He is a hero to them and to me. This new edition of The Little Book of Common Sense Investing offers you the same solid strategy as its predecessor for building your financial future. Build a broadly diversified, low-cost portfolio without the risks of individual stocks, manager selection, or sector rotation. Forget the fads and marketing hype, and focus on what works in the real world. Understand that stock returns are generated by three sources dividend yield, earnings growth, and change in market valuation in order to establish rational expectations for stock returns over the coming decade.
Recognize that in the long run, business reality trumps market expectations. Now, with the little book of common sense investing, he wants to help you do the same. It will also change the very way you think about investing. Zach Banks Bankszach10 — Profile Pinterest. Hannah Hannahkasali — Profile Pinterest.
Kristin Chapman Kachapman12 — Profile Pinterest. Melissa May Mmay05 — Profile Pinterest. Melanie Walters Mellowmomwalter — Profile Pinterest. Your email address will not be published. Save my name, email, and website in this browser for the next time I comment. Skip to content. Johnny Tremain Book Review. Ebay Harry Potter Audio Books. Leave a Reply Cancel reply Your email address will not be published. Then, not a moment too soon, they caught the full force of the downside.
Result: While the funds themselves achieved a net gain of 13 percent, the in- vestors in these funds incurred a loss of 57 percent. By in- vesting in these once high-flying funds, more than half of the capital that investors had placed in these hot funds had gone up in smoke. The message is clear: avoid per- formance chasing based on short-term returns, especially during great bull markets.
As it hap- pened, the top 20 funds of that ranked number one in each year had a subsequent average ranking of among the list EXHIBIT 9. During that period, the highest achievement on the fund list was turned in by the number one funds, which averaged a rank of in the subsequent year.
The clear reversion to the mean suggested by that single test represented powerful evidence that winning performance by a mutual fund is unlikely to be repeated. But there was no reason except common sense to as- sume that the to experience would recur. So, just for fun, I repeated the test in , beginning with the top-performing 20 funds in and the top 20 funds in each of the nine subsequent years. I then checked the rank of each fund in the following year, just as before.
In general, the results were remarkably similar. The average subsequent rank of the top 20 funds from through was , outpacing 57 percent of their peers and barely above the average fund among the 1, fund total—just as in the prior test.
In an interesting rever- sal of fortune, however, the number one funds of that era turned out to have, not the highest subsequent ranking, but the lowest ranking among the top These champi- ons subsequently earned an average ranking of among the 1,fund total, outpacing only 34 percent of their peers. The message is clear: reversion to the mean RTM —in this case, the tendency of funds whose records substantially exceed industry norms to return to average or below—is alive and well in the mutual fund industry.
So please remem- ber that the stars produced in the mutual fund field are rarely stars; all too often they are comets, lighting up the firmament for a brief moment in time and then flaming out, their ashes floating gently to earth. With each passing year, the reality is increasingly clear.
Fund returns seem to be random. And by then, you might ask yourself questions like these: 1 How long will that manager, with that staff and with that strategy, remain on the job? In short, selecting mutual funds on the basis of short-term performance is all too likely to be hazardous duty, and it is almost always destined to produce returns that fall far short of those achieved by the stock market, itself so easily achievable through an index fund.
We run [the contest] for the first year [for 10, managers]. Now we run the game a second year. Again, we can expect 2, managers to be up two years in a row; another year, 1,; a fourth one, ; a fifth, We have now, simply in a fair game, managers who made money for five years in a row. The number of managers with great track records in a given market depends far more on the number of people who started in the investment business in place of going to dental school , rather than on their ability to produce profits.
What do you mean? Under normal circumstances, it takes between 20 and years [of monitoring performance] to statistically prove that a money manager is skillful, not lucky. Investors need to know how the money management business really works. The game is unfair. Where do you invest? In Vanguard index funds. Once you throw in taxes, it just skewers the argument for active management. Personally, I think indexing wins hands-down.
Professional investment advisers provide many other services including asset allocation, information on tax considerations, and advice on how to save while you work and on how to spend when you retire; and they are always there to con- sult with you about the financial markets. Experienced advisers can also help you avoid the potholes along the investment highway.
