Friday, 27 June 2008

Fundamental Indexing is Not Indexing at All ...

... It's an investment strategy that overweights value stocks.

As the short but incisive paper Fundamentally Flawed Indexing by Harvard Finance prof André Perold, demonstrates with a simple example and a mathematical model, the idea that cap-weighted passive indexing will systematically under-perform because it tends to hold more over-valued stocks doesn't hold water. Any outperformance of fundamental indexing compared to normal cap-weighted indexing can only be due to the higher-risk higher-return greater investment in value stocks (those with higher Price/Earnings ratios or other fundamental data).

Perold's conclusion: "... Holding a stock in proportion to its capitalization weight does not change the likelihood that the stock is overvalued or undervalued. The notion that capitalization weighting imposes an intrinsic drag on performance is, accordingly, false. Fundamental indexing is a strategy of active security selection through investing in value stocks."


Jordan said...


How does this new research affect your view on the investment approach of Dimensional Funds / IFA Canada?

There are always conflicting information, so is this enough to say that Dimensional doesn't add value without adding risk? Do you think their strategy would continue to beat the standard DIY based index/portfolio?

CanadianInvestor said...

Good question. The approach of DFA/IFA , which IFA calls "Indexfolios" could be criticized for the same reason - the tilt/extra proportion in value stocks, as well as small caps is an investing strategy, not indexing per se.

That semantic criticism aside, a value/small cap tilt makes sense to boost returns, though there is extra risk involved, since they were shown by Fama and French to outperform. ... at least in the past. The revelation that small and value outperform may induce so many people to buy such stocks that the effect goes away.

I must admit that my own portfolio doesn't hold market weights as I have more invested in small cap and value stocks. In addition, my Canadian equity holdings are far more than the 3-4% that Canada holds in global market cap.

As for DFA vs a pure market-cap portfolio, the only reason they might do better on a risk-adjusted basis is if their indices are better constructed - i.e. more representative and diversified. They claim so on their website but it's hard for me to tell. There is an interesting source of fund by fund comparison of DFA (USA) vs Vanguard with mention of many ETFs (available to Canadians) at Altruist: . It doesn't address the total portfolio performance issue however. DFA/IFA does compare their portfolio performance with one made up of Vanguard's offerings (where DFA comes out on top, naturally) but again they use the same over-weighting on value and small cap in the comparison.

Jordan said...

So you must believe a value/small cap tilt will continue to outperform if you've done something similar in your own portfolio?

How does this tilt add more risk, looking at the data shows their risk/return ratio to be lower then Vanguard and many other comparables?

Do you believe that because the Fama/French research itself is known in the market that it will result in it becoming ineffective?

If owning those qualified stocks invalidates the added value of tilting, does indexing as a whole become deluted as it becomes more popular?

CanadianInvestor said...

It's ironic that if everyone did indexing then there would no one to be making the market more efficient to get prices closer to their reasonable fair value and not even a market at all. How could prices be set if both buyers and sellers merely accepted the other's price?

Fortunately, true passive indexing is still a very small proportion of the total market (though I don't recall exact % and can't seem to find it easily on the web right now) and promises to remain so due to human nature wanting to beat the market and indulging in active investing.

So I also think that small and value stocks will continue to outperform.

I believe the difference between Vanguard and DFA, since both espouse passive index investing, stems from two things: at the asset class level of small caps, value stocks etc DFA indices may be better constructed; at the portfolio level, this has a knock-on effect in producing better reward-risk ratios. Of course, this is based on modeling past data, which may not exactly follow in future.

The small and value tilt in a portfolio, including mine, actually reduces risk somewhat while adding return, through the marvel of non- or negative-correlation with the other asset classes in the portfolio. DFA's Indexfolios show that effect with their various portfolios forming a gradually increasing line up and to the left i.e. better, in the return-risk chart.

Jordan said...

Thanks very much for your explanations and info.

I'm very interested in being a DIYer with my portfolio, I'm learning a lot of what to do. I believe in the same principals of investing as you, but I'm also interested in DFA/IFA's approach which seems to add some value which might be hard to replicate myself.

I just really don't like that you have to use one of their certified advisors to purchase into the funds. I'd consider getting a flat rate financial plan created by one, but then would want to manage it without paying for further assistance unless I wanted it/paid for it.

Is that the same reason you chose to use iShares instead of DFA? Are there any other reasons? If DFA does add value by constructing a better index and manages it more efficiently, how much better of a return would you want to see to choose using them instead of DIY?

CanadianInvestor said...

I started managing my own portfolio before I knew about IFA and before DFA came to Canada. I've continued doing it since because I like doing so myself. I consider IFA a very viable alternative. Not sure exactly how much difference there is between my own collection of ETFs and what IFA could do. Almost certainly, the IFA advisors would be better than the run of the mill financial advisors for developing an overall financial plan.
Whatever you decide, good luck!

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