Dr. Bernstein was quoted in several comments in “The Globe and Mail” article “Investing smart is a ‘no-brainer,’ at least to this neurologist”. The following are some of the interesting excerpts from the article:

Smart investors ignore the economy, market sentiment and all strategists employed by investment firms, said Dr. Bernstein, who has long been a thorn in the side of active fund managers, Street analysts and peddlers of exotic exchange-traded funds and other vehicles designed more to enrich their architects than to reward their investors.

“I recommend a passive approach,” he said the other day in an e-mail exchange. “That is, I do not believe that there’s such a thing as skill in security selection, and I favour vehicles that transact as little as possible.”

His “no-brainer” portfolio of indexed funds regularly beats the market by a wide margin. Why? “Because it’s well-diversified, biased towards small and value stocks and passive.”

He doesn’t pull any punches when talking about such pet peeves as hedge fund managers and investment bankers, prospects for commodities or the current mania for the BRIC countries – Brazil, Russia, India and China.

On hedge funds: “The best vehicle known to man for separating country club members from their wealth.”

On bankers: “Bankers seem to have the attention span of a kindergarten class. I give them another five years before they’re back to playing the same melody with different instruments.”

On BRIC investing: “A wire-house gimmick. The correlations of these four nations to the returns of U.S. equities aren’t any different from Argentina, Turkey, Indonesia, Malaysia or the Philippines. If someone makes the point that the BRIC nations have high growth rates, they might as well be wearing a bright red neon sign on their foreheads that flashes ‘I can’t read,’ since the correlation between economic growth and stock returns is negative.”

On commodities: In theory, a good portfolio diversifier. “But in practice, I don’t trust any of the vehicles currently available, and I’m also generally skeptical of any ‘asset class du jour,’ which commodities certainly are. The time to expose yourself to an asset class is when no one else is interested.”

I tend to agree with him. His book — “The Four Pillars of Investing” remains my all-time favorite investing book.

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• July 30, 2009 — Squeezing out more tax efficiency from my portfolio (1)
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Related post HERE.

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You will be surprised by the amount of information covered. For a start, here is a list of topics in the library:

Table of Contents

I.References
A. Glossary
B. Investing: For Beginners
C. Books
D. Academic Research Links
E. About Vanguard and its Founder

II.Asset Allocation
A. Asset Allocation
B. Asset Location
C. Risk, uncertainty and behavioral pitfalls

III.Asset Classes

A. Equity
(a.) US Stocks
(b.) International Stocks
(c.) REITS
(d.) International REITS

B.Fixed Income
(a.) Bonds
(b.) TIPS
(c.) High Yield Bonds
(d.) Convertible Bonds

C. Alternative
(a.) Commodities

IV.Portfolio Management
A. Active vs. Passive Investing
B. Taxable account investing
(a.) ETF
C. Retirement and tax deferred investing
D. Rebalancing
E. Withdrawal Strategies

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• March 27, 2006 — International money transfer options (0)

For the mutual fund version (ticker VFWIX), the expense ratio is 0.40%, with a purchase fee of 0.25%, and a redemption fee of 2% if sold within two months. The expected date of offering is March 8, 2007.

For the ETF version (ticker VEU), the expense ratio is 0.25%. The expected date of offering is March 2, 2007. Usual brokerage fees apply if you do not have access to a free trade program.

The mutual fund version, with the purchase fee is not appealing to me at all but the ETF version does. Compared to the iShares MSCI EAFE ETF (ticker EFA, ER 0.35%), this new ETF would cover the equity market of the entire world except the US. This means that it also includes Canada and emerging markets which EFA doesn’t. In addition, it also comes with a lower price tag than EFA.

Hopefully, this fund would have a respectable trading volume when it debuts on Friday.

