How to Win the Loser's Game, Part 7
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Transcript:
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.
Nobel Prize-winning economist Professor Eugene 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.”
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: “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."
Richard Wood from Barnett Ravenscroft Wealth Management says: “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: “The best question an investor can ask is, Where do returns come from? 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: “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?"
http://SensibleInvesting.tv
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