What's wrong with this critique of indexing?

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Lauretta
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Re: What's wrong with this critique of indexing?

Post by Lauretta » Sun Apr 29, 2018 1:01 pm

nisiprius wrote:
Sun Apr 29, 2018 12:26 pm

In other words, all of the competing tilt, factor-based, fundamental indexing, smart beta strategies and products will beat the market, automatically, just by not being market-cap weighted, because market cap weighting is actually the worst of all. The whole contemporary zoo of factor-based, fundamentally indexed, smart beta products are all better than cap-weighted index funds. I imagine the Research Associates people, not speaking for academic publication, would say "of course our weighting system is the best." However, in a general sense, it is in the interest of Research Associates to make the case that investors should begin their consideration of mutual funds by screening out all cap-weighted products.
In more recent times RA have warned against factor investing:
https://www.researchaffiliates.com/en_u ... wrong.html

Of course what RA write is done also with the aim of promoting their products. But this doesn't mean that what academics write is more trustworthy or 'disinterested'.
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Re: What's wrong with this critique of indexing?

Post by gmaynardkrebs » Sun Apr 29, 2018 1:15 pm

nisiprius wrote:
Sun Apr 29, 2018 12:19 pm

If we try the same thing, looking at portfolios consisting of a mix of the VFINX (S&P 500) and MGC, the Vanguard Mega Cap Index ETF, it is really a joke since the two asset points almost lie on top of each other, but, nevertheless, the result is the same: the MGC has just a hair higher return and just a hair lower standard deviation, and the two have literally 1.00 correlation with each other (down to rounding error), and accordingly the optimum combination is 0% S&P 500, 100% mega caps.
I'd be curious to run a data set for a period before the widespread adoption of passive index investing to see what the correlation was then. A correlation of 1 is astonishing, and I wonder if the rise of the passive index funds has anything to do with it.

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Re: What's wrong with this critique of indexing?

Post by Christine_NM » Sun Apr 29, 2018 1:29 pm

Lauretta wrote:
Sun Apr 29, 2018 12:26 pm
golfCaddy wrote:
Sun Apr 29, 2018 12:15 pm

How do you define risk? In Fama's view, risk is multidimensional and defined as a weighting on one of the five factors.
profitability is one of the factors in the five factors model: why are profitable firms more risky?
It's the combination of smallness, low profitability, and high investment that makes for a higher risk profile according to what I can make of the five-factor model. Beware, this is a vast oversimplification. Swedroe had an in-English article about this in etf.com: http://www.etf.com/sections/index-inves ... nopaging=1


But even CMA (profitability-investment factor) has its winners, like Amazon investing revenue in itself in the early days. To exclude it because of CMA would have been a huge mistake, in my view a fatal error for this model.
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Re: What's wrong with this critique of indexing?

Post by lazyday » Sun Apr 29, 2018 1:39 pm

Christine_NM wrote:
Sun Apr 29, 2018 1:29 pm
It's the combination of smallness, low profitability, and high investment that makes for a higher risk profile according to what I can make of the five-factor model. Beware, this is a vast oversimplification.
I believe that high profitability and low investment have meant higher returns in backtests.

If low profitability gave high returns, then I might believe the risk story.

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Re: What's wrong with this critique of indexing?

Post by Christine_NM » Sun Apr 29, 2018 1:51 pm

lazyday wrote:
Sun Apr 29, 2018 1:39 pm
Christine_NM wrote:
Sun Apr 29, 2018 1:29 pm
It's the combination of smallness, low profitability, and high investment that makes for a higher risk profile according to what I can make of the five-factor model. Beware, this is a vast oversimplification.
I believe that high profitability and low investment have meant higher returns in backtests.

If low profitability gave high returns, then I might believe the risk story.
small, low profit + high investment = lower average return. (Perhaps I should not have equated that with higher risk. I am not sure of 5-factor jargon yet.)
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Re: What's wrong with this critique of indexing?

Post by nisiprius » Mon Apr 30, 2018 2:01 pm

Lauretta wrote:
Sun Apr 29, 2018 1:01 pm
...In more recent times RA have warned against factor investing:
How can "Smart Beta" Go Horribly Wrong?

Of course what RA write is done also with the aim of promoting their products. But this doesn't mean that what academics write is more trustworthy or 'disinterested'.
Notice the interesting inconsistency. Jason Hsu isn't an author of the this article, but he's mentioned eight times, and he's a partner in the firm of which author Rob Arnott is founder and chairman, so it is unlikely that Arnott doesn't know about his work.