Put more grossly, they may help you avoid making such dumb mistakes as chasing past performance or trying to time the market. At their best, these impor- tant services can enhance the implementation of your investment program.
The remaining 40 million families rely on profes- sional helpers. That is, their advice on equity fund selection produces re- turns for their clients that are probably not measurably different from those of the average fund, some 2. And if professional investment consultants are wise enough—or lucky enough—to keep their clients from jump- ing on the latest and hottest bandwagon for example, the new economy craze of the late s, reflected in the mania for funds investing in technology, telecommunica- tions, and Internet stocks , their clients could earn returns that easily surpass the disappointing returns achieved by fund investors as a group.
Remember the additional short- fall of 2. To remind you, the nominal return of fund investors came to just 7.
Alas from the standpoint of the advisers , there is sim- ply no evidence that the fund selection advice they provide has produced any better returns than those achieved by fund investors on average. In fact, the evidence goes the other way. For equity funds purchased directly: 6. Specifically, the study found that adviser asset alloca- tions were no better, that they chased market trends, and that those they advised paid higher upfront charges.
The other groups in- cluded funds operated by privately owned managers, by publicly-owned managers, by managers owned by finan- cial conglomerates, and by bank managers. The Merrill Lynch funds were 18 percentage points below the fund industry average; the Goldman Sachs and Morgan Stanley funds were 9 percentage points below av- erage; and both the Wells Fargo and Smith Barney funds were 8 percentage points behind.
Part of the reason for this disturbing performance may arise from the nature of the job. When the firm introduces a new fund, the brokers have to sell it to someone.
Imagine a day when nobody sold anything, and the stock market lay fallow, silent all day long. A Merrill Lynch example illustrates the destructive challenges that are often faced by investors who rely on stockbrokers. The subsequent returns of the funds, however, were an incredible failure. Internet Strategies tanked almost immedi- ately. Its asset value dropped 61 percent during the re- mainder of and another 62 percent by October The total loss was a cool 86 percent as most of its investors cashed out their shares at staggering losses.
Keeping a record like that alive would have been a continuing embarrassment to the firm. For what it is worth, the losses in Focus Twenty were less severe. Its asset value declined 28 percent in the remain- der of , another 70 percent in , and another 39 percent in , before finally posting positive returns in the three years that followed.
But, unlike its Internet Strategies cousin, Focus Twenty soldiers on. The comparative standard would be the returns earned by Vanguard Index Fund. Each quarter, the Times faithfully published the records of the index fund and the advisers, tracking their initial portfolios and the subsequent changes they made.
By , seven years later, the Times reported their ac- complishments Exhibit That is, the average ad- viser produced a paper profit on his portfolio of recommended funds that was about 40 percent less than the profit on the index fund. In mid, the Times abruptly terminated the con- test without notice. But the fact is that the Times terminated it at the very peak of the bull mar- ket, and at the moment of triumph for the index fund.
Since then, the index fund, like the market itself, has barely held its own. Two advisers did considerably better than the index fund during that subsequent period; one was worse, and one about the same. Here is a final piece of compelling evidence to sup- port that thesis.
Mark Hulbert, editor of the Hulbert Fi- nancial Digest, has been monitoring the real-time records of financial advisers who report their recommendations in newsletters subscribed to by investors. Only three outper- formed the market over the subsequent 26 years. These examples surely reinforce the thesis that index funds endure, while most advisers and funds do not; that index fund returns strongly exceed the returns earned even by those advisers and funds that do survive; that the odds against successful fund selection by advisers are large, and that compounding these rather consistent differentials in rates of annual return mount up to truly staggering differ- ences in wealth accumulation over the long term.
If you consider the selection of an adviser, please take heed of these findings. If you decide to go ahead, make sure you are paying a fair fee which results in a deduction from whatever rate of return your fund portfolio earns. Since most investment advisory fees tend to begin in the range of 1 percent per year, be sure to balance the worth of the peripheral services that advisers provide against the re- duction in your returns that those fees are likely to repre- sent over time.
