Indexing

I don’t know, I don’t care

Vanguard diehard hbarnard made this post about the U.S. markets, Is it “Half full or half empty?” Taylor’s reply was I think a classic article by Jason Zweig, “I don’t know, I don’t care“:

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.

Dow at new high and dividend distributions

I think by now many people are probably already aware that the Dow Jones Industrials Average (DJIA) Index closed on a new all-time high of 11,727.34 on Oct 3, 2006. The previous highest close was 11,722.98, reached on Jan 14, 2000.

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.

2006-10-04-dowonjan2000.png

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.

Bogle And Malkiel Fight Back

The following are excerpts from the article Bogle And Malkiel Fight Back:

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”.]