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EverydayInvestor (100.00)

John Mauldin is a big fat idiot; index investing works

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January 25, 2009 – Comments (13) | RELATED TICKERS: VTI , VEU , VEA

Normally I think Mauldin has good things to say, but this week's letter (see it here) shows he is guilty of some pretty sloppy self-serving bias. He goes on and on about the problems with the Dow Jones Industrial Average as an index and then uses its problems to argue against index investing.

"So, when you buy stocks "for the long run" you are buying stocks selected by a committee (the Dow) or because their market caps increased to a size where they were included (market-cap-weighted indexes). In a very real sense, the S&P 500 is a self-selective growth-stock index."

The problem with that? It is a straw man argument. We have known for 100 years that the DJIA is a bad index. Once computers were invented, the S&P 500 came along and it was much better. The S&P 500 still has the problem of picking its constituents by committee. Nowadays, there are several broad market indices such as the Dow Jones Wilshire 5000 and the MSCI US Broad Market Index (what Vanguard now uses for its ETF VTI) that cover essentially every stock and have none of the problems associated with the DJIA or S&P 500. There is NO evidence whatsoever that mutual fund managers can consistently outperform a broad market index.

So if you invest in mutual funds, buy broad index funds--the 0.5% to 1.0% in management fees you will save each year will help you to consistently outperform all active managers in the long run.And if you buy individual stocks, benchmark your performance against a broad market index; if you don't beat that over the long run, stop wasting your time, sell your individual stocks and buy and index fund.

Rusted Root - "Beautiful People (live)"

13 Comments – Post Your Own

#1) On January 25, 2009 at 12:51 PM, EverydayInvestor (100.00) wrote:

Rusted Root - "Martyr"

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#2) On January 25, 2009 at 12:51 PM, EverydayInvestor (100.00) wrote:

Rusted Root - "Martyr"

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#3) On January 25, 2009 at 2:34 PM, anchak (99.76) wrote:

I really like Mauldin.....and you know I am with you on the Indexing argument.

So before you start boiling your curd....lets see if the twain can meet - becuase I think it can - based on my own rationalization

Facts

(1) Mauldin is right about the selection issue with the Dow. It applies to a certain extent with the S&P also ie there's some human bias

(2) Market cap weighted indices - have a migration bias - basically it'll buy more of whatever's market cap is going up and less of the other

(3) There's both Survivorship bias and Censoring bias - essentially even VTI ( which is my favorite US Index Fund) - all are employing a Market-Cap driven Rank-selection method ( the top 5000 make the list). Thus as market cap shrinks - they'll fall off - if it comes back -it'll make the cut. The Wilshire 5000 by covering 5000 stocks mitigates this problem a lot - basically a micro-cap becoming a micro-micro-cap ( there's nothing called nano - right :) ) will fall off.

OPINION

Mauldin: ( My conjecture)  Mauldin doesn't believe in MPT or EMH - so by extension not "Buy-and-Hold" either. I think his animosity is derived more from the Indexing industry ( or semi-cult - ala DFA) whose survival depends on this mantra

My 2 cents:

Alternative to "Buy-and-Hold Indexing": There's a simple ( instead of Market-timing I'll use an alternative monicker here) - "Index-Adjustment/Balancing" strategy I tested - all the way back from 1928 on the DJIA  on a weekly basis with a $100/week DCA investing strategy ( I know $100/week in 1930 was A LOT OF MONEY - but this was for back-testing)

(1) Enter/Exit based on 6 week MA ( ala 40/50 day MA) crossing with 30 week ( ala 200 day MA) on a weekly chart

ie Buy with all "available" cash when the near term MA crosses UP and "Sell" when it crosses DOWN

(2) NEVER STOP: Continue to DCA , all the time or develop your own "short-term" market-timing strategy - my best wishes there.

(3) Eliminate/Control "False-positive" signals - by employing a simple but hard to execute ( I have my own) - Graph trending of whether Higher/Highs and Higher/Lows are intact - ie Bull market - then ignore the SELL. Conversely for the BUY.

