bertilak wrote: ↑
Fri Dec 15, 2017 6:36 pm
nedsaid wrote: ↑
Fri Dec 15, 2017 6:14 pm
bertilak wrote: ↑
Fri Dec 15, 2017 3:28 pm
I have said something similar in the past: As a TSM investor I am exposed to ALL factors, even ones that haven't been discovered yet.
Well, no. What you have is a market portfolio where the factors are all cancelled out except for perhaps Profitability/Quality and maybe a whiff of momentum. You have exposure to the Market factor as you hold the index. Well constructed indexes, such as the S&P indexes screen out what I call the "anti-factors" or the lottery stocks. Stocks have to achieve certain quality measurements just to be included in the better indexes. Seeing that Total Market is skewed towards the mega-caps, you have exposure to Profitability/Quality, the top 100 companies by market cap are 50% of the Total Market Index. Because Total Market is essentially a Large Core with a tilt towards Large Growth, you don't have exposure to the Small factor or the Value factor. Momentum, at least as can be captured by investors, is mostly a Large Growth phenomenon. You might have a whiff of momentum exposure.
In Total Market, you have Small Stocks, Value Stocks, Momentum Stocks but not the factors. They mostly are cancelled out with the two exceptions that I mentioned above.
An example of this is the Small Cap effect, which in the whole universe of stocks, seems to have disappeared. When you use let's say the S&P Small-Cap 600 Index, the Small Cap effect returns with a vengeance as the very act of indexing has taken out the lottery stocks. S&P requires that stocks in their indexes be profitable, thus the act of indexing itself does some screening for you. This is one reason that indexing works well, the junk just isn't there. One reason Vanguard Small Growth Index does pretty well, no junk.
I agree with that "Well, no" which is why I used the past tense (said ... in the past, not say now) and followed up with Swedroe's correction to that misconception (which, as mentioned, I accepted.) I COULD have mentioned Beta which is sort of the non-factor factor but that would have obfuscated the point. TSM, being cap-weighted, is NOT tilted in any way. It is the base-line from which actual tilts are measured. It's like saying vertical lines are "tilted" straight up, or tilted 0 degrees meaning not tilted at all. That's playing with semantics.
What I have tried and apparently failed to say is that the indexes don't contain the bad stocks the academics rail against. Small Growth is the "black hole of investing" and yet when you look at the Vanguard Small Growth Index it performs as well as the Vanguard Small Value Index which should reflect investing nirvana. For one thing, the bad stocks, the lottery stocks, the anti-factors, or whatever you want to call them are not present in the Vanguard Small Growth Index. Secondly, Vanguard doesn't do the best job of screening for size and value, its Small Cap Value Index contains a lot of Mid-Cap and it contains a lot of Core Stocks.
Yes, Total Market by definition isn't tilted towards anything as it is the market. You can't help but notice that the largest 100 companies have as much market cap as the other 3,200 companies in the index. In my view, this bakes in Profitability/Quality into the Total Market cake though supposedly there are no tilts. 50% in 100 companies looks a lot like a tilt to my untrained eye. Furthermore, in the Small-Cap and Micro-Cap space, Total Market has to invest in stocks that have enough liquidity to be investable. The Wild West stocks found on the NASDAQ Bulletin Board are just not there. It seems that the academics include stocks in their research that the indexes don't touch.
I also mentioned above that the Size factor works great when you put it in with Profitability/Quality. With the bad stuff mixed in, the Small-Cap stocks have no premium over larger stocks. Screen for profitability, the premium returns with a vengeance. Again, I point to the example of the S&P 600 Small-Cap Index. Profitability/Quality also helps Value and if you set Momentum to neutral, Value is helped even more.
Pretty much, I am saying that the well constructed indexes have already screened for Profitability/Quality. They are not as factor neutral as you would think. Shoot, even Total Market is not, in my view, factor neutral as it has a big dash of Profitability/Quality. I am also saying that the lottery stocks are sort of like the Bogeyman. Responsible investors should not touch the lottery stocks and yet the academics include them in their research even though they are absent in the indexes. If you hold a good index, like the Total Market or the S&P 500, you have the good stuff and not the bad stuff. The S&P 400 Mid-Cap and the S&P 600 Small-Cap are also good indexes.
Even Beta has a low volatility tilt to it. I think what kicked off factor research were the findings that low volatility stocks performed better than predicted and that high volatility stocks performed worse than predicted. I suspect that Profitability/Quality was involved. If Beta really was Beta, then except for the extremes at each end, returns should have gone up with volatility but they did not. In fact, Low Volatility performs better than High Volatility.
I hope that someone more articulate than I will come riding to my rescue. This is more than semantics.
A fool and his money are good for business.