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Don Phillips, managing director at Morningstar, offers his insight on whether market-cap weighted indexes serve investors’ best interests. He also discusses the risks associated with today’s specialized indexes and what steps providers can take to moderate those risks:

The bottom line is this; the index community is at a crossroads. It’s wandered so far from its roots of offering one-stop, broad-based exposure to the market that a return to that simpler approach may not be possible. In creating more complex offerings, the index community has found new revenue sources from hedge funds and other parties seeking very specialized tools, but it has done so at the risk of doing considerable harm to less sophisticated investors. The test of character facing the index community is whether it ignores that risk or steps up and tries to mitigate it.

Morningstar director of mutual fund research, Russel Kinnel, examines the role indexing plays in active and passive investing strategies. All too often, he says, the industry uses an incorrect proxy for indexing that can lead to the wrong conclusions:

For the trailing three years ending 2005, fewer than one-third of small-cap U.S. stock funds beat their respective Morningstar Index. Meanwhile, more than half of large-cap U.S. stock funds beat their respective index.

Index returns from July 1997 through January 2006 are shown below:

I particularly think that the following statements make a lot of sense for investors when selecting mutual funds:

Our studies have shown that lower-cost funds—regardless of whether they are active or passive—are a good bet. Maybe small caps really are less efficient than large caps despite what these figures show, but on another level, it doesn’t really matter. Either way, lower-cost funds are the way to go, and investors ought to do well whether they choose active or passive funds. And of course, investors can do better by focusing on other fundamentals, too, such as management, strategy, and asset size. When choosing an index fund, investors should look for one with low turnover, low costs, and a diversified portfolio.

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However, since the ‘raw’ index does not include dividends, the above conclusion is incorrect; we need to include dividends. To do this, and to use an investment easily understood and reproducible by investors (as opposed to just a hypothetical investment), I shall use the popular SPY ETF (expense ratio 0.10%) as a proxy for the actual investment returns obtainable by an investor if it were held in a tax-deferred account.

Using data from Yahoo finance, the “adjusted close” value (“adjusted close” means that the value is adjusted for dividend distributions) of SPY on Mar 24, 2000 was $139.23. The most recent closing value of SPY (Oct 6, 2006) was $135.01, or roughly 97% of the peak. This means that the breakeven point for a lump-sum investment in the S&P 500 made on Mar 24, 2000, will be reached if the index rises by another 3% or so.

The effect of dividend distributions can be observed in the attached figure. In the figure, the ‘raw’ index values (in blue) are given on the left axis and superimposed on the right axis are the ‘dividend-adjusted’ values of the SPY ETF (in green). We can see that dividend distributions have significant effect on the returns of the investment. These should never be ignored when comparing an investment’s performance with a given index.

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Will value stocks do better than growth stocks? I don’t know, and I don’t care — my index fund owns both. Will health care stocks be the best bet for the next 20 years? I don’t know, and I don’t care — my index fund owns them. What’s the next Microsoft? I don’t know, and I don’t care — as soon as it’s big enough to own, my index fund will have it, and I’ll go along for the ride.

With an index fund, you’re on permanent auto-pilot: you will always get what the market is willing to give, no more and no less. By enabling me to say “I don’t know, and I don’t care,” my index fund has liberated me from the feeling that I need to forecast what the market is about to do.

I agree. The fact is, if you have a low-cost, tax-efficient and well diversified investment plan set up, you really “will have more time and mental energy for the important things in life, like playing with my kids and working in my garden”. You really wouldn’t be constantly fretting over the latest stock pick or hunting for the next hot stock to buy.

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While the new high is only some 0.0372% higher than the number set six and a half years ago, it is incorrect to conclude that had an investor invested $100,000 in the DJIA companies back in Jan 14, 2000, he would now be back to square one, i.e. roughly breakeven on the investment ($100,037.20). This is because the index itself does not adjust for the effect of dividends.

To see this, let’s use the example of the DIAMONDS ETF (DIA), which specifically invests in the Dow companies. Using data from Yahoo finance, on Jan 14, 2000, DIA closed at 117.50 and on Oct 3, 2006 it closed at 117.14. (In fact, if we just looked at the raw numbers, DIA actually closed lower on Oct 3, 2006 than on Jan 14, 2000! This is probably due to the effect of expenses incurred by the fund; but this is not the main point of this post.) But if we take dividend distributions into account, the picture is different.

