Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
User avatar
Topic Author
Forester
Posts: 623
Joined: Sat Jan 19, 2019 2:50 pm
Location: UK

Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Forester » Sat Aug 24, 2019 6:03 am

https://podcasts.apple.com/us/podcast/r ... 0447426382

Rob Arnott discusses value vs growth over the last few decades and how passive indexes are prone to holding on to large megacap stocks with a high chance of subsequent underperformance. Microsoft was the only top-10 tech stock in 1999 to beat the S&P 500 over the next 20 years.

columbia
Posts: 2162
Joined: Tue Aug 27, 2013 5:30 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by columbia » Sat Aug 24, 2019 6:09 am

Passive indexes are also prone to holding onto companies which subsequently outpace the market, including adding new ones.

User avatar
Topic Author
Forester
Posts: 623
Joined: Sat Jan 19, 2019 2:50 pm
Location: UK

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Forester » Sat Aug 24, 2019 6:16 am

columbia wrote:
Sat Aug 24, 2019 6:09 am
Passive indexes are also prone to holding onto companies which subsequently outpace the market, including adding new ones.
True, that none of the winners will be missed. He still has a point though. Let's say Robotics becomes the industry craze of the 2030s, then the S&P 500 would be prone to another bubble-and-bust scenario as played out in 2000. Even if an indexer had misgivings about the concentration of megacap names in one sector, he/she would still be forced to go along for the ride.

User avatar
nisiprius
Advisory Board
Posts: 39779
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by nisiprius » Sat Aug 24, 2019 6:31 am

Here is how Rob Arnott's firm's RAFI fundamental indexing strategy, as embodied in the Schwab Fundamental US Broad Index ETF, has fared compared to Total Stock. RAFI blue, total market orange.

Source

Image

So, FNDB was holding Microsoft as 1.94% of total--while Total Stock's held of MSFT at 3.50%. On the other hand, FNDB was holding Apple at 4.02% while Total Stock was only holding it at 3.00%. Big deal.

The Vanguard international small-cap fund doesn't go back as far as the SFILX, the Schwab Fundamental International Small-cap Index Fund, but SCZ, the iShares MSCI EAFE Small-Cap ETF, does.

Source

Image

The RAFI fund did show moderately lower risk in the form of a less severe decline in 2008-2009; PortfolioVisualizer scores it as -50.43% for SFILX versus -56.38% for SCV, but there's only a tiny superiority in Sharpe ratio (0.33 versus 0.31) and overall, since inception, the two came out pretty close together.

Emerging markets. SFENX, Schwab Fundamental Emerging Markets Large Company Index Fund (blue), versus VEMAX, the Vanguard Emerging Markets Stock Index Fund.

Source

Image

The rhetoric for fundamental indexing sounds plausible, but in the real world, running real money in real funds I don't see any compelling evidence of superiority. "Achilles heel?" Not even plantar fasciitis. Randomly jigger the weights a bit and get random differences in performance, I think.
Last edited by nisiprius on Sat Aug 24, 2019 8:07 am, edited 1 time in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

David Althaus
Posts: 129
Joined: Wed Feb 14, 2018 8:05 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by David Althaus » Sat Aug 24, 2019 7:55 am

He inadvertently drove home the perils of adopting such a strategy when he allowed that his return was 10% vs. 13% of a period of time which I don't recall. That means subsequent years returns suffered by the earlier relatively poorer performance. Reversion to mean gets most of these guys. I rest easy at 72 knowing that VTI reverts to the mean each and every day and can identify trends before anyone sees them coming. When people use the word "has" they are often implying "will" about the future. Maybe. Maybe not.

All the best

User avatar
nisiprius
Advisory Board
Posts: 39779
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by nisiprius » Sat Aug 24, 2019 8:42 am

In the Vanguard Total Stock Market Index Fund, as in the market itself, the ten largest holdings constitute 18.3% of the portfolio:

Image

And in FNDB, the Schwab Fundamental U.S. Broad Market Index ETF, whose "goal is to track as closely as possible, before fees and expenses, the total return of the Russell RAFI™ US Index," after downloading the current holdings and doing some editing and rearranging, looking at the same ten stocks, I find that:

Image
  • the ten largest holdings in FNDB constitute about 18.43% of the portfolio, about the same as VTI
  • 60% of the top ten stocks in VTI are also among the top ten stocks in FNDB
  • those ten largest holdings in Total Stock--the ten largest stocks in the market by cap weight--constitute 13.20% of the RAFI fundamental index
  • the RAFI methodology has indeed cut way down on Amazon, Facebook, Google (Alphabet) and VISA, while putting over twice as into ExxonMobil
  • But, it's still true that RAFI has put almost 20% of its money into 0.6% of its stocks (10/1641).
So it's not that RAFI gets very far from the bedrock reality that most of the money in the market is in the stocks of the largest companies. If you believe that RAFI is superior to cap-weighting, it can't be because it avoids mega-caps, because it doesn't.

You have to believe that it successfully identifies the better mega-caps. That is, it is (yet another) stock-picking formula. Maybe you want ExxonMobil and don't Alphabet, in which case you might prefer the RAFI index, but it can't be on the basis of "don't want to put too much into the biggest companies."
Last edited by nisiprius on Sat Aug 24, 2019 9:27 am, edited 5 times in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

User avatar
JoMoney
Posts: 8198
Joined: Tue Jul 23, 2013 5:31 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by JoMoney » Sat Aug 24, 2019 9:10 am

*shrug*... when in a withdrawal stage I'll be selling off more of those large mega-caps, and over the period I bought at held them I'll have captured the return of the broad stock market. After they pay their fees and trading expenses, the broad markets return will be better than the returns of those following other strategies. In aggregate, alternative weightings and trading machinations can't generate anything extra (other than fees for those who work in the industry).
Success with some alternate weighting scheme carries with it the seeds of its own destruction. Predominately these strategies will focus more on smaller narrower areas of the market that are simply unable to absorb the price impact of higher demand, inevitably more prone to "bubbles" and lower future returns.

When these alternative "index" funds were first being introduced in 2006, with their impressive back-testing, John Bogle wrote an Op Ed in the WSJ
"Turn on a Paradigm?"
... First let us put to rest the canard that the remarkable success of traditional marketweighted indexing rests on the notion that markets must be efficient. Even if our stock
markets were inefficient, capitalization-weighted indexing would still be -- must be -- an
optimal investment strategy. All the stocks in the market must be held by someone. Thus,
investors as a whole must earn the market return when that return is measured by a
capitalization-weighted total stock market index. We can not live in Garrison Keillor's
Lake Wobegon, where all the children are above average. For every investor who
outperforms the market, there must be another investor who underperforms. Beating the
market, in principle, must be a zero-sum game. ...

