Monday, 24 January 2011

Book Review: All About Index Funds by Richard Ferri

Disappointing. After reading the excellent All About Asset Allocation by the same author (my review here), I expected more of the same quality from All About Index Funds, especially since this book is a second edition. Alas, too many small slip-ups and an inconsistent approach bring down the value of much useful information and sensible enough investment suggestions.

Slip-ups - Is it too much to ask for a proofreader to eliminate typos and for an editor to help with sentence construction? Yes, it is true that no book is perfect and we can usually fill in the blanks but such carelessness undermines credibility.

Unfortunately, I believe that loss of credibility is justified at times. Take this statement on page 160: "The sad part about modified-weight funds is that the issues claim to have found a new indexing nirvana when in fact all they have done is create more funds titled toward value stocks." Huh? "issues" find something? Would a better word not be something like "proponent" or "advocate"? As well, "titled" instead of "tilted"? We know what Ferri is trying to say but these trivial errors belie a too-casual, too-brief treatment of a critical issue in indexing. That issue is whether cap-weight funds are better than modified-weight funds such as equal-weight or fundamental-weight funds. Mere summary dismissal by Ferri does not help the reader make up his or her own mind. The absence of any footnotes or citations of research that he deems would answer any doubts about his position leaves the reader with a take-it or leave-it situation.

I happen to believe that fundamental weighting is better for the individual investor than cap weighting, my definition of better being a higher return to risk ratio. Whether I am right or wrong (and to find out I have a little experiment going in the form of the test portfolios at the bottom of this blog), the answer as to which is better is an empirical question that Ferri does not address. He should. Putting two and two together from information in the book, we can see that the supposed purist indices that underlie such index funds as the S&P 500 Spider (SPY) do not conform very well to purist cap-weighting conditions (e.g. violations like free-float adjustment, arbitrary stock selection by a committee, buffer zones to minimize trading and prevent front-running by hedge funds). All index funds can be seen to be merely trading strategies. The question is only which works best.

Ferri might answer that the book is only a beginner book, whose aim is to provide the "easy way to get started", as the sub-title says. Fair enough, but that raises the other problem I find with the book.

Inconsistent Approach - If the purpose of the book is to give advice, a basic how-to manual, then huge chunks of the material where the details and descriptions of various indices and myriad sector funds become irrelevant and distracting. In fact, Chapter 15 could do nicely for the investor who just wants to know what to do. The chapter lays out sensible sample portfolios with the names of specific funds and percentages to allocate across the funds.

On the other hand, if Ferri's objective is to give the investor the tools and rules to make up his/her own mind, then the pros and cons of his positions and of the alternatives need to be laid out. For example, there is lots of descriptive detail of commodities (with some errors, like saying on page 196 that cotton is an Industrial commodity! - see the S&P GSCI) and associated indices and funds but nowhere do we have an assessment of which are better, nor even a suggested method for deciding the matter.

Content - The book is divided into three parts. Part 1 puts forward the case for basing individual investing on low-cost index funds. Part 2 describes the many categories of index funds, their underlying indices and lists most of the available ETFs/mutual funds as they existed in 2007 (so inevitably this is out of date as ETF proliferate - is a book the right way to catalogue ETFs?). Part 3 says how to combine and manage index funds in portfolios. The portfolios suggested should do investors fine. The portfolios are based on mainstream cap-weighted funds and should perform well enough, even if fundamental- or equal-weight index funds do better over the long term. They offer the key feature of avoiding loss of money through high-fee funds and through the protection from diversification.

The content is at a beginner level, with no math, not even arithmetic. There are lots of illustrative tables and charts. The appendix includes a short reading list with classic books like those of John Bogle, William Bernstein and Burton Malkiel. A number of low-cost fund provider website addresses are given (I wish it included the handiest one for quickly finding all the ETFs by category, the completely mis-named Stock Encyclopedia).

The target audience is squarely people in the USA. Canadians will find it useful for their US ETF investing, but need to ignore all content to do with taxes, account types and mutual funds. No Canadian ETFs are even mentioned, nor is any pertinent history (Ferri could have acknowledged that the first successful ETF, the TIPS was created in Canada in 1990, predating the 1993 SPY - see Wikipedia).

Despite the beginner orientation, there is lots of interesting content for more advanced investors. I got many blog ideas, for questions that came into my mind during reading (but which Ferri does not answer), such as:
  • what would happen if everyone indexed?
  • book says there isn't an index ETF for high-yield bonds ... there is now, Powershares' PHB
  • past correlations of asset classes have not been stable and tended to peak during crises - can we construct a model of correlation effects for various crisis types? e.g. asteroid strikes earth = all assets perfectly correlated at 1
  • some indices are based on free-float, others on full cap for weighting, so does it matter and what is the effect?
  • why have index providers all discarded the definition of Value stocks as those in the bottom half of price to book for more complicated multiple factors and what difference does it make?
My rating: 3 out of 5 stars.

Disclaimer: Thanks to McGraw Hill for providing me with a copy for review.

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