Finally—and this will hardly surprise you—look with particular favor on advisers who recom- mend stock and bond index funds in their model portfolios. The warning signs here are recommendations of load funds, insurance products, limited partner- ships, or separate accounts. It is simply not worth paying anybody more than 1 percent to manage your money. If he tells you that he is able to find managers who can beat the indexes, he is fooling both you and himself.
Relying on even the best-intentioned financial advice seems to work only spasmodically. How can suc- cessful fund selection prove so difficult? Because of some- thing that, deep down, our common sense tells us: Performance comes and goes. That factor is the costs of owning mutual funds. Costs go on foreve r. While some funds scale down their fee rates as assets grow, the reductions are usually suf- ficiently modest that high-cost funds tend to remain high- cost; lower-cost funds tend to remain lower-cost, and the few very low-cost funds tend to remain very low-cost.
The average-cost funds, too, tend to persist in that category. Another large cost of equity fund ownership is the sales charge paid on each purchase of shares. It, too, tends to persist. Load funds rarely become no-load funds, and vice versa. I can recall no large fund organization making the immediate conversion from a load to a no- load distribution system since Vanguard took that drastic and unprecedented step 30 years ago.
Transactions cost money, and we estimate that turnover costs are roughly 0. Similarly, 50 per- cent turnover would cost about 0. Rule of thumb: turnover costs equal 1 percent of the turnover rate. Most comparisons of fund costs rely solely on re- ported expense ratios, and uniformly find that higher costs are associated with lower returns.
This pattern holds not only for equity funds as a group, but in each of the nine Morningstar style boxes large-, mid-, and small- cap funds, each sorted into fund groups with growth, value, and blended objectives.
While few independent comparisons take into account the additional cost of fund portfolio turnover, a similar relationship exists. Funds in the low-turnover quartile have consistently outperformed those in the high-turnover quartile for all equity funds as a group, and in each of the nine style boxes.
Tak- ing into account both costs, we find that the all-in annual costs range from 0. This exercise ignores sales charges and, therefore overstates the net returns earned by the funds in each quartile. Costs matter! Net annual return of low-cost funds, Pre-cost returns fall into a narrow range: a high of Costs account for most of the difference in the annual net returns earned by the funds. And there is another significant difference.
Those highest-expense, highest- turnover-cost funds assumed fully 34 percent more risk than their lowest-cost cousins. When we compound those annual returns over time, the cumulative difference reaches staggering proportions. Total compound gain for the period: percent for the low-cost funds, percent for the high-cost funds, a near doubling of profit arising almost entirely from the cost differential.
Talk about the relentless rules of humble arithmetic! In other words, the final value of the low-cost funds more than tripled over the decade, whereas the value of the high-cost funds barely doubled. Again, yes, costs matter!
But if you are seeking the lowest-cost funds, why limit the search to actively managed funds? The classic index fund had the lowest costs of all: an expense ratio averaging 0.
With no measura- ble turnover costs, its total all-in costs were but 0. The gross return of the Index Fund was Carrying a lower risk than any of the four cost quartiles annual price volatility averaging If investors could rely on only a single factor to select future superior performers and to avoid future inferior performers, it would be fund costs. The record could hardly be clearer: the more the managers and brokers take, the less the investors make.
So why not own an index fund with no active manager and no management fee, and with virtually no trading of stocks through those Helpers mentioned in Chapter 1? Why not, indeed? Chapter 12 explores this idea further. And for much of that time, mil- lions of fund investors not to mention dozens of fi- nancial journalists including this one basically ignored him. Sure, we recognized the intrinsic mer- its of index funds such as low annual expenses and because the funds keep turnover to a minimum, tiny transaction costs.
Moreover, because index fund managers convert paper profits into realized gains less frequently than do the skippers of actively man- aged funds, shareholders pay less tax each year to Uncle Sam. To be sure, those three advantages form a trio as impressive as Domingo, Pavarotti, and Carreras. You win. In fact, more often than not, aiming for bench- mark-matching returns through index funds assures shareholders of a better-than-average chance of out- performing the typical managed stock or bond port- folio.