... While we have witnessed many "new paradigms" over the years, none have persisted.
The "concept" stocks of the Go-Go years in the 1960s came, and went. So did the "Nifty
Fifty" era that soon followed. The "January Effect" of small-cap superiority came, and
went. Option-income funds and "Government Plus" funds came, and went. High-tech
stocks and "new economy" funds came as well, and the survivors remain far below their
peaks. Intelligent investors should approach with extreme caution any claim that a "new
paradigm" is here to stay. That's not the way financial markets work.
Since 2006, Mr. Bogles Op Ed, WIsom Tree's DTD, - "Dividend" fund focused on Siegel's "Dvididend Factor",
PRF - Arnott's "Fundamental Indexing", and DFA's Fama French Small-Value Factor fund DFSVX
... Vanguard's Total Market VTI bested them all
Image
(I will concede that the DTD dividend focused fund, despite lower returns, did have a higher focus on lower risk larger-cap stocks, so risk adjusted returns may have been better... but the strategy was primarily sold on it's returns)
Last edited by JoMoney on Sat Aug 24, 2019 9:21 am, edited 2 times in total.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

Dottie57
Posts: 7561
Joined: Thu May 19, 2016 5:43 pm
Location: Earth Northern Hemisphere

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Dottie57 » Sat Aug 24, 2019 9:12 am

columbia wrote:
Sat Aug 24, 2019 6:09 am
Passive indexes are also prone to holding onto companies which subsequently outpace the market, including adding new ones.
Thank you.

User avatar
nisiprius
Advisory Board
Posts: 39779
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by nisiprius » Sat Aug 24, 2019 9:47 am

What we find is that indexing itself has an important Achilles' heel. You're weighting stocks in direct proportion to the price of the stock and to its market capitalization. If a stock doubles in price, its weight in the portfolio doubles, all else equal. And why would you want to do that? Why would you want to have twice as much invested in the stock just because it has recently doubled in price?
Arnott can say "why would you want to do that?" with raised eyebrows in a tone of voice that implies that nobody would. But there is a perfectly good, rational answer to what was intended to be a rhetorical question.

"Because under one strong but not totally crazy set of assumptions, the market portfolio has the highest risk-adjusted return."

Another answer is "because if I do that, I do not need to pay any transaction fees."

"Why would you want to have twice as much invested in the stock just because it has recently doubled in price" is clever wording. It's spin. A phrase like "Why would you want to have twice as much invested in the stock..." mentally makes you think that when the stock doubles in price you run out and buy more. But actually, it is what happens when you do nothing.

When I write, half of the letters I type are just six of the 26 letters of the alphabet: E, T, A, O, I, N. Why would I want to do that? Because it happens naturally. Without even trying, I reflect the letter frequencies of the English language.

And if I don't, if I stray too far from a statistical analysis of glyph popularity, and try to avoid roughly matching it, my writing sounds odd, unnatural, stiff, laborious, and awkward. It sounds as if I am just clumsily showing off my ability to play with words. Mayhap you think it is good writing, you can do so. But I find it rational to match that natural statistical composition of writing symbols, according to my mother idiom's corpus of words, and, thus, to sound normal.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

User avatar
Topic Author
Forester
Posts: 623
Joined: Sat Jan 19, 2019 2:50 pm
Location: UK

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Forester » Sat Aug 24, 2019 10:57 am

Arnott said on the podcast that their strategies automatically dial back the value exposure if the value-growth spread is narrow vs history. I think the performance of PRF is pretty good, it's lagged the S&P 500 a little yet the P/E & P/B look well-placed against the S&P 500 if value makes a come back. (Or more accurately, if "value sectors" make a come back). All the S&P 500 lead comes from September 2017.

https://www.invesco.com/portal/site/us/ ... ductId=prf

https://www.invesco.com/portal/site/us/ ... top-50-etf

User avatar
JoMoney
Posts: 8198
Joined: Tue Jul 23, 2013 5:31 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by JoMoney » Sat Aug 24, 2019 11:35 am

Forester wrote:
Sat Aug 24, 2019 10:57 am
Arnott said on the podcast that their strategies automatically dial back the value exposure if the value-growth spread is narrow vs history. I think the performance of PRF is pretty good, it's lagged the S&P 500 a little yet the P/E & P/B look well-placed against the S&P 500 if value makes a come back. (Or more accurately, if "value sectors" make a come back). All the S&P 500 lead comes from September 2017.

https://www.invesco.com/portal/site/us/ ... ductId=prf

https://www.invesco.com/portal/site/us/ ... top-50-etf
" If.... "
And all the while having higher expenses, and exposure to higher risk regardless....
Even at the peak of PRF's performance (from start to 2014) it had higher standard deviation, and higher exposure to the small and value risk factors, and lower "risk adjusted" returns than VTI
PV Link inception-2014
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

User avatar
Carlos Danger
Posts: 147
Joined: Fri Mar 16, 2018 6:32 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Carlos Danger » Sat Aug 24, 2019 3:13 pm

Forester wrote:
Sat Aug 24, 2019 6:03 am


Rob Arnott discusses . . . how passive indexes are prone to holding on to large megacap stocks with a high chance of subsequent underperformance.
Apparently so is he. Overweight Apple and Exxon? :oops: I think I'll stick with the index.

ReadyOrNot
Posts: 243
Joined: Sun Aug 21, 2016 1:51 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by ReadyOrNot » Sat Aug 24, 2019 3:36 pm

So few megacorp stocks can beat the S&P500. How is this a problem if you own an index fund which tracks the S&P500?

garlandwhizzer
Posts: 2568
Joined: Fri Aug 06, 2010 3:42 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by garlandwhizzer » Sat Aug 24, 2019 3:55 pm

nisi wrote:

The rhetoric for fundamental indexing sounds plausible, but in the real world, running real money in real funds I don't see any compelling evidence of superiority. "Achilles heel?" Not even plantar fasciitis. Randomly jigger the weights a bit and get random differences in performance
1+

I think nisi sums it up well. Theoretically fundamental indexing is very appealing. It is supposed to harvest the value premium and perhaps add some quality as well, hence avoiding at least partially the long spells of underperformance that value periodically goes through. I myself have bitten on this lure. So far however reality has made its own case against US fundamental index outperformance in spite of that appeal. SFLNX, the Schwab Fundamental US Large Company Index whose fundamental index was designed by Arnott, has been in existence since 2007, 12 years. During that time frame it has underperformed Vanguard's TSM fund which is supposedly dominated by mega-caps that are destined to underperform. Yes, dumb beta has so far beaten smart beta. Maybe dumb beta is smarter than we think. It is certainly possible that this will reverse in the future, but like real multi-factor funds since their inception a few years ago, fundamental index results are to date underwhelming. If this trend continues some investors might start to question the reliability of the academic models to explain and forecast stock returns. After all most of us would prefer a simple less expensive investment approach that actually puts real money in our pockets rather a portfolio with attractive and appealing factor loads according to the academic model flavor of the month (3?,4?,5? factors: F&F?, AQR?, Alpha Architect?). My strong suspicion is that if we take factor funds as a group, not just pick the winners, we'll find that on average factor funds underperform comparable indexes in most situations.