To take dividend distributions into account, we have to dig up the dividends distributed by DIA through the six and a half years. However, there is an easier way; you can view this information from Yahoo finance since it conveniently adjusts for the effect of dividends. This is shown in the last column of the attached figure.

To get the full picture, we note that the adjusted close of DIA on Jan 14, 2000 was $103.52. It closed at $117.14 on Oct 3, 2006. So the gain is 13.16% for the six and a half years. In other words, if you had put $100,000 in the DJIA companies in a tax-advantaged account on Jan 14, 2000, you would now have roughly $113,160. Not a big gain, but far better than the $100,037.20 had we not properly accounted for the dividends.

Note that this “quirk of index construction” is sometimes used by indexing-bashers to confuse investors that investing in index funds gets you nowhere after ‘X’ number of years. But the fact is, the raw index numbers usually does not include dividend distributions, and does not tell the true story.

Update:

DIA’s adjusted close on Jan 14, 2000 was $103.52. The next high for DIA’s adjusted close was on Dec 21, 2004 at $103.55. So the DIA ETF first broke the breakeven point on Dec 21, 2004.

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When WisdomTree Investments launched its first 20 dividend-weighted exchange-traded funds (ETFs) in June, CEO Jonathan Steinberg didn’t hold back. Calling market-cap weighted indexes “flawed,” Steinberg said that his funds “had the potential to change the way investors think about indexing and investing.”

Weighting stocks by dividend, Steinberg said, as opposed to market capitalization, was simply “a better way to index.”

…

Writing on the op-ed pages of the Wall Street Journal, John Bogle and Burton Malkiel issued a fiercely worded bromide against “fundamental indexing,” calling it little more than a fad made possible by the tremendous outperformance of value stocks in the wake of the Internet bubble. Fundamental indexing’s large-scale outperformance, they suggest, is sure to be dashed … perhaps soon … against the rocky shores of reversion-to-the-mean.

“[W]e need to be cautious before accepting any “new paradigm” that implicitly suggests that the “old paradigm”— reflected in more than $3 trillion of capitalization-weighted index investment funds—is in error,” they wrote.

…

Costs Matter

Bogle and Malkiel start by pointing out the central, tautological truth of capitalization-weighted indexes: Investors as a whole must earn the same return provided by a capitalization-weighted index.

“We can not live in Garrison Keillor’s Lake Wobegon, where all the children are above average,” they write. “For every investor who outperforms the market, there must be another investor who underperforms.”

In fact, the universe of investors in aggregate must under-perform the benchmarks because you must deduct the fees and taxes that come with investing in the market. And that, say Bogle and Malkiel, is where fundamental indexes start to suffer.

The pair note that the expense ratios for publicly available fundamental index funds range from 0.49 percent to 1.14 percent. Although the WisdomTree ETFs cost significantly less than that, even their low fees (some as low as 28 basis points) are still significantly higher than traditional index strategies. The FTSE/RAFI U.S. 1000 PowerShare comes in at 60 bps.

Moreover, the pair notes, fundamental indexes will tend to experience higher turnover than cap-weighted indexe s , thanks to weighting adjustments mandated by changes in the fundamental factors. In cap-weighted indexes (at least, in total market cap-weighted indexes), those adjustments are made automatically with no cost to investors tracking the index.

Interestingly, the core backtested data published by WisdomTree, Arnott and others do not reflect the impact of fees or taxes.

[Note : See post The next wave of indexing investing which discusses "fundamental indexing".]

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“The introduction of the First Index Investment Trust was one of the few truly seminal dates in the mutual fund industry,” said John J. Brennan, Vanguard chairman and CEO. “It offered the individual investor a broadly diversified, low-cost investment approach that wasn’t available before.”

The reaction to this momentous event from Wall Street was “a frown and a shrug”. Conventional wisdom said that only actively managed funds made sense for individuals. Why would anyone not try to beat the market?