Now, in the 2006 article, Cap-Weighted Portfolios are Suboptimal Portfolios, Hsu says that cap-weighting is uniquely bad. You don't need to do anything particular, to beat cap-weighting, you just have to use... well, let's quote his words: "However, portfolios constructed from weights, which do not depend on prices, do not exhibit the same underperformance observed for cap-weighted portfolios."

Yet "Smart Beta" portfolios are an example of "portfolios constructed from weights which do not depend on," well, let's say, "prices alone." So if "Smart Beta" portfolios can go horribly wrong, this (seems) inconsistent with the (apparent) claim that any departure from cap-weighting is better than cap-weighting.

A possible explanation might be found in a later paper mentioned in the article, a paper by Arnott andHsu and two others... The Surprising Alpha From Malkiel’s Monkey and Upside-Down Strategies. As I read it, this paper is saying much less intriguing than "cap-weighting is the worst strategy." They say
"value and small-cap exposures are naturally occurring portfolio characteristics, unless an investor constructs a portfolio to have a positive relationship between price and portfolio weights.
In other words, they say, most non-cap-weighted portfolios turn out to have small-cap value tilts, intentionally or not. (Malkiel's monkeys throwing darts at the stock listings incorporate a small-cap tilt because they are statistically doing equal weighting; the listing for Apple is printed in the same-sized type as the listing for News Corporation.) So instead of "anything is better than cap-weighting," we are just back to the old "small-cap value tilts are better than cap-weighting." They dodge the obvious by saying "We do not attempt to comment on the interesting debate regarding the nature of value and small-cap premiums," and also do not answer the question I always have: whether they are talking about superior risk-adjusted return, or just about a premium which might well be no more than reward commensurate with extra risk.

Anyway, we are not left with "cap-weighting is worst." We're left with "small-cap value is best, cap-weighting is worse, and" (I suppose) "whatever strategies result in large-cap or growth tilts, intentional or not, are worst." Same-old same-old argument that's been going on for decades.

And meanwhile large-cap growth funds, indexed or active, continue merrily on their way, with plenty of people investing in them with seemingly not-terrible results.
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Re: What's wrong with this critique of indexing?

Post by neurosphere » Tue May 01, 2018 10:34 am

nisiprius wrote:
Mon Apr 30, 2018 2:01 pm
Anyway, we are not left with "cap-weighting is worst." We're left with "small-cap value is best, cap-weighting is worse, and" (I suppose) "whatever strategies result in large-cap or growth tilts, intentional or not, are worst." Same-old same-old argument that's been going on for decades.
The entire post from which this quote is taken is marvelous. :beer
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Re: What's wrong with this critique of indexing?

Post by Lauretta » Tue May 01, 2018 10:49 am

nisiprius wrote:
Mon Apr 30, 2018 2:01 pm

And meanwhile large-cap growth funds, indexed or active, continue merrily on their way, with plenty of people investing in them with seemingly not-terrible results.
yes the results of large growth funds are good. It's just that studies have shown that historically, over long periods of time, those of small cap value have been better.
In the last 10 years growth has outperformed and indeed there have always been stretches of time when this was the case - people argue that this is precisely the reason why the value premium will persist, because you have to stick for a long time with an underperforming strategy and not many people are prepared to do it. Will value outperform in future? Nobody knows. But I think it makes more sense to base one's opinions on the results over the last 100 yrs, rather than on those of the last 10 yrs...
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Re: What's wrong with this critique of indexing?

Post by Alpha3 » Wed May 16, 2018 8:11 am

Lauretta wrote:
Sat Apr 28, 2018 10:48 am
Can you please point out at which point the following reasoning is wrong?
This has been a very interesting thread to read. Here's my attempt to answer the original riddle:
In my mind, yours is not a critique to indexing, it is a critique to the particular indexing approach of the S&P500, which is cap weighting. And there's nothing wrong in the critique. As far as I can tell, allocation on the basis of market cap has been shown to deliver weaker performances. In other words, as per your last point, investing more in Apple than News corp isn't the best decision. That said, this doesn't prove indexing is wrong though, just that indexing on the basis of cap is far from optimal.

But I completely hear you. In fact, I had a very similar question (which I posted last week, coincidentally). I thought: if the S&P500 is widely regarded as the most efficient way to track the market, and the S&P is weighted on capitalization, surely the same principle can be applied to the problem of asset allocation. To my surprise, I found multiple papers with evidence suggesting this was a poor performing strategy.