Garland Whizzer

Northern Flicker
Posts: 5072
Joined: Fri Apr 10, 2015 12:29 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Northern Flicker » Sun Aug 25, 2019 1:24 am

Rob Arnott discusses value vs growth over the last few decades and how passive indexes are prone to holding on to large megacap stocks with a high chance of subsequent underperformance. Microsoft was the only top-10 tech stock in 1999 to beat the S&P 500 over the next 20 years.
As soon as I read that he cherry-picked 1999 as the start year to tout the underperformance of megacaps (and promote his product strategy) I lost all interest in listening to the podcast.
Index fund investor since 1987.

User avatar
Topic Author
Forester
Posts: 623
Joined: Sat Jan 19, 2019 2:50 pm
Location: UK

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Forester » Sat Aug 31, 2019 7:02 am

To summarise Arnott, reading his Fundamental Index book;

- During the collapse of the dotcom bubble, an average 401(k) participant with $100k invested in the S&P 500 lost almost $4k alone on just one stock - Cisco Systems.

- While the S&P 500 lost 9% in 2000, the average NYSE stock had a double-digit gain.

dharrythomas
Posts: 1003
Joined: Tue Jun 19, 2007 4:46 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by dharrythomas » Sat Aug 31, 2019 10:13 am

If you want someone to value tilt for you this is reasonable. It would be cheaper to add some of the Vanguard Indexes to TSM and would accomplish about the same thing.

User avatar
Topic Author
Forester
Posts: 623
Joined: Sat Jan 19, 2019 2:50 pm
Location: UK

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Forester » Sat Aug 31, 2019 10:17 am

dharrythomas wrote:
Sat Aug 31, 2019 10:13 am
If you want someone to value tilt for you this is reasonable. It would be cheaper to add some of the Vanguard Indexes to TSM and would accomplish about the same thing.
Yeh I agree, one could kind of take Arnott's side in the argument but simply own a SCV fund alongside the TSM rather than use a large cap factor fund.

User avatar
JoMoney
Posts: 8198
Joined: Tue Jul 23, 2013 5:31 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by JoMoney » Sat Aug 31, 2019 10:30 am

Forester wrote:
Sat Aug 31, 2019 7:02 am
To summarise Arnott, reading his Fundamental Index book;

- During the collapse of the dotcom bubble, an average 401(k) participant with $100k invested in the S&P 500 lost almost $4k alone on just one stock - Cisco Systems.

- While the S&P 500 lost 9% in 2000, the average NYSE stock had a double-digit gain.
The dot-com bubble period was not typical market performance though, over many other periods the "average stock" is a failure.

Image
http://read.jpmorgan.com/i/371035-eotm- ... tion/0?m4=

Of over 13,000 stocks that traded on the Russell 3000 and the S&P 500 Index from 1980-2014:
-40% of those 13,000 stocks analyzed suffered a PERMANENT DECLINE of 60%-70%+ from their peak value that they never recovered from
-67% of the 13,000 stocks’ returns were lower than the Russell 3000 Index return
-Over 320 companies were dropped from the S&P 500 Index due to “business distress” or failure (even large stocks aren’t immune)
The “distress rate” of individual stocks is significantly higher than the distress rate of a stock index
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

randomguy
Posts: 8535
Joined: Wed Sep 17, 2014 9:00 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by randomguy » Sat Aug 31, 2019 11:01 am

nisiprius wrote:
Sat Aug 24, 2019 6:31 am
Here is how Rob Arnott's firm's RAFI fundamental indexing strategy, as embodied in the Schwab Fundamental US Broad Index ETF, has fared compared to Total Stock. RAFI blue, total market orange.

<deleted some graphs>

The rhetoric for fundamental indexing sounds plausible, but in the real world, running real money in real funds I don't see any compelling evidence of superiority. "Achilles heel?" Not even plantar fasciitis. Randomly jigger the weights a bit and get random differences in performance, I think.
Sure. The questions is was the last 10 years a bad period for fundamental investing and a good one for indexing or vice versa? If this is the worst case for fundamental investing but the best cases is like all those back testing years where you get decent out performance, sign me up. Obviously that is the unanswerable question. The guy who started a Small Value fund in 1995 looked like an idiot. The guy who did in 2000 looked like a genius. Same strategy different parts of the cycle. All of this factor style investing basically requires a leap of faith and to some extent that is why it might work. If everyone tried to do it, the premiums would go away. As it is they MIGHT still exists going forward.

Arnott is definitely a salesman pushing his companies products. He might also be right.

User avatar
nisiprius
Advisory Board
Posts: 39779
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by nisiprius » Sat Aug 31, 2019 12:06 pm

randomguy wrote:
Sat Aug 31, 2019 11:01 am
nisiprius wrote:
Sat Aug 24, 2019 6:31 am
Here is how Rob Arnott's firm's RAFI fundamental indexing strategy, as embodied in the Schwab Fundamental US Broad Index ETF, has fared compared to Total Stock. RAFI blue, total market orange.

<deleted some graphs>

The rhetoric for fundamental indexing sounds plausible, but in the real world, running real money in real funds I don't see any compelling evidence of superiority. "Achilles heel?" Not even plantar fasciitis. Randomly jigger the weights a bit and get random differences in performance, I think.
Sure. The questions is was the last 10 years a bad period for fundamental investing and a good one for indexing or vice versa? If this is the worst case for fundamental investing but the best cases is like all those back testing years where you get decent out performance, sign me up. Obviously that is the unanswerable question. The guy who started a Small Value fund in 1995 looked like an idiot. The guy who did in 2000 looked like a genius. Same strategy different parts of the cycle. All of this factor style investing basically requires a leap of faith and to some extent that is why it might work. If everyone tried to do it, the premiums would go away. As it is they MIGHT still exists going forward.