Of course, now we know that history was re-written with the introduction of this fund. The Vanguard 500 index fund has also grown to become one of the largest funds in the world.

Below are some statistical snapshots of index funds:

I started investing with Vanguard in August 2001. So, this month also marks my 5 year anniversary of investing with index funds.

Note: The article “Indexing turns 30, and the revolution continues” appears on the Vanguard website HERE.

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1. Index funds (on average) have higher returns than managed funds. (play the odds).

2. Diversification: The increased diversification of index funds results in lower risk. Baer & Ginsler did a study of Standard Deviaton for actively managed funds vs. the total stock market over both 5 and 10-year periods. Their conclusion: “The returns of actively managed funds were 20 to 25% more volatile than the broad market.”

3. Consistancy: Vanguard’s Total Stock Market Index Fund ranked among the top 25% of large-blend funds in just two of the past 10 years. Nevertheless, because of it’s consistency, only twice falling below average, it outpaced 85% of all large-blend stocks after taxes.

4. Continuation: Of 355 actively managed equity mutual funds around in 1974, less than half survive today. Indexers do not have to worry that their fund will disappear.

5. No style drift: We know that asset allocation determines about 90% of portfolio performance. Managed fund allocations often change.

6. No overlap. It is almost inevitable that a portfolio of managed funds will have overlap. This is not a problem with index funds.

7. No manager changes: History tells us that the average manager leaves within five years. Index fund investors do not worry about manager changes.

8. No worry about underperforming a benchmark index: Many current best performing managed funds later seriously underperform (U.S. Growth, Magellan, Legg Mason Value Trust, etc.). It is much more important to avoid losses than to achieve extra gains.

9. No worry about “asset bloat” which often causes large successful funds to underperform (Magellan).

10. Less cash dilution. Index funds hold less cash than active funds.

11. Less worry that a manager has “lost his touch.” Index funds are expected to return to profitability.

12. Tax-Efficiency: Index funds are significantly more tax-efficient than most managed funds. It is after-tax return that counts.

13. Low maintenance: Index funds are simple, predictible, and easy to understand, explain, and maintain.

14. Peace of mind: Indexers know the averages are always working for them. The index investor has much less worry and more free time to spend with family and other more enjoyable endeavors.

Testimonials to indexing from leading investment experts:

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees.” Warren Buffet

“Most investors would be better off in an index fund.” Peter Lynch

“Only about one out of every four equity funds outperforms the stock market. That’s why I’m a firm believer in the power of indexing.” Charles Schwab

“Index funds are perhaps the most underrated stock funds in existence.” “Mutual Funds for Dummies”

“The fund industry’s dirty little secret: most actively managed funds never do as well as their benchmark.” Arthur Levitt, Chairman, SEC

“The closest thing to a sure thing is that the Wilshire 5000 index will outperform actively-managed funds by l.5 to 2 percentage points a year over a sustained period.” Jack Bogle

“Over the long-term the superiority of indexing is a mathematical certainty.” Jason Zweig, senior writer for “Money”

“The media focuses on the temporarily winning active funds that score the more spectacular bull’s eyes, not index funds that score every year and accumulate less flashy, but ultimately winning, scores.” W. Scott Simon, author

“I love index funds.” William Sharpe, Nobel Laurete

“Indexing is for winners only.” Jane Bryant Quinn, author, syndicated columnist

“The most efficient way to diversify a stock portfolio is with a low fee index fund.” Paul Samuelson, Nobel Laurete

“Most people should simply have index funds so they can keep their fees low and their taxes down.” Jack Meyer, CEO, Harvard Management

“Four years ago I was a fan of index funds. Today I am a true believer.” Jonathan Clements, senior writer, Wall Street Journal

“We find that on average, active management reduces a portfolio’s returns and increases its volatility compared with a static index.” Vanguard Investment Counseling & Research Analysis

“They’re just not going to do it (beat the market). It’s just not going to happen. Daniel Kahneman, Nobel Laureate