Whatever principle is making cap weighting to be a bad heuristic for asset allocation, surely it must also be working at the equity allocation level.

Interestingly, I found several studies suggesting that 1/N (equal weighting) was possibly the best ex-ante porfolio. It is the one Markowitz ended up choosing, in spite of comming up with MPT!!! :) I recommend the following paper on the topic:
https://pdfs.semanticscholar.org/094d/2 ... 06953e.pdf

This also compares a global market asset allocation on cap weight, vs several other heuristics, showing that cap weighting isn't preferrable: http://www.sr-sv.com/global-market-port ... rformance/

More evidence: http://www.macroresilience.com/2010/07/ ... llocation/

In short, I think you can conclude there's nothing wrong with the principles you call upon, and equal size investing (as you were suggesting) has been shown to deliver stronger performance than cap weighting.

PS: Thinking about this has made me wonder whether the size factor in the French-Fama models is actually introduced by the very wide adoption of S&P500 as a benchmark. By general allocating on the basis of weight, small companies are penalized. As their cap increases however, allocators increasingly have to add more weight, which in turn drives prices up. This made me wonder... if at some point the S&P500 lost its current glamour, and was replaced by 1/N indexes, perhaps the size factor would all together disappear and be fully arbitraged out. I'm still pondering on this :)

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Re: What's wrong with this critique of indexing?

Post by tadamsmar » Thu May 17, 2018 6:42 am

Alpha3 wrote:
Wed May 16, 2018 8:11 am
Interestingly, I found several studies suggesting that 1/N (equal weighting) was possibly the best ex-ante porfolio. It is the one Markowitz ended up choosing, in spite of comming up with MPT!!! :)
To be specific, Markowitz used 1/2 (equal weighting) of stocks and bonds, nothing more complex than that:

http://www.mymoneyblog.com/harry-markow ... folio.html

But he was no more wedded to equal weighting than he was to MPT:

"Say you were 65, and invested $1 million, with 60 percent in stocks and 40 percent in bonds," he said. "It became $800,000, and you are not happy, but you lived to invest another day."

http://articles.chicagotribune.com/2010 ... -investing (<- This is a good read)

He seemed to choose practical heuristics that were rough approximations of MPT.

PS: That last article indicates that Markowitz did a lot of things. Early in his life, was 50/50, he rebalanced only with new money , in 2007 he decided the market was risky and sold a bunch of stock, he did not get back in till the the Fed started increasing interest rates, he made a bad real estate investment, he is big into municipal bonds in his late 80s.

But, there is not a enough quantitative info in that article to indicate that he would have done worse if he had just earnestly invested according to MPT principles as best he could for his whole life and engaged in systematic rebalancing and chose an appropriate level of risk based on age. His 2007 move (not staying the course) seems good, but slavishly rebalancing an MPT portfolio once a year though that recession (staying the course) was good too.

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Re: What's wrong with this critique of indexing?

Post by unclescrooge » Thu May 17, 2018 8:58 am

nisiprius wrote:
Sat Apr 28, 2018 9:30 pm
(Sorry, I didn't see that ThriftyPhd had beaten me to it. He makes exactly the same PortfolioVisualizer comparison I show below, except he chose RSP as Portfolio 1 and SPY as portfolio 2.)
clown wrote:
Sat Apr 28, 2018 7:53 pm
...Therefore, in my view, the most important thing among two strategies is how much money is made and how much risk is taken. Being a skeptic, I prefer to run my own numbers. The following spreadsheet confirms the outperformance of equal-weight with only marginal increase in risk (if volatility is your definition of risk, a definition with which some investors disagree).
Why did you choose 2008 as your starting point instead of using all available data? If I go into PortfolioVisualizer and compare SPY and RSP, and use all available data, this is what I'm seeing.
Portfolio 1, blue, is SPY;
portfolio 2, red, is RSP.
  • Yes, RSP had higher return.
  • Yes, it had higher risk.
  • No, it didn't have "only marginal increase in risk."
  • No, it didn't just have an increase as measured by standard deviation, but by every measure calculated--higher standard deviation, worse worst year, and worse drawdown.
  • No, it was not superior if you looked at risk-adjusted return. If you look at risk-adjusted return the difference goes away. The Sharpe ratio was exactly the same to within roundoff error; the Sortino ratio was only a hair higher.
(Jan 2004 - Mar 2018)

Source

Image

RSP has the lure of novelty and something different, but I think it's just a sloppy and imprecise way of applying a modest small-cap tilt (within the universe of the S&P 500).
Given portfolio 2 has the same Sharpe ratio, and tiny bit better sortino, wouldn't you want to prefer that portfolio?

