Wednesday, March 08, 2006

Asset allocation basics: Part V Index investing

It’s been difficult to decide what to write about index funds since so much information on them are already available and I want to have at least a hint of originality in what I write. In the end, I decided to tackle the common practice of just buying one or two major index funds. I apologize if I end up sounding like a broken record. This is really important stuff.

Now that the asset mix has been determined, the logical next step is to choose the best available securities that represent each asset class. These securities are likely to be mutual funds or exchange traded funds since individual stocks do not offer the kind of diversification necessary. Moreover, most proponents of the asset allocation approach are also proponents of the passive style of investing and shun away from picking individual stocks. There is solid evidence, especially among domestic, large cap funds, that index funds are the best which I’m sure my readers are aware of. At the same time, I have seen many people use the total market index fund or the S&P index fund as their sole exposure to stocks. I believe extra return can be gained through a little bit more work.

Index investing

Most people have heard of index investing, but it bears reiterating that index investing under the paradigm of asset allocation aims to obtain above-market returns. Many people confuse index investing with buying a fund of the S&P 500 or the Wilshire total market index. While an S&P index fund is as good a way as any to fulfill the US large cap segment, it should constitute only a small portion of the asset allocation plan. The following diagram from Money Chimp illustrates various indices and their relation to the entire stock market.

Someone buying the Wilshire 5000 is devoting only about 5% to the small cap space. Now recall the asset allocation (see Part III) for domestic equities that called for an equal weight in large blend, large value, small blend and small value segments. In effect, the small and value components are accentuated relative to the overall market. This approach is rooted in the seminal work by Fama and French that quantified the extra return potential by value and small cap stocks.

To appreciate the extra return provided by small(er) cap and value stocks, let’s look at the comparison between SPY, the popular ETF that tracks the S&P 500 index, and RSP, the Rydex S&P equal weight index ETF. The expense ratio of SPY is 0.11%, lower than the 0.4% for RSP (A moment’s reflection should convince you this should be the case even if the two funds are of the same size. Annual turn over is 55% for RSP and 2.23% for SPY.) In spite of this handicap, RSP handily outperforms SPY as shown in the chart below. The equal weight index actually has a longer track record than the ETF and has made all-time highs while the S&P is still below its 2000 peak. RSP has the same stocks as those in the S&P500 index, but assigns the same dollar amount to each; in other words, the stocks with smaller market caps that also tend to be value stocks are overweighed in RSP vs. SPY. Frequent rebalancing (quarterly, I believe) as stock values change incurs higher expenses, but apparently not enough to deter RSP from out performing SPY in the past three years, and by 15.28% to 9.81% in the past year. (All figures from Yahoo Finance dated Mar 3, 2006.)

So again the point I’m trying to make is that by properly allocating the index funds, one can achieve above-market returns. We should always keep in mind that the goal of diversification is not to replicate the stock market, which will naturally give market returns. The goal of diversification is to reduce correlation of portfolio components such as with large and small caps, or on a greater scale, domestic and foreign funds, to achieve above-market returns. That’s why I don’t have mid caps in my allocation plan even though they are perfectly fine investments by themselves. They also happen to behave like a mixture of the large and small caps, thus add to trading expenses without providing extra portfolio returns.

As an aside, note the ETF account #1 in my asset allocation accounts. It was based on Merriman’s balanced ETF buy-and-hold portfolio except I replaced SPY with RSP. I allocated $30k to this plan on 9/8/2005 and intend to write about it from time to time. To a young investor starting out, I would suggest looking into this plan, maybe reduce SHY and AGG to 15% each and add 5% each of IGE and GLD for some commodities exposure. Note the Merriman portfolio was updated recently and he replaced some iShares ETFs with Vanguard Vipers, perhaps due to the lower fees.

There is also something to be said about the precision of various indices, e.g., the kind of value metric, P/E, P/S or whatever, to differentiate value and growth stocks, etc. DFA funds are said to be backed by tons of academic research and more precise as a result. Unfortunately, they are only available to individual investors through approved financial advisors. They have, however, recently become available through West Virginia’s Smart 529 Select plan.

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