Arnott is definitely a salesman pushing his companies products. He might also be right.
Sure. But in the case of SFILX I wasn't looking at "the last ten years," I was looking at a time period starting at 1/31/2008, 11-1/2 years, which may seem like a distinction without a difference, but that's long enough to include the Global Financial Crisis. So didn't that give fundamental indexing a chance to prove itself over a whole market cycle?

But, you tell me. Your personal opinion. Serious question.

1) How many years would you say is a fair number fo a typical "market cycle?"

2) How many market cycles do you think we need to see in order to make a fair judgement about the value of a strategy?
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

User avatar
Topic Author
Forester
Posts: 623
Joined: Sat Jan 19, 2019 2:50 pm
Location: UK

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Forester » Sat Aug 31, 2019 1:01 pm

I would rather own VOO & IJS than pay 0.41% for the Fundamental Index product. The problem Arnott has identified is better remedied via portfolio construction, than by trying to pick one fund to do it all.

columbia
Posts: 2162
Joined: Tue Aug 27, 2013 5:30 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by columbia » Sat Aug 31, 2019 1:06 pm

He’s trying to remedy the problem of you not giving him your money. ;)

Elysium
Posts: 1944
Joined: Mon Apr 02, 2007 6:22 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Elysium » Sun Sep 01, 2019 7:26 am

garlandwhizzer wrote:
Sat Aug 24, 2019 3:55 pm
My strong suspicion is that if we take factor funds as a group, not just pick the winners, we'll find that on average factor funds underperform comparable indexes in most situations.

Garland Whizzer
You hit the nail on the head. It isn't just a suspicion, it is the truth. If you average out the factors then you would get returns similar to the market minus the cost, and since factor strategies are more expensive, not just the fund fees but trading costs (hedging, long/short in some cases), then they as a group must underperform after costs, include taxes and the drag is even more. This is the same logic used by factor proponents against active managers, then they simply follow active management in the name of academic theory.

User avatar
vineviz
Posts: 5391
Joined: Tue May 15, 2018 1:55 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by vineviz » Sun Sep 01, 2019 7:57 am

Elysium wrote:
Sun Sep 01, 2019 7:26 am
garlandwhizzer wrote:
Sat Aug 24, 2019 3:55 pm
My strong suspicion is that if we take factor funds as a group, not just pick the winners, we'll find that on average factor funds underperform comparable indexes in most situations.

Garland Whizzer
You hit the nail on the head. It isn't just a suspicion, it is the truth. If you average out the factors then you would get returns similar to the market minus the cost, and since factor strategies are more expensive, not just the fund fees but trading costs (hedging, long/short in some cases), then they as a group must underperform after costs, include taxes and the drag is even more. This is the same logic used by factor proponents against active managers, then they simply follow active management in the name of academic theory.
There are lots of loosely defined terms and assertions here, so it’s hard to pin down the actual claim, but the analogy isn’t apt: factor funds, in aggregate, don’t necessarily hold a market-mimicking portfolio.

In fact, is is unlikely that they do so if you define “factor strategies” with the normal meaning.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

randomguy
Posts: 8535
Joined: Wed Sep 17, 2014 9:00 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by randomguy » Sun Sep 01, 2019 10:42 am

nisiprius wrote:
Sat Aug 31, 2019 12:06 pm
randomguy wrote:
Sat Aug 31, 2019 11:01 am
nisiprius wrote:
Sat Aug 24, 2019 6:31 am
Here is how Rob Arnott's firm's RAFI fundamental indexing strategy, as embodied in the Schwab Fundamental US Broad Index ETF, has fared compared to Total Stock. RAFI blue, total market orange.

<deleted some graphs>

The rhetoric for fundamental indexing sounds plausible, but in the real world, running real money in real funds I don't see any compelling evidence of superiority. "Achilles heel?" Not even plantar fasciitis. Randomly jigger the weights a bit and get random differences in performance, I think.
Sure. The questions is was the last 10 years a bad period for fundamental investing and a good one for indexing or vice versa? If this is the worst case for fundamental investing but the best cases is like all those back testing years where you get decent out performance, sign me up. Obviously that is the unanswerable question. The guy who started a Small Value fund in 1995 looked like an idiot. The guy who did in 2000 looked like a genius. Same strategy different parts of the cycle. All of this factor style investing basically requires a leap of faith and to some extent that is why it might work. If everyone tried to do it, the premiums would go away. As it is they MIGHT still exists going forward.

Arnott is definitely a salesman pushing his companies products. He might also be right.
Sure. But in the case of SFILX I wasn't looking at "the last ten years," I was looking at a time period starting at 1/31/2008, 11-1/2 years, which may seem like a distinction without a difference, but that's long enough to include the Global Financial Crisis. So didn't that give fundamental indexing a chance to prove itself over a whole market cycle?

But, you tell me. Your personal opinion. Serious question.

1) How many years would you say is a fair number fo a typical "market cycle?"

2) How many market cycles do you think we need to see in order to make a fair judgement about the value of a strategy?
And why do you think including the global financial crisis matters? 11 years is still obviously way too short when looking at investing strategies. Lets look at some numbers from a simple example
2008-2019
Total market 8.35%
SV . 7.87%
Clearly SV is a load of crap right? What happens if we add in a few more years
2000-2019
Total Market . 5.85
SV 9.29

Hmm there is pretty much the exact premium we expect. Now fundentamental investing isn't exactly SV (they do weight towards value and size among other things) but you get the basic idea of how 11 years isn't remotely enough to draw any conclusions.

How many years of data? 50+. Seriously we have some 15+ year cycles (bond rates), some 5 year ones of sector rotation and so on. You need a lot of data to not just catch one favorable trend. And you also want to make sure you have enough cycles that you just aren't capturing 3 years of A, 4 years of B, and 4 years of A so that what you are comparing is 2 cycles of A to 1 cycle of B.

If you want to judge this fund, go look at the back testing data and see how often we have 11 year periods like this. You might find they are pretty common (25% of the time). It is easy to see the results and say that fundamental return 12%, index returns 10% and expect a 2% outperformance over a 10 year time period.But you might also find you get +4% half the time and -2% the other half for a net outperformance of 2%. Pretty much all of the SV outperformance of the last 20 years was in 2000-2 where you made close to an extra 20%/year by using this strategy. You can either go, you need to be patient or you can go this doesn't work cause you have to wait 15+ years.