Wouldn't it tilt more towards mid-cap?

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Re: What's wrong with this critique of indexing?

Post by Lauretta » Tue May 29, 2018 3:39 pm

nisiprius wrote:
Sat Apr 28, 2018 12:27 pm
(ThrustVectoring beat me to it while I was composing a psot. Here's the same point made in a different way).

Let's make a set of wildly unrealistic simplifying assumptions. Suppose there are only two stocks in the stock market, Apple and News Corporation. Let's say their market capitalizations are $1000 billion and $10 billion. Let's suppose that we are talking about such a short period of time, or anyway just talking, about a closed system: a situation in which no money enters or leaves the market--anyone who sells a stock immediately buys the other stock. So, for purposes of discussion, there is $1,010 billion in the market.

A closed system also implies no dividends--the only transactions that are occurring are speculative.

Let's say Lauretta has $10,000 each invested in Apple and News Corporation, total $20,000.
Let's say I have $19,802 in Apple and $198 in News Corporation, total $20,000.

Let's say a big institutional investor sells $5 billion worth of News Corporation. Since it's a closed system, he must buy $5 billion worth of Apple. The only way this can happen is if prices adjust in such a way that the market cap is now $1,005 billion for Apple and $5 billon for News Corporation, total $1,010 as before.
This argument doesn't make any sense since if the institutional investor sells $5 billions worth of new Corporation, it means that someone else will have bought those shares. Thus the market cap of News Corporation is still $10 billion after the operation (i.e. $5 billions owned by those who owned the stock before the operation, plus $5 billions owned by those who bought the stock from the institutional investor who sold) and not $5 billion. In other words, your calculation misses the point that the 5$ billion worth of shares sold by the big investor will be owned by new investors (and not disappear in thin air).

If your argument was simply that large trades may affect the price of a stock (though this goes against the assumptions of EMH, which you seem to believe in) this is true (and to a lesser extent it's true of all stocks, even the ones of big companies) but there is no reason why the price should be exactly half after that trade. The halving of the price in your example seems to be due to a simple conceptual mistake.
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Re: What's wrong with this critique of indexing?

Post by nisiprius » Tue May 29, 2018 3:51 pm

The market capitalization of a stock is not a constant. Market cap is constantly being created and destroyed in transactions, although in small increments. If I have "$5 billion" worth of News Corporation stock and I actually try to sell it, there may not be anybody who wants to buy it at that price. In order to clear $5 billion on the deal, I may need to find someone willing to pay $5 billion for a number of shares of stock that I thought was worth, and that yesterday based on the posted "market value" was worth, $5.01 billion. When the transaction occurs, or possibly at the instant I decide to accept that $10 million "loss," the value of the stock declines and the market cap declines.

The value destruction does not happen at the instant of the trade, when the money exchanges hands and the seller receives the same number of dollars the buyer pays. It happens in the time when the seller and buyer discover the price both will agree to. At that point, market capitalization is created or destroyed depending on whether the stock is sold at a higher or a lower price than the previous transaction.

To suggest that market cap destruction cannot take place because there is always a buyer for every seller is like Zeno's paradox, the claim that an arrow shot from a bow cannot move, because at any instant it is always at some particular place.

(I'd add that the idea of stock having a market price is an illusion, or an approximation that is valid with great precision most of the time; it is true only when the stock is liquid and the trading is orderly. The stock market has worked for a century or so to create a system in which that is very close to true almost all the time... but it is "very close" and "almost all.")

It would not occur instantaneously in a single transaction but none of the rest of my hypothetical is realistic, either. Conceptually, the cap-weighted investor is on both sides of every trade and does not gain or lose from purely speculative transactions, and that is the only weighting system for which this is true. Every other weighting system means that you are taking sides, betting on one side against the other. The cap-weighted investor is indifferent to speculation and profits only from the general rise in value due to the stock market not being a closed system--specifically from the portion of corporate earnings that flows into it as dividends (or buybacks).
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Re: What's wrong with this critique of indexing?

Post by Lauretta » Tue May 29, 2018 4:39 pm

nisiprius wrote:
Tue May 29, 2018 3:51 pm
The market capitalization of a stock is not a constant. Market cap is constantly being created and destroyed in transactions, although in small increments. If I have "$5 billion" worth of News Corporation stock and I actually try to sell it, there may not be anybody who wants to buy it at that price. In order to clear $5 billion on the deal, I may need to find someone willing to pay $5 billion for a number of shares of stock that I thought was worth, and that yesterday based on the posted "market value" was worth, $5.01 billion. When the transaction occurs, or possibly at the instant I decide to accept that $10 million "loss," the value of the stock declines and the market cap declines.