You have a right to call it, as you recently did in a booklet you wrote, The Triumph of Indexing. Several index funds carry expense ra- tios as low as 0. And it works. The case for the success of indexing in the past is compelling and unarguable. And with the outlook for subdued returns on stocks during the decade ahead, I am concluding my anecdotal stroll through the relentless rules of humble arithmetic with a final statis- tical example that suggests what the future may hold.
We can, in fact, use statistics designed to project the odds that a passively managed index fund will outpace an actively managed equity fund over various time periods. The particular example presented here assumes that index fund costs will run to 0. Result: Over one year, about 29 percent of active managers on average, would be expected to outpace the index; over five years about 15 percent would be expected to win; over 10 years, 9 percent; over 25 years, 5 percent; and over 50 years just 2 percent of active managers would be expected to win Exhibit How will the future actually play out?
So it looks as if our statistical odds are in the right ballpark. This arithmetic suggests—even demands— that index funds deserve an important place in your portfolio, even as they constitute the overriding portion of my own. Whatever the case, in the era of subdued stock and bond market returns that most likely lies in prospect, fund costs will become more important than ever. Even more so when we move from the illusion that mutual funds as a group can capture whatever returns our finan- cial markets provide to the even greater illusion that most mutual fund investors can capture even those depleted re- turns in their own fund portfolios.
My conclusions about the market returns we can expect in the years ahead, as well as my conclusions about the share of those returns that funds will capture, and the share of those returns that we investors will actually enjoy, have one thing in com- mon: They rely, not on opinion, but largely on mathe- matical facts—the relentless rules of humble arithmetic that make selecting winning funds rather like looking for a needle in a haystack.
You ignore these rules at your peril. If the road to investment success is filled with dan- gerous turns and giant potholes, never forget that sim- ple arithmetic can enable you to moderate those turns and avoid those potholes. So do your best to diversify to the nth degree; minimize your investment expenses; and focus your emotions where they cannot wreak the kind of havoc that most other people experience in their investment programs. Rely on your own common sense.
Emphasize all-stock-market index funds. Care- fully consider your risk tolerance and the portion of your investments you allocate to equities. Then stay the course. I should add, importantly, that all index funds are not created equal. While their index-based portfolios are sub- stantially identical, their costs are anything but identical.
Some have miniscule expense ratios; others have expense ratios that surpass the bounds of reason. Some are no-load funds, but nearly a third, as it turns out, have substantial front-end loads, often with an option to pay those loads over a period of usually five years; others entail the pay- ment of a standard brokerage commission. Exhibit The wise investor will select only those index funds that are avail- able without sales loads, and those operating with the lowest costs. These costs—no surprise here!
Fidelity Spartana 0. Vanguard Admiral a 0. Vanguard Regular 0. USAA 0. Rowe Price 0. UBS 0. Morgan Stanley 0. Wells Fargo 0.
Evergreen 0. Morgan 0. I assume, however, that these variations will be lower in the future, and have therefore ignored them as an element in the cost-value equation. Funds tracking a par- ticular index are—or should be—commodities in terms of their portfolios and the returns they provide. While cost differentials may look trivial when expressed on an annual basis, com- pounded over the years they make the difference between investment success and failure.
Its subsequent return can be compared with that of the original Van- guard Index Fund over the same period. The sales commission on the Vanguard Index Fund was eliminated within months of its initial offering, and it has operated with an expense ratio averaging 0.
By , the ratio had decreased to 0. In con- trast, the Wells Fargo fund carried an initial sales charge of 5. These seemingly small differences added up to a 23 percent enhancement in value for the Vanguard fund.
All index funds are not created equal. Intelligent investors will select the lowest cost index funds that are available from reputable fund organizations. It should be your own cash cow. Some years ago, a Wells Fargo representative was asked how the firm could justify such high charges.
Investors face a mind-boggling set of confus- ing choices—large cap, mid-cap, small-cap, industry sec- tors, international, single country, and so on. To make it more confusing, indexing works like a charm in every one of these areas. A well-administered index fund is in- evitably destined to surpass the returns earned by the other investors in the market segment tracked by its index.
