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How to Win the Loser's Game

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How to Win the Loser's Game, Part 7

October 08, 2014
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Although indexing is a relatively simple way to invest, there are still important questions an index investor needs to ask. Crucially, you need to ensure that you invest in a diverse range of assets that reflects your attitude to risk. You might also want to "tilt" your portfolio to particular risk factors - small-cap or value stocks, for example - which, although more volatile, have been shown to deliver higher returns over the long term.

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Part 7, Transcript and References

Last time on How to Win the Loser’s Game

Nobel Prize-winning economist Professor Eugene Fama says: “I laugh because I’ve been saying the same story for 52 years now.”

Investment author Larry Swedroe says: “Buffett has told people in advice in his 1996 shareholder letter, if you invest in an index fund you’re virtually guaranteed to outperform the vast majority of investors.”

Former fund manager John Redwood says: “The more research I did into it the more I realised there were very few people who were able to sustain outperformance sufficiently to cover all the extra costs of active investing.”

So, we’ve explained how the academic evidence points overwhelmingly to indexing being the best way for the vast majority of people to invest.

Index funds should form the biggest part of every portfolio.

We’ve already mentioned the importance of asset allocation - deciding how much to invest in equities or bonds, for example.

Another key decision is what type - or types - of index fund to go for.

The traditional and still the most common type is the cap-weighted or market value-weighted fund.

One drawback with cap-weighted funds is that as the price of a stock goes up, so does its weighting.

That can sometimes leave you overweighted in a relatively small number of stocks.

Professor Stephen Thomas from Cass Business School says: “Go back to 1999, 2000, the technology bubble. You know, you suddenly had 6 to 7, 8% of the portfolio in Cisco and the next thing it’s bombed out. So the question then is, is there a better way of constructing a portfolio, a better way of constructing, if you like, an index? And some experiments in the past - they’ve been going on for 10 years - have suggested there are better ways. I’ll give you a really simple example. Instead of weighting by the market capitalisation of each stock, how about making it equal-rated. So you’ve got 100 stocks in the FTSE. Put 1% in each. So that’s the sort of thing that starts us researching, looking at the top 1000 US stocks, and asking, are simple rules like that - we call them heuristics - are they capable of forming portfolios that actually do better over time than buying, say, the S&P 500 or the FTSE 100?”

You’ll remember we looked at different types of risk, or beta - often known as factors. Certain types of stocks are more volatile but do offer higher returns in the long run.

It’s now possible to buy an index fund comprised entirely of small-company or value stocks, for example, to complement conventional index funds. They’re more expensive than cap-weighted funds but still far cheaper than actively managed funds.

This sort of strategy is usually referred to as smart beta, though others call it alternative beta, fundamental indexing, factor investing or tilting. Whatever name you prefer to call it, it’s becoming increasingly popular.

Professor Fama says: “The overall cap-weight market portfolio - including everything, not just stocks - model is always a legitimate portfolio. In any asset-pricing model it’s always one of the so-called efficient portfolios. But if you take, for example, our work seriously, what it says is there are multiple dimensions of risk and you can tilt towards these dimensions, so you can move away from the market portfolio towards these dimensions depending on your taste for bearing different sources of risk… There isn’t one strategy that’s optimal or efficient. In a sense there’s a whole spectrum.”

A staunch proponent of this approach is Yves Choueifaty, who runs TOBAM, an asset management company based in Paris.

For him, it’s all about diversification. Ideally, the investor should be exposed to all the different risk factors.

Yves Choueifaty says: “In order to build a diversified portfolio you will want to try your best to have your own risk evenly contributed by all the risk factors that are available in the universe. If every single source of risk, if every single risk factor, evenly contributes to my own risk, by definition you will not be able to tell me that I am biased, and if you cannot say that I am biased, probably I will be able to say that I am diversified.”

Others are more sceptical about smart beta - or at least that particular label.

Nick Blake from Vanguard says: “I think the name is unfortunate in that it seems to suggest that it’s a smart outcome when in fact smart is a requirement when it comes to smart beta as it’s called. Our view is that smart beta is actually a factor bet, it’s a rules-based factor bet where somebody is choosing to index a part of the market or part of a broader market cap index. Now that in itself can be fine, but I think it’s very important to understand that you’re taking a very active decision at the start there to actively go after one factor of the market.”

Richard Wood from Barnett Ravenscroft Wealth Management says: “I think it makes it more complicated for an investor, because previously you had active and passive. It’s taken us a long time to get across what passive is, and I still don’t think many people understand what it is. Yes, we believe that smart beta is another way of getting an extra 1 or 2% return per year, but to the average person on the street, I think it does confuse them and just means that there’s more product for them to to try to understand.”

David Swanwick from Dimensional Fund Advisors says: “I think smart beta is another industry label that has emerged out of the funds management community - possibly out of some marketing department, cynically. The best question an investor can ask is, “where do returns come from in the asset classes?” And really no one has studied this more deeply than the academic community. And so when it comes to investment capital, it makes so much sense to do with that capital only that which has been proven and thats where dimensions of return become so powerful because they have survived peer review. They have survived intense scrutiny.”

Complicated or not, is smart beta an option worth exploring? Well, it might be, depending on the level of risk you’re willing to take.

Professor John Cochrane from the University of Chicago says: “One touchstone to remember… The average investor has to hold the market portfolio. If you decide you’re going to buy value, someone else has to hold less value. If you’re going to buy Microsoft, somebody else has to hold less Microsoft. The average portfolio has to add up to the market, and if anybody outperforms the market, somebody else has to underperform the market. We need a better theory of why we should do anything but just hold the market index.

I do think there is one, and that is if you view these as alternative dimensions of risk and that what we’re doing in asset markets is basically writing insurance to each other. Look at the stocks. Are you really the kind of investor who can bear that kind of risk? What you are doing is you’re writing insurance to other investors who don’t want to bear that kind of risk. What is the risk? Why are some people not willing to bear that risk. Why can I bear that risk? That’s a good place to start thinking about these alternative betas you want to invest in.”

Next time on How to Win the Loser’s Game…

Professor Bruce Greenwald says: “You’re looking for cheap, ugly, disappointing, obscure and otherwise orphaned stocks.”

Bill McNabb from Vanguard says: “Morningstar did some really ground-breaking work a couple of years ago where they found the best predictor of future performance was actually cost.”

Professor Cochrane says: “If you don’t know what you’re doing, don’t step into the casino.”


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