The value destruction does not happen at the instant of the trade, when the money exchanges hands and the seller receives the same number of dollars the buyer pays. It happens in the time when the seller and buyer discover the price both will agree to. At that point, market capitalization is created or destroyed depending on whether the stock is sold at a higher or a lower price than the previous transaction.

To suggest that market cap destruction cannot take place because there is always a buyer for every seller is like Zeno's paradox, the claim that an arrow shot from a bow cannot move, because at any instant it is always at some particular place.

(I'd add that the idea of stock having a market price is an illusion, or an approximation that is valid with great precision most of the time; it is true only when the stock is liquid and the trading is orderly. The stock market has worked for a century or so to create a system in which that is very close to true almost all the time... but it is "very close" and "almost all.")

It would not occur instantaneously in a single transaction but none of the rest of my hypothetical is realistic, either. Conceptually, the cap-weighted investor is on both sides of every trade and does not gain or lose from purely speculative transactions, and that is the only weighting system for which this is true. Every other weighting system means that you are taking sides, betting on one side against the other. The cap-weighted investor is indifferent to speculation and profits only from the general rise in value due to the stock market not being a closed system--specifically from the portion of corporate earnings that flows into it as dividends (or buybacks).
Of course market capitalisation is not constant. If it were (leaving aside dividends) there would be no point in buying stocks as one buys them in the hope that their value - and hence the market cap - increases.

Price impact is a known phenomenon (though EMH, which you seem to like, assumes there is no such thing). I am not arguing against the existence of price impact (though like I said it occurs for all stocks, not just for the smaller ones) but I am pointing out the faulty reasoning in your example, where you said that selling half the shares of a company would make its price halve from 10 to 5 billions. This does not make sense, as there is no such relationship between the number of shares one sells and the impact on the share price. Or perhaps you are suggesting that selling x% of shares in a company will make the price drop by the same proportion, x%?!

The only way I can explain why you had a 50% drop in market cap in your example, is that you made the conceptual error that if 50% of shares are sold, they disappear from the calculation of the market cap, so that it will correspond to the total value of the other 50% of shares which are not sold (and ironically that calculation was made under the assumption that the price did not drop). That missed the obvious point that the shares that are sold do not disappear, but there will be a buyer who will own them, so that the total number of existing shares is unchanged.
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Re: What's wrong with this critique of indexing?

Post by neurosphere » Sat Jun 02, 2018 6:05 am

Lauretta wrote:
Tue May 29, 2018 4:39 pm
nisiprius wrote:
Tue May 29, 2018 3:51 pm
If I have "$5 billion" worth of News Corporation stock and I actually try to sell it, there may not be anybody who wants to buy it at that price. In order to clear $5 billion on the deal, I may need to find someone willing to pay $5 billion for a number of shares of stock that I thought was worth, and that yesterday based on the posted "market value" was worth, $5.01 billion. When the transaction occurs, or possibly at the instant I decide to accept that $10 million "loss," the value of the stock declines and the market cap declines.
The only way I can explain why you had a 50% drop in market cap in your example...
50% drop? I think perhaps you confused the millions with the billions. :D

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Re: What's wrong with this critique of indexing?

Post by Lauretta » Sat Jun 02, 2018 3:16 pm

neurosphere wrote:
Sat Jun 02, 2018 6:05 am
Lauretta wrote:
Tue May 29, 2018 4:39 pm
nisiprius wrote:
Tue May 29, 2018 3:51 pm
If I have "$5 billion" worth of News Corporation stock and I actually try to sell it, there may not be anybody who wants to buy it at that price. In order to clear $5 billion on the deal, I may need to find someone willing to pay $5 billion for a number of shares of stock that I thought was worth, and that yesterday based on the posted "market value" was worth, $5.01 billion. When the transaction occurs, or possibly at the instant I decide to accept that $10 million "loss," the value of the stock declines and the market cap declines.
The only way I can explain why you had a 50% drop in market cap in your example...
50% drop? I think perhaps you confused the millions with the billions. :D
I think you didn't read the post, or perhaps you have some difficulty in calculating 50% of 10 billions. Here's the original text:
nisiprius wrote: ↑
Sat Apr 28, 2018 7:27 pm
(ThrustVectoring beat me to it while I was composing a psot. Here's the same point made in a different way).