User avatar
JoMoney
Posts: 8198
Joined: Tue Jul 23, 2013 5:31 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by JoMoney » Sun Sep 01, 2019 10:56 am

DFA's Small-Value fund DFSVX from inception, compared to it's less "valuey" sibling the original DFA small-cap "factor" fund DFSCX:
Image

DFA's small-cap DFSCX fund from inception, compared to Vanguard's S&P 500 index fund (VFIAX)
Image
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

User avatar
Topic Author
Forester
Posts: 623
Joined: Sat Jan 19, 2019 2:50 pm
Location: UK

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Forester » Sun Sep 01, 2019 11:02 am

JoMoney wrote:
Sun Sep 01, 2019 10:56 am
DFA's small-cap DFSCX fund from inception, compared to Vanguard's S&P 500 index fund (VFIAX)
Image
What is that intended to prove? One zigs while the other zags - job done.

User avatar
JoMoney
Posts: 8198
Joined: Tue Jul 23, 2013 5:31 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by JoMoney » Sun Sep 01, 2019 11:21 am

Image
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

typical.investor
Posts: 1364
Joined: Mon Jun 11, 2018 3:17 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by typical.investor » Sun Sep 01, 2019 11:34 am

nisiprius wrote:
Sat Aug 31, 2019 12:06 pm

But, you tell me. Your personal opinion. Serious question.

1) How many years would you say is a fair number fo a typical "market cycle?"

2) How many market cycles do you think we need to see in order to make a fair judgement about the value of a strategy?
I think it's fair to look at fund performance since inception. It's not been a time when value has done well, but let's look.

Note 1) EM Small value did relatively well compared to EM Large. RAFI has no exposure there, and I use DGS so included it.
Note 2) RAFI is a value strategy. Let's use the funds Larry listed in his recent post on factor investing working. If I didn't get the best performing DFA fund, it's not deliberate. Please correct any errors.

Int Dev Large Apr 2007 - Aug 2019
Vanguard Developed Markets Index Admiral 1.85% (includes small caps which helped)
Schwab Fdmtl Intl Lg Co Idx 1.52%
DFA International Value I 0.32%

Int Dev Small Feb 2008 - Aug 2019
Schwab Fdmtl Intl Sm Co Idx 4.81%
iShares MSCI EAFE Small-Cap ETF 4.44%
DFA International Small Cap Value I 3.58%

EM Large (Feb 2008 - Aug 2019)
Schwab Fdmtl Emerg Mkts Lg Co Idx 1.41%
Vanguard Emerging Mkts Stock Idx Adm 1.32%
DFA Emerging Markets Value I 0.79%

EM Small(Feb 2008 - Aug 2019)
DGS WisdomTree Emerging Markets SmCp Div ETF 3.85%
DFA Emerging Markets Small Cap I 3.69%

US Large (Apr 2007 - Aug 2019)
Vanguard Total Stock Mkt Idx Adm 8.29%
Schwab Fundamental US Large Company Idx 7.79%
Vanguard Value Index I 6.61%
DFA US Large Cap Value III 6.51%

US Small (Apr 2007 - Aug 2019)
Vanguard Small-Cap ETF 7.99%
Schwab Fundamental US Small Company Idx 7.63%
Vanguard Small-Cap Value ETF 6.71%
DFA US Small Cap Value I 4.58%

My conclusions:
[*]RAFI isn't going to beat the market when growth does well.
[*]RAFI performs better than typical value strategies (especially considering DFA has an advisors fee) when growth does well.
[*]Value strategies will likely do better in time. It's been a period of widening valuations and we know that hurts value.
[*]Who knows how RAFI will do when value does well. Probably not as good as DFA but better than market cap funds.
[*]I don't think any investor needs to hold RAFI over Vanguard cap weighted funds, despite what Arnott may say. Even assuming there is ultimately a value premium, the time to capture is so long it seems to be causing people to abandon their attempt. RAFI has warned about that a very long time now.

Comments?

countmein
Posts: 480
Joined: Fri Dec 06, 2013 9:10 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by countmein » Sun Sep 01, 2019 12:27 pm

JoMoney wrote:
Sat Aug 24, 2019 9:10 am
After they pay their fees and trading expenses, the broad markets return will be better than the returns of those following other strategies. In aggregate, alternative weightings and trading machinations can't generate anything extra (other than fees for those who work in the industry).
Success with some alternate weighting scheme carries with it the seeds of its own destruction. Predominately these strategies will focus more on smaller narrower areas of the market that are simply unable to absorb the price impact of higher demand, inevitably more prone to "bubbles" and lower future returns.
This is too strong of an assertion. For example, MTUM, since inception, has returned 133% vs VTI's 104%, with stellar tax efficiency. Momentum has been well-known and applied for decades. Where are the "seeds of its own destruction"?

countmein
Posts: 480
Joined: Fri Dec 06, 2013 9:10 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by countmein » Sun Sep 01, 2019 12:53 pm

Forester wrote:
Sun Sep 01, 2019 11:02 am
JoMoney wrote:
Sun Sep 01, 2019 10:56 am
DFA's small-cap DFSCX fund from inception, compared to Vanguard's S&P 500 index fund (VFIAX)
Image
What is that intended to prove? One zigs while the other zags - job done.
It was intended to mislead, unfortunately. DFA small value has outperformed TSM since inception, as you'd expect.

DFSVX growth of 10K: 143K
VFIAX growth of 10K: 108K

Image

Elysium
Posts: 1944
Joined: Mon Apr 02, 2007 6:22 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Elysium » Sun Sep 01, 2019 2:16 pm

vineviz wrote:
Sun Sep 01, 2019 7:57 am
Elysium wrote:
Sun Sep 01, 2019 7:26 am
garlandwhizzer wrote:
Sat Aug 24, 2019 3:55 pm
My strong suspicion is that if we take factor funds as a group, not just pick the winners, we'll find that on average factor funds underperform comparable indexes in most situations.

Garland Whizzer
You hit the nail on the head. It isn't just a suspicion, it is the truth. If you average out the factors then you would get returns similar to the market minus the cost, and since factor strategies are more expensive, not just the fund fees but trading costs (hedging, long/short in some cases), then they as a group must underperform after costs, include taxes and the drag is even more. This is the same logic used by factor proponents against active managers, then they simply follow active management in the name of academic theory.
There are lots of loosely defined terms and assertions here, so it’s hard to pin down the actual claim, but the analogy isn’t apt: factor funds, in aggregate, don’t necessarily hold a market-mimicking portfolio.

In fact, is is unlikely that they do so if you define “factor strategies” with the normal meaning.
It is hard to pin down perhaps because the strategies are not clearly defined and the definitions are always changing. Between practitioners and within the industry there seems to be no consensus, and everyone has way of slicing and dicing based on their favorite model. Rob Arnott's fundamental weighting is not same as DFA 3- factor models (or is 5-now? I lost track), or AQR.