“I was not always an obnoxious indexing zealot. Ten years of believing in and selling active management strategies in the brokerage industry made me this way.” Rick Ferri, CFA, author, financial adviser

“Active portfolio management thus tends to generate lower returns and higher taxes.” John Haslem, author, “Mutual Funds: Risk and Performance Analysis”

“Indexing virtually guarantees you superior performance. Bill Bernstein, author, financial adviser

“Index funds save on management and marketing expenses, reduce transacton costs, defer capital gain, and control risk — and in the process beat the vast majority of actively managed mutual funds.” Good & Hermansen, authors

“In every asset class where they are available. Index! Four of five funds will fail to meet or beat an appropriate index.” Frank Armstrong, author, financial adviser

“With an index fund–the certainty of keeping up with the market is a very worthwhile trade-off for the possibility of beating it.” Jack Brennan, CEO Vanguard

“Searching through a list of 234 domestic equity funds that have survived for 20 years, only 31 did better than the Vanguard 500 Index. That means the odds are really, really poor that any of us will do better than a low-cost broad index fund.” Scott Burns, syndicated columnist

“Choosing actively managed funds is the triumph of hope over reason and experience.” Larry Swedroe, author, financial adviser

“It’s just not true that you can’t beat the market. Every year about one-third do it. Of course, each year it is a different group.” Robert Stovall, investment manager

“Giving up the futile pursuit of beating the market is the surest way to increase your investment efficiency and enhance your financial peace of mind.” Ron Ross, author and adviser

“It is basically impossible to beat the market.” Prof. Eugene Fama

“Indexing is a marvelous technique, I wasn’t a true believer, I was just an ignoramus. Now I am a convert. Indexing is an extraordinarily sophisticated thing to do.” Douglas Dial, former CREF portfolio manager

“Simple buy-and-hold index investing is one of the best, most efficient ways to grow your money.” Michael Lebouf, Ph.D., author

“The best plan for most of us, is to commit to buying some index fundss and do nothing else.” Charles Ellis, author

“With the market beating 91% of surviving managers since the beginning of 1982, it looks pretty efficient to me.” Bill Miller, portfolio manager

“We should just forget about choosing fund managers and settle for index funds to mimic the market.” Pat Regnier, former Morningstar analyst

“Because active and passive returns are equal before cost, and because active managers bear greater cost, it follows that the after-cost return from active management MUST be lower than that from passive management.” William Sharpe, Nobel Laurete

“The most efficient way to diversify a stock portfolio is with a low fee index fund.” Paul Samuelson, Nobel Laurete

“We find that on average, active management reduces a portfolio’s returns and increases its volatility compared with a static index implementation of the portfolio’s asset allocation policy.” Vanguard study

“Buy and hold. Diversify. Put your money in Index Funds.” Justin Fox, Fortune senior writer

“Index funds save on management and marketing expenses, reduce transaction costs, defer capital-gain, and control risk–and in the process, beat the vast majority of actively manage mutual funds.” Good & Hermansen, authors

“You should switch all your investment in stocks to index funds as soon as possible, after giving proper consideration to any tax consequences.” Chandan Sengupta, author

“I am somewhat skeptical about anyone’s ability to consistently beat the market.” Moshe Milevsky, author

“With an index fund–the certainty of keeping up with the market is a very worthwhile trade-off for the possibility of beating it.” Jack Brennan, Vanguard CEO

“With a very simple and basic understanding of index funds, you can consistently beat 70% to 80% of all professionally managed index funds.” Tweddell & Pierce, authors

“Invest in a stock index mutual fund. What a brilliant, ingenious, common sense idea that I can’t take credit for, but can religiously pass along to those of you who want to unclutter your financial lives and own a sophisticated portfolio.” Bill Schultheis, author

“For most of us, trying to beat the market leads to disastrous results.” Prof. Jeremy Siegel, author

“The surest way to make money in the stock market is not to work very hard at it. Don’t try to outsmart the market; settle for matching it. Put most of your money in an index mutual fund.” Gary Belsky, author

“Most investors should simply invest in index funds.” Robert Rubin, Secretary of the Treasury