Let's make a set of wildly unrealistic simplifying assumptions. Suppose there are only two stocks in the stock market, Apple and News Corporation. Let's say their market capitalizations are $1000 billion and $10 billion. Let's suppose that we are talking about such a short period of time, or anyway just talking, about a closed system: a situation in which no money enters or leaves the market--anyone who sells a stock immediately buys the other stock. So, for purposes of discussion, there is $1,010 billion in the market.

A closed system also implies no dividends--the only transactions that are occurring are speculative.

Let's say Lauretta has $10,000 each invested in Apple and News Corporation, total $20,000.
Let's say I have $19,802 in Apple and $198 in News Corporation, total $20,000.

Let's say a big institutional investor sells $5 billion worth of News Corporation. Since it's a closed system, he must buy $5 billion worth of Apple. The only way this can happen is if prices adjust in such a way that the market cap is now $1,005 billion for Apple and $5 billon for News Corporation, total $1,010 as before.
Since the market cap of of News Corporation, in this example by nisiprius, goes from 10 billions to 5 billions, it drops by 5 billions (10-5=5). 5 billions is 50% of 10 billions. You can calculate that by doing: 5/10 X 100=50%
I hope you were able to follow my reasoning - I tried my best to do it as simply as I could.
Last edited by Lauretta on Sat Jun 02, 2018 3:19 pm, edited 1 time in total.
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Re: What's wrong with this critique of indexing?

Post by Prospero » Sat Jun 02, 2018 3:59 pm

I've not read all 3 pages so apologies if this point has already been made.

You are buying the future cash flows. If the market is completely efficient then every £ of future earnings costs the same right now.

Small does well compared to large because there is a premium for the additional risk. To mitigate against this risk we diversify into hundreds of thousands of small companies.

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Re: What's wrong with this critique of indexing?

Post by Epsilon Delta » Sat Jun 02, 2018 4:23 pm

LeisureLee wrote:
Sat Apr 28, 2018 7:02 pm

"Fair before" means that each dollar has the same expected return, before you know what happens.

The EMH, if true, says that all stocks are "fair before" - they have the same risk adjusted return.

No. Just no. The EMH does not say this and it does not imply this. The EMH would imply this only if all correlations were 1.

The issue is that you should only get paid for taking risk that somebody has to take. You should do not get paid for taking diversifiable risk. Every non-diversified portfolio should have a lower risk adjusted return than the market portfolio. And the less diversified the risk the lower the risk adjusted return.

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Re: What's wrong with this critique of indexing?

Post by whodidntante » Sat Jun 02, 2018 4:38 pm

If markets are efficient, then it is reasonable to expect all factors to have the same risk adjusted return. But that isn't supported by regressions. Value, for example, has lower volatility and higher returns. I don't know if that means markets are not efficient, or that the data just aren't very good.

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Re: What's wrong with this critique of indexing?

Post by Epsilon Delta » Sat Jun 02, 2018 5:00 pm

whodidntante wrote:
Sat Jun 02, 2018 4:38 pm
If markets are efficient, then it is reasonable to expect all factors to have the same risk adjusted return.
No it isn't.

If risk is defined as variance then it is false by the cauchy-schwartz inequality, which relates variance and covariance of random variables. If risk is something else then we have to work harder to show it is false but there is simply no reason to believe it is true.

If you start from a false premise everything that follows from it is unreliable.

gmaynardkrebs
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Re: What's wrong with this critique of indexing?

Post by gmaynardkrebs » Sat Jun 02, 2018 5:05 pm

It seems like the "risk" most people have in their minds in volatility -- ie the VIX, which is basically the ups and downs. That seems to me to be the major risk that the market is paying you for. What about the other type? I really wonder whether the market pays one sufficiently for the risk of the market going down and staying down, possibly forever. Personally, I don't think it does. That's why I have a pretty low equity component -- about 27% right now (age 68). But I would be at about 25%-30% even if I were 30 again. But, I often wonder if I'm just too much of a pessimist.

anil686
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Re: What's wrong with this critique of indexing?

Post by anil686 » Sat Jun 02, 2018 5:39 pm

I have read most of the three pages but to go to the OP original questions
1). The market is not efficient- at least not perfectly especially in small cap where there is traditionally less liquidity, less analyst coverage and possibly more mispricing. Indexing, btw, works best in inefficient markets where costs are typically higher than in relatively more efficient markets. Indexing just guarantees the average returns of the asset class minus fees - the spread will be higher between underperformance and outperformance in inefficient markets, but so will be the costs. This gives indexing a bigger advantage.