As an example, Momentum was not considered in the original 3-factor model, now they have recognized it and started including it. As we saw above, if you add that to a Value portfolio, you end up diluting Value loads, then you have the issue of the stocks leaving one portfolio and bought in another, resulting in inefficiencies. This isn't same as re-creating the market portfolio of course, that was an oversimplification to get the point across, which is when you add this and that, you end up with a portfolio that may end up trailing the market, then you end up making justifications such as getting different risk exposures are worth the effort, so on.

User avatar
willthrill81
Posts: 15204
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by willthrill81 » Sun Sep 01, 2019 2:45 pm

There's no beating around the bush: total market funds are large cap funds for all intents and purposes. From 1993 until now, the annualized returns of VTSMX (TSM) and VFINX (S&P 500) were separated by just one basis point, and all other metrics were nearly identical.

That doesn't make TSM or market-cap weighing necessarily bad. It is what it is. But there's no denying what it is.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
willthrill81
Posts: 15204
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by willthrill81 » Sun Sep 01, 2019 2:49 pm

Forester wrote:
Sat Aug 24, 2019 6:03 am
Microsoft was the only top-10 tech stock in 1999 to beat the S&P 500 over the next 20 years.
If you move the starting year to 2000, not one of the top 10 largest cap-weighted stocks outperformed the S&P 500.
At the beginning of 2000, the 10 largest market-cap tech stocks in the United States, collectively representing a 25% share of the S&P 500 Index—Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm, and HP—did not live up to the excessively optimistic expectations. Over the next 18 years, not a single one beat the market: five produced positive returns, averaging 3.2% a year compounded, far lower than the market return, and two failed outright. Of the five that produced negative returns, the average outcome was a loss of 7.2% a year, or 12.6% a year less than the S&P 500.
emphasis added
https://www.researchaffiliates.com/en_u ... -what.html

I brought up this issue in this thread last year.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

skeptic42
Posts: 81
Joined: Mon Feb 11, 2019 5:27 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by skeptic42 » Sun Sep 01, 2019 5:27 pm

willthrill81 wrote:
Sun Sep 01, 2019 2:45 pm
There's no beating around the bush: total market funds are large cap funds for all intents and purposes. From 1993 until now, the annualized returns of VTSMX (TSM) and VFINX (S&P 500) were separated by just one basis point, and all other metrics were nearly identical.

That doesn't make TSM or market-cap weighing necessarily bad. It is what it is. But there's no denying what it is.
The market itself is market-cap weighted. By definition, TSM is only exposed to market beta. So, there is no (negative) exposure to the size factor. How can one reconcile that with your observation that total market funds are large cap funds?

stlutz
Posts: 5511
Joined: Fri Jan 02, 2009 1:08 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by stlutz » Sun Sep 01, 2019 5:56 pm

skeptic42 wrote:
Sun Sep 01, 2019 5:27 pm
willthrill81 wrote:
Sun Sep 01, 2019 2:45 pm
There's no beating around the bush: total market funds are large cap funds for all intents and purposes. From 1993 until now, the annualized returns of VTSMX (TSM) and VFINX (S&P 500) were separated by just one basis point, and all other metrics were nearly identical.

That doesn't make TSM or market-cap weighing necessarily bad. It is what it is. But there's no denying what it is.
The market itself is market-cap weighted. By definition, TSM is only exposed to market beta. So, there is no (negative) exposure to the size factor. How can one reconcile that with your observation that total market funds are large cap funds?
"Smallcap" stocks are usually defined as the bottom 10-15% of overall market cap. So, by definition then, most of the market is "large". Not sure that this really tells you much of anything.

One could call the bottom 50% "small" and then the market is evenly split between the two.

User avatar
vineviz
Posts: 5391
Joined: Tue May 15, 2018 1:55 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by vineviz » Sun Sep 01, 2019 6:14 pm

skeptic42 wrote:
Sun Sep 01, 2019 5:27 pm
The market itself is market-cap weighted. By definition, TSM is only exposed to market beta. So, there is no (negative) exposure to the size factor. How can one reconcile that with your observation that total market funds are large cap funds?
It's true that TSM has zero exposure to the size factor, but I think that's not exactly what willthrill81 was referring to. I think he was referring to the more colloquial classification schemes used by Mornginstar, Lipper, and the like.

When you decompose the risk of TSM into two components (the large cap (e.g. S&P 500) portion and the rest), 85% of the risk exposure is coming from the large cap portion.

I agree with willthrill81 that effect of VTSMX (TSM) and VFINX (S&P 500) in portfolio are going be virtually identical "for all intents and purposes."
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

randomguy
Posts: 8535
Joined: Wed Sep 17, 2014 9:00 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by randomguy » Sun Sep 01, 2019 7:04 pm

willthrill81 wrote:
Sun Sep 01, 2019 2:49 pm
Forester wrote:
Sat Aug 24, 2019 6:03 am
Microsoft was the only top-10 tech stock in 1999 to beat the S&P 500 over the next 20 years.
If you move the starting year to 2000, not one of the top 10 largest cap-weighted stocks outperformed the S&P 500.
At the beginning of 2000, the 10 largest market-cap tech stocks in the United States, collectively representing a 25% share of the S&P 500 Index—Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm, and HP—did not live up to the excessively optimistic expectations. Over the next 18 years, not a single one beat the market: five produced positive returns, averaging 3.2% a year compounded, far lower than the market return, and two failed outright. Of the five that produced negative returns, the average outcome was a loss of 7.2% a year, or 12.6% a year less than the S&P 500.
emphasis added
https://www.researchaffiliates.com/en_u ... -what.html

I brought up this issue in this thread last year.
And historically how have the returns been when you eliminate the top 20 companies from your portfolio? How many times has TSM-20 outperformed TSM over say 10 year rolling periods since 1950?

The argument that index just buys the latest winners has been around forever. But I am unaware of people finding ways to exploit this to make money.

Elysium
Posts: 1944
Joined: Mon Apr 02, 2007 6:22 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Elysium » Sun Sep 01, 2019 7:22 pm

vineviz wrote:
Sun Sep 01, 2019 6:14 pm
I agree with willthrill81 that effect of VTSMX (TSM) and VFINX (S&P 500) in portfolio are going be virtually identical "for all intents and purposes."
This is a well established fact. Not a new information, I recall these discussions on previous forum back in early 2000's and most people understood Wilshire 5K and 500 Index are interchangeable, with nearly no difference in performance. That proves nothing though, other than S&P 500 is a good representation of the U.S Market.