Even though we never have complete information about the precise returns earned by investors as a group in each segment, given the relentless rules of humble arithmetic, it must work that way. Remarkable but unsurpris- ing. While these comparisons, sorted by number of funds rather than by fund assets, have the flaws noted earlier, the message could hardly be clearer: indexing is the winning strategy. During the past five years alone, an astonishing 28 percent of all general eq- uity funds have gone out of business.
But common sense tells us that for each big success, there must also be a big failure. As it must. For, whether markets are efficient or inefficient, as a group all investors in that segment earn the return of that segment.
In inefficient markets, the most successful managers may achieve unusually large returns. But never forget that, as a group, all investors in any discrete seg- ment of the stock market must be, and are, average. Common sense tells us that for each big success, there must also be a big failure.
But after all those deductions of even larger management fees that funds incur in less efficient markets, and the damaging impact of their even larger turnover costs, the aggregate lag is even wider. So even in inefficient market segments, index funds, with their tiny costs, win again. International funds are also subject to the same allega- tion that it is easier for managers to win in supposedly less-efficient markets.
But also to no avail. With indexing so successful in both more ef- ficient and less efficient markets alike, and in U. But while investing in particular market sectors is done most efficiently through index funds, betting on the winning sectors is exactly that: betting. Largely because emotions are almost certain to have a powerful negative impact on the returns that investors achieve. Whatever returns each sector may earn, the investors in those very sectors will likely, if not certainly, fall well behind them.
For there is abundant evi- dence that the most popular sector funds of the day are those that have recently enjoyed the most spectacular re- cent performance. As a result, after-the-fact popularity is a recipe for unsuccessful investing. Betting on stock market sectors, a weak reality. Alas, while the original idea was strong, the ensuing reality was weak.
What followed their introduction was a classic example of performance chasing. During the to period, the stock market was relatively placid, and value stocks and growth stocks delivered similar returns. Then in the new economy bub- ble, growth stocks took off, earning a cumulative return by that left value stocks in the dust to March Growth Index total return, percent; Value Index total return, percent.
Re- version to the mean took hold, and growth stocks plum- meted through Investor interest in the two fund styles was well balanced during the early years. Since , the two funds have achieved substantial positive returns on the standard time-weighted basis—9. With their counterproductive timing and selection, how- ever, investors in these index funds have not come even close to matching those returns.
While investors in the Value Index Fund did better, their return of 7. Since , the cumulative return of the Growth Index has been percent, versus percent for the Value Index, based on the traditional calculation of fund performance. The Growth Index Fund investor, mean- while, earned but 13 percent, and the Value Index Fund investor earned about percent. So look before you leap in trying to pick which mar- ket sector to bet on. It may not be as exciting, but owning the classic stock market index fund is the ultimate strat- egy.
It holds the mathematical certainty that marks it as the gold standard in investing, for try as they might, the alchemists of active management cannot turn their own lead, copper, or iron into gold. Just avoid complexity, rely on simplicity, take costs out of the equation and trust the arithmetic.
If so, consider the odds calculated by Michael J. While my 2 percent estimate would mean that 1 portfolio in 50 would outperform the stock market over 50 years, Mauboussin calculates the odds of a fund outperforming for 15 years con- secutively at 1 in ,, and at 1 in 31 million over 21 years.
Either way, the odds of outpacing an all-market index fund are, well, terrible. There is one thing sure about all this complexity, the total cost of all the investment management, plus the frictional costs of fairly often getting in and out of many large investment posi- tions, can easily reach 3 percent of foundation net worth per annum. The wiser choice is to dispense with the consultants and reduce the investment turnover, by changing to indexed investment in equities. The only way for a manager to add an in- crement to that return is to make interest rate bets—for example, by selling bonds when he expects rates to go up and prices down , and then buying bonds when the re- verse is expected to happen.
If you think that picking stocks and timing their purchase is hard, just imagine how hard it is to execute these same strategies successfully in the incredibly efficient precincts of the bond market.
Thus, managers of fixed income funds almost in- evitably deliver a gross return that parallels the baseline constituted by the interest rate environment. Yes, a few managers might do better—even do better for a long time—by being extra smart, or extra lucky, or by taking extra risk. While these costs make the task of adding returns far more difficult, overly confident bond fund managers may be tempted to take just a little extra risk by extending ma- turities of the bonds in the portfolio.