2). No due to 1. Indexing says nothing about the future prospects of individual stocks - the market participants do that. P/E ratios may be helpful but in all actuality - the fundamental business returns of a company primarily influence stock prices IMO...

3). Again not due to 1 not right and 2 misunderstood to #1

4). Because market participants have valued AAPL at more than Fox and thus in a market cap weighted index - AAPL is that much more. The market can be wrong and - of course it can and it is not perfectly efficient. However, really smart people wanting to make money place their money and “make” the market for stocks. The collective wisdom is typically pretty good and is found cheaper than an expensive fund manager and thus indexing typically beats most active funds with high expenses. If your argument is how to do a rules based index outside of cap weighting - that is a separate story - but in any weighting of an index (by value - PE/PB/Dividend or by growth or by quality or momentum) - there will be a ranking and it is based on the collective wisdom of the market participants with respect to that metric. Cap weighting uses size, but using any other metric also results in differences in weighting - either under or over weighting based on the collective wisdom of all participants.

https://www.npr.org/sections/money/2015 ... -cow-weigh

https://www.npr.org/sections/money/2015 ... w-they-did

Just a story on guessing cow weights and how individuals who have no experience with cows can beat experts by just using the averages...

Hope it helps...

Ben Mathew
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Re: What's wrong with this critique of indexing?

Post by Ben Mathew » Sat Jun 02, 2018 6:07 pm

Lauretta wrote:
Sat Apr 28, 2018 10:48 am
Can you please point out at which point the following reasoning is wrong?
1) If one believes in the EMH and in common asset pricing models, then one accepts the idea that all information about firms in the stock market is baked into their current prices, so that for every stock you should expect the same risk adjusted return.
2) If this is the case, then my understanding is that the expected risk adjusted return for Apple should be the same as that for any other stock, say for News Corporation (if this weren't so their stock prices would instantly be adjusted - since markets are efficient - till that condition holds).
3) If both stocks (Apple and News Corporation) have all information baked into their price, and have the same risk adjusted returns, the rational thing for me to do is to make the same bet on each of them. The only reason why I should bet more on one stock than on the other, is if I had reason to believe that it would be more likely to outperform (and according to point 2) this is not true)
4) Yet by indexing, for every 100$ invested in the S&P500, I invest more than 3.5$ in Apple and less than one cent on News Corporation. How can this make sense? (i.e. what justifies this much bigger bet on Apple, just because it's bigger and more money is invested in it by other people?).
This is an interesting question. The finance textbook answer to this would be that, in a world where all assets are correctly priced, the market cap weighted portfolio is on the risk-return efficient frontier whereas an equal weighted portfolio is not. You can reduce the risk in an equal weighted portfolio without sacrificing return by switching to cap weighting.

One way to think about this result is to view companies as a collection of assets. Big companies have lots of assets while small companies have fewer assets. If you're trying to own an equal piece of all assets in the world, you'd have to invest twice as much in a company that has twice as many assets. Otherwise you would be overly concentrating in the assets of the small company--meaning you won't be diversifying as much as possible. In a sense, equal weighting of assets leads to cap weighting of companies.
Lauretta wrote:
Sat Apr 28, 2018 11:43 am
Does this mean that empirically it is found that the covariance between stocks is so adjusted that you actually get the highest risk adjusted returns for a portfolio consisting of a market cap weighted index?
Not empirically, but theoretically.

If all assets are priced correctly, then it's a theoretical result that the market portfolio (cap weighted) is efficient. Of course, the real world might not match up to that ideal. To the extent that there is mispricing, one can benefit by tilting towards underpriced assets. But unless you believe that small companies are underpriced, there is no reason to tilt towards equal weights. Even if you do believe that small companies are underpriced, an optimal tilting strategy would probably involve something other than equal weighting.

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neurosphere
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Re: What's wrong with this critique of indexing?