User avatar
willthrill81
Posts: 15204
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by willthrill81 » Sun Sep 01, 2019 7:33 pm

Elysium wrote:
Sun Sep 01, 2019 7:22 pm
vineviz wrote:
Sun Sep 01, 2019 6:14 pm
I agree with willthrill81 that effect of VTSMX (TSM) and VFINX (S&P 500) in portfolio are going be virtually identical "for all intents and purposes."
This is a well established fact. Not a new information, I recall these discussions on previous forum back in early 2000's and most people understood Wilshire 5K and 500 Index are interchangeable, with nearly no difference in performance. That proves nothing though, other than S&P 500 is a good representation of the U.S Market.
It means that from an operational standpoint, TSM has virtually no meaningful exposure to anything other than large-caps. We have a few posters here who pontificate about the fact that TSM includes small-caps by their market-cap weighting, but this is essentially meaningless from a differentiation standpoint from a 'pure' large-cap fund. The quantity of small-caps included in TSM are just not enough to 'move the needle' compared to fund/portfolio of only large-caps.
Last edited by willthrill81 on Sun Sep 01, 2019 7:39 pm, edited 1 time in total.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
willthrill81
Posts: 15204
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by willthrill81 » Sun Sep 01, 2019 7:38 pm

randomguy wrote:
Sun Sep 01, 2019 7:04 pm
willthrill81 wrote:
Sun Sep 01, 2019 2:49 pm
Forester wrote:
Sat Aug 24, 2019 6:03 am
Microsoft was the only top-10 tech stock in 1999 to beat the S&P 500 over the next 20 years.
If you move the starting year to 2000, not one of the top 10 largest cap-weighted stocks outperformed the S&P 500.
At the beginning of 2000, the 10 largest market-cap tech stocks in the United States, collectively representing a 25% share of the S&P 500 Index—Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm, and HP—did not live up to the excessively optimistic expectations. Over the next 18 years, not a single one beat the market: five produced positive returns, averaging 3.2% a year compounded, far lower than the market return, and two failed outright. Of the five that produced negative returns, the average outcome was a loss of 7.2% a year, or 12.6% a year less than the S&P 500.
emphasis added
https://www.researchaffiliates.com/en_u ... -what.html

I brought up this issue in this thread last year.
And historically how have the returns been when you eliminate the top 20 companies from your portfolio? How many times has TSM-20 outperformed TSM over say 10 year rolling periods since 1950?

The argument that index just buys the latest winners has been around forever. But I am unaware of people finding ways to exploit this to make money.
I'm not saying that the result noted above was a persistent one, namely, that the top market-cap weighted companies underperform the rest of the market, although others have (e.g. Meb Faber), nor that it would be exploitable if it existed. But it does illustrate that the largest companies as defined by market-cap weighting can individually and collectively woefully underperform the rest of the market over a lengthy period of time. This runs counter to what a few posters have suggested here from time to time (i.e. buying only FANG stocks).
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

Elysium
Posts: 1944
Joined: Mon Apr 02, 2007 6:22 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Elysium » Mon Sep 02, 2019 8:04 am

willthrill81 wrote:
Sun Sep 01, 2019 7:33 pm
Elysium wrote:
Sun Sep 01, 2019 7:22 pm
vineviz wrote:
Sun Sep 01, 2019 6:14 pm
I agree with willthrill81 that effect of VTSMX (TSM) and VFINX (S&P 500) in portfolio are going be virtually identical "for all intents and purposes."
This is a well established fact. Not a new information, I recall these discussions on previous forum back in early 2000's and most people understood Wilshire 5K and 500 Index are interchangeable, with nearly no difference in performance. That proves nothing though, other than S&P 500 is a good representation of the U.S Market.
It means that from an operational standpoint, TSM has virtually no meaningful exposure to anything other than large-caps. We have a few posters here who pontificate about the fact that TSM includes small-caps by their market-cap weighting, but this is essentially meaningless from a differentiation standpoint from a 'pure' large-cap fund. The quantity of small-caps included in TSM are just not enough to 'move the needle' compared to fund/portfolio of only large-caps.
That's like saying the market is nothing but a collection of large caps stocks and nothing else, which is inherently wrong. Labeling of mutual funds is one thing, beyond that the market is a true representation of all publicly traded securities by their weight in the market. In other words someone did not decide randomly that Apple should be 3% of the market, is it so by nature of their contribution of the GDP as a whole. It is determined by thousands of decisions that millions of people make every day. Same can be said of some SCV company selling IT services out of Clearwater FL. You cannot weight the two as same and then say it is increasing your diversification. Market portfolio already contains the small company, just at a weight appropriate for their contribution to the GDP.

Anyhow, these discussions have happened at great length on this forums over the years, and I can't think of any single piece of information that wasn't uncovered, and we are still at the state where people claiming their side is correct.

To me, deviating from the market portfolio is an active strategy seeking higher alpha, however you project it, and I am fine with it so long as we all know what that is. Just don't call it a superior strategy.

reformed.trader
Posts: 80
Joined: Sat Apr 15, 2017 11:14 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by reformed.trader » Mon Sep 02, 2019 8:22 am

Judging FNDB and other fundamental indices over the last 10 years alone will only confirm existing biases of market cap junkies. If I had to choose VTI vs FNDB, I would go with FNDB. But if I wanted the tilts to factors FNDB offers, I would rather choose a fund that targets those factors specifically.

User avatar
willthrill81
Posts: 15204
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by willthrill81 » Mon Sep 02, 2019 8:59 am

Elysium wrote:
Mon Sep 02, 2019 8:04 am
willthrill81 wrote:
Sun Sep 01, 2019 7:33 pm
Elysium wrote:
Sun Sep 01, 2019 7:22 pm
vineviz wrote:
Sun Sep 01, 2019 6:14 pm
I agree with willthrill81 that effect of VTSMX (TSM) and VFINX (S&P 500) in portfolio are going be virtually identical "for all intents and purposes."
This is a well established fact. Not a new information, I recall these discussions on previous forum back in early 2000's and most people understood Wilshire 5K and 500 Index are interchangeable, with nearly no difference in performance. That proves nothing though, other than S&P 500 is a good representation of the U.S Market.
It means that from an operational standpoint, TSM has virtually no meaningful exposure to anything other than large-caps. We have a few posters here who pontificate about the fact that TSM includes small-caps by their market-cap weighting, but this is essentially meaningless from a differentiation standpoint from a 'pure' large-cap fund. The quantity of small-caps included in TSM are just not enough to 'move the needle' compared to fund/portfolio of only large-caps.
That's like saying the market is nothing but a collection of large caps stocks and nothing else, which is inherently wrong. Labeling of mutual funds is one thing, beyond that the market is a true representation of all publicly traded securities by their weight in the market. In other words someone did not decide randomly that Apple should be 3% of the market, is it so by nature of their contribution of the GDP as a whole. It is determined by thousands of decisions that millions of people make every day. Same can be said of some SCV company selling IT services out of Clearwater FL. You cannot weight the two as same and then say it is increasing your diversification. Market portfolio already contains the small company, just at a weight appropriate for their contribution to the GDP.
As I said before,
That doesn't make TSM or market-cap weighing necessarily bad. It is what it is. But there's no denying what it is.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
vineviz
Posts: 5391
Joined: Tue May 15, 2018 1:55 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by vineviz » Mon Sep 02, 2019 8:59 am

