Aug 01, 2017 7:01 pm, edited 5 times in total.

Punta Cana DR
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Re: Equal Parts Small, Mid, Large Cap Indexes

Post by Punta Cana DR » Tue Aug 01, 2017 6:48 pm

This is a great forum!

My concern is that if everyone in the world modeled same purchase investment policies, we may inflate an asset class? I have recently been exposed to Paul Merriman and has me thinking?

Life is tough in the Dominican Republic :happy

bigred77
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Re: Equal Parts Small, Mid, Large Cap Indexes

Post by bigred77 » Tue Aug 01, 2017 7:16 pm

@jhbolden1517

I think I'm understanding your post better.

When you said "constant percentage" I assumed you meant percentage of the funds total holdings, not percentage of publically traded shares for any unique company.

I think I follow your thoughts on buybacks and reduced float but I don't see it as a problem for index fund investors. Buybacks increase share prices, funds sell them at higher prices to keep the ownership percentage constant, the fund effectively has the same dollar amount of the stock (lower shares but at higher prices) plus some amount of cash. Same dollar effect as a dividend (in terms of dollars invested in equities and dollars that are now in cash).

When you talk about "control investors" I assumed you were talking about active investors or those who hold a sizable ownership position in a publically traded company and can exert influence (Carl Icahn for example, or activist hedge funds). I think your actually referring to investors who own non-publically traded shares who decide to sell them on the open market. Effectively issuing more shares but without the cash going to the company to put to good use. Frankly I don't know how common that is or how index funds actually account for that (do they only consider market cap to be the value of shares publically trading and not total value of the company?) I think I'm getting above my pay grade here.

The rest of your comments I think boil down to the fact that we disagree on market efficiency. I think the market is pretty efficient over the long term. I think there are a sufficient number of arbitrage traders and active traders to set prices and keep markets, Ill call it "sufficiently effecient" in the short run and efficient enough in the long run to make indexing the superior choice.

Now my head hurts :mrgreen:

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