“My strongest commitment in the mutual fund arena is to index funds.” Richard Young, editor

“I recommend that the long-term buy-and-hold portion of your equity portfolio be invested in equity mutual funds.” Sheldon Jacobs, author

“The smartest thing people can do if they want money in the equities market is buy an index fund that is run for 30 basis points a year and forget about it.” Elliot Spitzer, NY Attorney General

“The only consistent superior performer is the market itself and the only way to capture the superior consistency is to invest in a properly diversified portfolio of index funds.” Rex Sinquefield, researcher

“It’s extremely difficult to beat the market.” Peter Brimlow, Forbes senior editor

“There can be no question that indexing for most categories of taxable invesor and for most marketable conditions, will outperform conventional active management.” Robert Arnott, CEO First Quadrant

“A passive index fund managed by a not-for-profit investment management organization represents the combination most likely to satisfy investor aspirations.” David Swensen, author

“The S&P index benchmarks outperformed their active peer funds in all nine Morningstar style boxes over the past ten years.” Gus Sauter (1-25-05)

Additional articles of interest:

“The Index Fund Moves from Heresy to Dogma”

S&P Indices Versus Active Funds Scorecard

The Arithmetic of Active Management

The Difficulty of Selecting Superior Mutual Fund Performance

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Siegel thinks that a growing body of evidence suggests that fundamentally-weighted indexes may offer investors an attractive alternative to traditional cap-weighted indexes.

His arguments against the retort by capitalization-weighed supporters are reproduced below:

Supporters of the traditional capitalization-weighted indexes have criticized the fundamentally-weighted approach. Most notably, John Bogle and Burton Malkiel recently claimed that the five-year period from 2000 to 2005 is responsible for a large part of the difference between the backtested performance of dividend-weighted indexes and comparable cap-weighted indexes. But the performance of these fundamentally-weighted indexes over the last five years simply helped make up for the underperformance of such indexes during the tech boom of the previous five years, when dividend-weighted indexes significantly underperformed capitalization-weighted indexes.

To take out the last five years distorts the data. Using the same logic would allow you to say that tech stocks have a good track record over the past 40 years if we ignore the data since 2000 when tech stocks crashed. By underweighting the speculative sectors of the market compared to their market-cap weighted peers, dividend-weighted indexes did not experience the roller coaster ride that capitalization-weighted indexes suffered during this time period.

Supporters of market-cap weighted indexes have also questioned whether fundamentally-weighted indexes would, like their cap-weighted brethren, exhibit relatively low turnover when compared to more actively managed portfolios. While this may be a criticism of some fundamentally-weighted indexes, I do not believe this criticism is valid with respect to the category as a whole. There is no theoretical reason why properly constructed fundamentally-weighted indexes could not have nearly the same relatively low turnover rates, particularly if such indexes are reconstituted only once a year like many cap-weighted indexes.

Note: Some familiar “capitalization-weighted indexes” include the S&P 500, Wilshire total market, Russell 2000 etc. Example of “fundamentally-weighted indexes” include for example the Dow Jones Select Dividend Index (DVY) and many of the ETFs introduced by WisdomTree.

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Each quarter Standard & Poor’s publishes a “Standard & Poor’s Indices Versus Active Funds Scorecard” for domestic stock funds. For the first time Standard and Poor’s has also included comparative figures for international and fixed income funds vs. their benchmark indexes.

Here are five year results (the longest period shown):

PERCENTAGE OF EQUITY FUNDS OUTPERFORMED BY INDEX:
67% Large Cap
84% Mid Cap
79% Small Cap

PERCENTAGE OF INTERNATIONAL FUNDS OUTPERFORMED BY INDEX:
65% Global
80% International
88% Emerging Markets

PERCENTAGE OF FIXED INCOME FUNDS OUTPERFORMED BY INDEX:
75% Government Intermediate
84% Government Short
73% General Intermediate
88% General Short
84% High Yield
89% Mortgage-Backed Securities

The report is HERE.

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