Long-dated bonds— say, 30 years—are much more volatile than short-term bonds—say, two years—but usually provide higher yields.
They are also tempted to reduce the investment quality of the portfolio, holding less in U. Treasury bonds rated AAA or in investment-grade corporate bonds rated BBB or better , and holding more in below-investment- grade bonds BB or lower , or even some so-called junk bonds, rated below CC or even unrated. Since stocks represent the residual ownership or equity of corporations, the word safety is not usually associated with them. Bonds, on the other hand, represent debt.
If the payments of interest that corporations and governments promise to make every six months are threatened, their ratings will be downgraded and the market value of their bonds reduced. And if they fi- nally fail to make the promised payments, they enter bank- ruptcy proceedings. So this chapter presents the three basic maturity levels that have become the industry standard, one in each of the three major bond segments— taxable corporate and government bonds, tax-exempt mu- nicipal bonds, and U.
Treasury issues. The discussion begins with intermediate-term taxable bond funds; then turns to long-term tax-exempt bond funds; and finally evalu- ates funds investing in short-term U. Treasury notes. A finding that indexing wins should no longer surprise you.
With a year return averaging 6. But there are few other bond funds in these categories that imple- ment index or index-like strategies, and literally none with lower costs for individual investors.
While the actively managed bond funds as a group earned a lower gross return than either the index fund or the index, relative cost proved to be the principal differen- tiator in net return. As a group, the portfolios of the actively managed bond funds include about 25 percent corporate and 75 per- cent U. And so the message echoes. Among intermediate-term taxable bond funds, in terms of maximizing your return and minimizing your risk, the low-cost index fund is truly a su- perior performer.
In addition, its return benefits from the absence of sales loads. Always avoid bond funds with sales loads. A typical 5 percent load would obliterate your en- tire yield for the first year. Because of complexities in the construction of municipal bond in- dexes, there are no pure index funds in this category.
Since the index provided a gross return of 5. Once again, low costs lead to higher returns. The 5. With low- costs, broad diversification, and no serious attempt to outguess the market in long-term tax-exempt bond funds, once again indexing wins.
Our sweep of the bond fund arena concludes with an examination of short-term funds investing in U. Trea- sury obligations Exhibit There are few surprises here.
The net return earned by the index itself 5. Again, while the Vanguard Short-Term Government Bond Fund is not, technically speaking, an index fund, it tracks the index re- turn with remarkable precision, turning in a net average annual return of 5. The lowest cost options win again, outpacing 97 of the short-term government funds. Treasurys being Trea- surys, investment quality is virtually uniform.
Both the Vanguard index fund and the index itself hold percent of their portfolios in short-term U. Treasury notes, and the active funds hold 99 percent. With its towering 0. Again, many of these actively managed funds carry sales charges, averaging 3 percent, which are incorporated into the returns shown in Exhibit The tracking of its benchmark, its quality parity, and its extremely low expenses mark the Vanguard Short- Term Treasury Bond Fund as the functional equivalent of the Lehman 1—5 Year Government Bond Index.
While there are no bond funds that track this index, the Van- guard fund is the virtual equivalent of an index fund. Money market funds can be thought of as very short-term bond funds with uniformly high credit qual- ity. As a result, they tend to earn substantially identical gross yields on their portfolios. With their short maturities, extremely high credit quality, and broadly diversified portfolios, money mar- ket funds essentially become commodities.
Thus, when all else is equal as it is here , relative performance is determined by relative cost. So, even more than in stock index funds and bond index funds, cost tells virtually the entire story in money market funds. If we rank the records of all money market funds in terms of the returns they have delivered to investors over the past 10 years highest first and then compare their expense ratio lowest first , the relationship is almost perfect.
The Vanguard Prime Money Market Fund, close cousin to our hypothetical index fund, was among the leaders, producing a net annual re- turn of 3. Among comparable funds, it ranked number 7. Remarkably, while the data are not shown in Exhibit But with a shocking annual expense ratio of 1. Why would investors pay more than a 0. The answer is beyond me. They should probably have their heads examined. How the supposedly independent directors of these 45 money funds with expense ratios at or above the 1.