Post by neurosphere » Sun Jun 03, 2018 2:08 pm

Lauretta wrote:
Sat Jun 02, 2018 3:16 pm
neurosphere wrote:
Sat Jun 02, 2018 6:05 am
Lauretta wrote:
Tue May 29, 2018 4:39 pm
nisiprius wrote:
Tue May 29, 2018 3:51 pm
If I have "$5 billion" worth of News Corporation stock and I actually try to sell it, there may not be anybody who wants to buy it at that price. In order to clear $5 billion on the deal, I may need to find someone willing to pay $5 billion for a number of shares of stock that I thought was worth, and that yesterday based on the posted "market value" was worth, $5.01 billion. When the transaction occurs, or possibly at the instant I decide to accept that $10 million "loss," the value of the stock declines and the market cap declines.
The only way I can explain why you had a 50% drop in market cap in your example...
50% drop? I think perhaps you confused the millions with the billions. :D
I think you didn't read the post, or perhaps you have some difficulty in calculating 50% of 10 billions. Here's the original text:
Agreed. I didn't see that post. Just the post you quoted, of market cap going from 5.01 Billing to 5.00 billion. Sorry.
Last edited by neurosphere on Sun Jun 03, 2018 2:12 pm, edited 1 time in total.
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Lauretta
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Re: What's wrong with this critique of indexing?

Post by Lauretta » Sun Jun 03, 2018 2:09 pm

Ben Mathew wrote:
Sat Jun 02, 2018 6:07 pm
Lauretta wrote:
Sat Apr 28, 2018 10:48 am
Can you please point out at which point the following reasoning is wrong?
1) If one believes in the EMH and in common asset pricing models, then one accepts the idea that all information about firms in the stock market is baked into their current prices, so that for every stock you should expect the same risk adjusted return.
2) If this is the case, then my understanding is that the expected risk adjusted return for Apple should be the same as that for any other stock, say for News Corporation (if this weren't so their stock prices would instantly be adjusted - since markets are efficient - till that condition holds).
3) If both stocks (Apple and News Corporation) have all information baked into their price, and have the same risk adjusted returns, the rational thing for me to do is to make the same bet on each of them. The only reason why I should bet more on one stock than on the other, is if I had reason to believe that it would be more likely to outperform (and according to point 2) this is not true)
4) Yet by indexing, for every 100$ invested in the S&P500, I invest more than 3.5$ in Apple and less than one cent on News Corporation. How can this make sense? (i.e. what justifies this much bigger bet on Apple, just because it's bigger and more money is invested in it by other people?).
This is an interesting question. The finance textbook answer to this would be that, in a world where all assets are correctly priced, the market cap weighted portfolio is on the risk-return efficient frontier whereas an equal weighted portfolio is not. You can reduce the risk in an equal weighted portfolio without sacrificing return by switching to cap weighting.

One way to think about this result is to view companies as a collection of assets. Big companies have lots of assets while small companies have fewer assets. If you're trying to own an equal piece of all assets in the world, you'd have to invest twice as much in a company that has twice as many assets. Otherwise you would be overly concentrating in the assets of the small company--meaning you won't be diversifying as much as possible. In a sense, equal weighting of assets leads to cap weighting of companies.
Lauretta wrote:
Sat Apr 28, 2018 11:43 am
Does this mean that empirically it is found that the covariance between stocks is so adjusted that you actually get the highest risk adjusted returns for a portfolio consisting of a market cap weighted index?
Not empirically, but theoretically.

If all assets are priced correctly, then it's a theoretical result that the market portfolio (cap weighted) is efficient. Of course, the real world might not match up to that ideal. To the extent that there is mispricing, one can benefit by tilting towards underpriced assets. But unless you believe that small companies are underpriced, there is no reason to tilt towards equal weights. Even if you do believe that small companies are underpriced, an optimal tilting strategy would probably involve something other than equal weighting.
thank you for your feedback and the excellent points :happy
The idea that
One way to think about this result is to view companies as a collection of assets. Big companies have lots of assets while small companies have fewer assets. If you're trying to own an equal piece of all assets in the world, you'd have to invest twice as much in a company that has twice as many assets.
does make sense; at the same time, it seems to me that if you take the collection of assets of a single big company, they are more highly correlated between themselves than the assets of many small individual companies. Take BP in the UK, one single event (Deepwater Horizon) devalued significantly all the assets of that company; owning several smaller companies for a total market cap equal to that of BP would have seemed less risky. Indeed the Ftse 100 suffered significantly because BP was a big part of that index.

I liked this observation:
If all assets are priced correctly, then it's a theoretical result that the market portfolio (cap weighted) is efficient. Of course, the real world might not match up to that ideal.
From the little I know, it seems that the theoretical models of MPT, CAPM and EMH can be quite divorced from reality in practice. This piece by Taleb made sense to me when I read it:
http://www.fooledbyrandomness.com/FT-Nobel.pdf
When everyone is thinking the same, no one is thinking at all

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