Elysium wrote:
Mon Sep 02, 2019 8:04 am
willthrill81 wrote:
Sun Sep 01, 2019 7:33 pm
Elysium wrote:
Sun Sep 01, 2019 7:22 pm
vineviz wrote:
Sun Sep 01, 2019 6:14 pm
I agree with willthrill81 that effect of VTSMX (TSM) and VFINX (S&P 500) in portfolio are going be virtually identical "for all intents and purposes."
This is a well established fact. Not a new information, I recall these discussions on previous forum back in early 2000's and most people understood Wilshire 5K and 500 Index are interchangeable, with nearly no difference in performance. That proves nothing though, other than S&P 500 is a good representation of the U.S Market.
It means that from an operational standpoint, TSM has virtually no meaningful exposure to anything other than large-caps. We have a few posters here who pontificate about the fact that TSM includes small-caps by their market-cap weighting, but this is essentially meaningless from a differentiation standpoint from a 'pure' large-cap fund. The quantity of small-caps included in TSM are just not enough to 'move the needle' compared to fund/portfolio of only large-caps.
That's like saying the market is nothing but a collection of large caps stocks and nothing else, which is inherently wrong.
That's not what people are saying. They are pointing out the the market is MOSTLY a collection of large cap stocks, which is objectively true: the 100 largest US stocks make up over 50% of the total US stock market capitalization. This is why the S&P 100 has a correlation of 0.97 with the total US stock market.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

User avatar
JoMoney
Posts: 8198
Joined: Tue Jul 23, 2013 5:31 am

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by JoMoney » Mon Sep 02, 2019 9:08 am

vineviz wrote:
Mon Sep 02, 2019 8:59 am
... the market is MOSTLY a collection of large cap stocks, which is objectively true: the 100 largest US stocks make up over 50% of the total US stock market capitalization. This is why the S&P 100 has a correlation of 0.97 with the total US stock market.
... the 'Extended Market' that has everything not in the S&P 500 is around .96 correlated with the Total Stock Market
Link
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

User avatar
vineviz
Posts: 5391
Joined: Tue May 15, 2018 1:55 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by vineviz » Mon Sep 02, 2019 9:14 am

JoMoney wrote:
Mon Sep 02, 2019 9:08 am
vineviz wrote:
Mon Sep 02, 2019 8:59 am
... the market is MOSTLY a collection of large cap stocks, which is objectively true: the 100 largest US stocks make up over 50% of the total US stock market capitalization. This is why the S&P 100 has a correlation of 0.97 with the total US stock market.
... the 'Extended Market' that has everything not in the S&P 500 is around .96 correlated with the Total Stock Market
Link
This is certainly true, and it's one of the reasons that something like Vanguard S&P Small-Cap 600 Value ETF (VIOV) is a better diversifier than Vanguard Extended Market ETF (VXF).
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Elysium
Posts: 1944
Joined: Mon Apr 02, 2007 6:22 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by Elysium » Mon Sep 02, 2019 5:19 pm

vineviz wrote:
Mon Sep 02, 2019 8:59 am
Elysium wrote:
Mon Sep 02, 2019 8:04 am
willthrill81 wrote:
Sun Sep 01, 2019 7:33 pm
Elysium wrote:
Sun Sep 01, 2019 7:22 pm
vineviz wrote:
Sun Sep 01, 2019 6:14 pm
I agree with willthrill81 that effect of VTSMX (TSM) and VFINX (S&P 500) in portfolio are going be virtually identical "for all intents and purposes."
This is a well established fact. Not a new information, I recall these discussions on previous forum back in early 2000's and most people understood Wilshire 5K and 500 Index are interchangeable, with nearly no difference in performance. That proves nothing though, other than S&P 500 is a good representation of the U.S Market.
It means that from an operational standpoint, TSM has virtually no meaningful exposure to anything other than large-caps. We have a few posters here who pontificate about the fact that TSM includes small-caps by their market-cap weighting, but this is essentially meaningless from a differentiation standpoint from a 'pure' large-cap fund. The quantity of small-caps included in TSM are just not enough to 'move the needle' compared to fund/portfolio of only large-caps.
That's like saying the market is nothing but a collection of large caps stocks and nothing else, which is inherently wrong.
That's not what people are saying. They are pointing out the the market is MOSTLY a collection of large cap stocks, which is objectively true: the 100 largest US stocks make up over 50% of the total US stock market capitalization. This is why the S&P 100 has a correlation of 0.97 with the total US stock market.
I think we are going circular where we agree on the part that market is made up of mostly large companies, but disagree on whether that makes market less diversified. The fact that top 100 stocks makes 50% of US market capitalization, or the top 10 make up 25% of it, is by design. That's the way they are supposed to be given their economic footprint. Using the same analogy I had from before, why should a small IT services company located in Clearwater, FL get same weight as Microsoft. This is like saying their significance to the US economy is about same.

This is what the market has determined to be the correct representation, if you are saying the weighting is wrong, then you are going against the collective information available to millions of consumers who participate in making the economy. Then comes the part where there is disagreement between those who says market weighting is not correct. Rob Arnott, DFA, and AQR are not on the same page. There are several others, so now you have a problem who is right, it is much more easier to determine that the market makeup which is made up of information from activity of millions of consumers is more correct. Perhaps this isn't a perfect science, in the absence of a prescient formula we have to rely on what is next best reasonable approach.

User avatar
vineviz
Posts: 5391
Joined: Tue May 15, 2018 1:55 pm

Re: Rob Arnott on value investing and the Achilles' heel of market cap indexing (Morningstar podcast)

Post by vineviz » Mon Sep 02, 2019 5:29 pm

Elysium wrote:
Mon Sep 02, 2019 5:19 pm
This is what the market has determined to be the correct representation, if you are saying the weighting is wrong, then you are going against the collective information available to millions of consumers who participate in making the economy.
I’m not saying the market weight is wrong: that doesn’t follow as an implication of anything I’ve said.

Trying to think about market weights as being “correct” or “incorrect” is overly simplistic.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Post Reply