Their job is to represent the interests of the fund shareholders, and they have failed. Nonetheless, smart investors will save themselves lots of money—and substantially improve their returns—if they apply the same principles of broad diversifi- cation, low-cost, no-load, minimal turnover, and long-term investing when they select fixed income funds. These are the very commonsense characteristics that enable index funds to guarantee your fair share of the returns in the bond and money markets, even as they do in all financial markets.
For the actively- managed load funds, the index fund advantage amounts to 1. The data provide a sobering glimpse of the challenge encoun- tered by the active bond fund manager. Near-index bond mutual funds provide an alternative to indexing the bond market.
While the funds do not completely conform to the index fund model, they share key characteristics: very high degree of diversification [in the specified market segment], very low expense ratio, very low transaction costs, and absence of sales loads. The evidence is compelling and comes down firmly in favor of investing in index funds. Over the ten-year period —, US bond index funds returned 8.
This differential is largely due to fees. Today, most indexed assets are concentrated in classic index funds representing the broad U. Indexing has become a competitive field. The largest managers of the classic index funds are engaged in a fiercely competitive price war, cutting their expense ratios to draw the assets of investors who are smart enough to realize the price is the difference.
This trend is great for index fund investors. But it slashes profits to index fund managers and discourages entrepreneurs who start new fund ventures in the hopes of enriching themselves by building fund empires. So how can promoters take advantage of the proven attributes that underlie the success of the traditional index fund? Why, create new indexes! And then charge a higher fee for that higher poten- tial reward, whether or not it is ever actually delivered. Traditional indexes, as noted in Chapter 3, are cap- weighted.
That is, the weight of each stock or bond in the index portfolio is determined by its market capitaliza- tion. The total U. Remember the Gotrocks family, in Chapter 1. If the market rises by 10 percent, all investors as a group earn 10 percent before costs. So the miracle, as it were, of the index fund, is simple arithmetic. By minimizing all those costs of investing, it guarantees that its participants will earn higher net returns than all the other participants in stock ownership as a group.
This is the only approach to equity in- vesting that can guarantee such an outcome. The only way to beat the market portfolio is to depart from the market portfolio. For their trading merely shifts ownership from one holder to another.
All that swapping of stock certificates back and forth, however it may work out for a given buyer or seller, enriches only our financial intermediaries. The active money manager, in effect, puts forth this ar- gument. I know that the stock market is highly efficient, but through my intelligence, my expert analysts, my computer programs, and my trading strategies, I can spot temporary inefficiencies and capture them, over and over again.
Nonetheless, hope springs eternal among money managers, and they strive for excellence. Of course, they believe in themselves. This field has few shrinking violets!
But they also have a vested financial in- terest in persuading investors that if they have done well in the past they will continue to do so in the future. In- teresting! They have developed new methods of weighting portfolio holdings that they vow will outperform the tradi- tional market-cap-weighted portfolio that represents the holdings of investors as a group. This new breed of indexers—not, in fact, indexers, but active strategists—focuses on weighting portfolios by so-called fundamental factors.
Rather than weighting by market cap, they use a combination of factors such as cor- porate revenues, cash flows, profits, or dividends for ex- ample, the portfolio may be weighted by the dollar amount of dividends distributed by each corporation, rather than the dollar amount of its market capitaliza- tion.
They argue, fairly enough, that in a cap-weighted portfolio, half of the stocks are overvalued to a greater or lesser extent, and half are undervalued. But who really knows which half is which? And—this will not surprise you— the fundamental factors they have identified as the basis for their portfolio selections actually have outpaced the tradi- tional indexes in the past.
We call this data mining. For you can be sure that no one would have the temerity to promote a new strategy that has lagged the traditional index fund in the past. The members of this new breed are not shy about their prescience.
They compare the traditional market-cap weighted in- dexers with ancient astronomers who attempted to perpet- uate the Ptolemaic view of an earth-centered universe.
They come armed with vast statistical studies that prove how well their methodologies have worked in the past or at least since , when their back-tested studies began.
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