This depends a lot on the amount of capital you have amassed or the life-stage you are in the investment cycle. Like if someone did invest from 1928 - they would have a lot to loose in this bear.

A bit of prudence added with Indexing I feel be should the "core" investing strategy for most individuals

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#4) On January 25, 2009 at 4:06 PM, EverydayInvestor (100.00) wrote:

anchak - I perhaps overstated my case; Mauldin makes good points and I do like him; that said, he is a hedge fund consultant. Therefore he will sing the song of almighty alpha.

With the broad market indices the additions / deletions are unimportant; does it really matter if a $50 million company gets deleted / added to a market cap weighted index?

As to your strategy, some trader buddies of mine had a contest to come up with the best performing strategy in a backtest. Even with the "reasonable" ones generated over 10,000% plus returns. The best strategy was of course quite simple:

Rank all stocks (price(day(-1)) / price(day(0)))
Buy top 1 stocks
Rebalance daily

In other words, buy stocks where the price tomorrow is much higher than the price today. Repeat daily. This strategy generated over 10 billion percent annual returns. :)

So rather than anything like this, I'd just recommend asset allocation with rebalancing. The market return is efficient in that it is the return everyone on average must get. I am chary of recommending any strategy that will on average increase the variance of returns (create more winners and losers) without increasing the average return.

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#5) On January 25, 2009 at 5:04 PM, BigFatBEAR (99.27) wrote:

Hey Everyday,

I appreciate Top Fools taking the time to talk indexing sense into the stock-picking Fool masses.

Do you think Vanguard ETFs are superior to just about every other way of indexing? I was looking at SPY and DIA when the market first started to crash, but the more you talk about VTI, the more it seems superior in a variety of ways (slightly better yield, slightly stronger technicals, slightly lower fees). Currently looking to put most of my IRA into VTI, if/when it retests November lows.

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#6) On January 25, 2009 at 6:44 PM, anchak (99.76) wrote:

 BigFatBEAR ie Neil......Quick answer

As far as traditional (ie Market-Cap weighted) index funds go - there's none to beat Vanguard - and the VTI or its Mutual counterpart - VTSMX, are the best.

But seriously consider the FTSE-All World (VEU or  VFWIX - has a 0.05% transaction fee or front-load - strange for VG!). I think VEU and VEA are going to be extremely correlated.

With that I would do some VWO ( it would some extra weighting to Emerging). Or some exposure that you like personally.

 

EverydayInvestor
===============

Some thoughts on "back-test" - a lot of people make a mish-mash of backtest - by combining it with Optimization( or Fit) and Validation.

See your friends brilliant strategy has one problem with it :) If I knew "A-priori" - what the Top 1 stock is going to be - either I am a soothsayer or have a "Rocking Horse" - which I don't.

Its a post-facto strategy which will not work - because its Over-Optimized with any Out-of-time validation. 

No my friend....if you asked me the best way to run a "Back-Test" - it would be close to impossible without all the computing power in the world. One would need to run a dynamic optimization

(1) Selection: You need a searchable set of stocks
(2) You need a Multi-Objective unbiased optimization function: ie return based  BUT You need at least 3 simultaneous objectives

(a) time-period generalization: Essentially returns averaged over a long period of time
(b) Cover Bull periods separately
(c) Cover Bears separately

Compute them both on counts and $ returns ( ie both pure incidence and $ weighted probabilities)

(3) Do a dynamic adjustment to the selection mix - by doing a Rolling Out-Of-time validation like a series of Optimized candidates which perform the best till say 1970 - how do they perform in the 73-74 bear and then choose a winning set and then take it forward.

Easy to formulate - Not-so-easy to implement/execute. And obviously there's the survivorship problem.( stocks chosen cant' be defined by tickers - in which case you have a identification problem of whether there's anything that ties them. Otherwise you have a problem of adding free search parameters to the problem of choosing the stocks themselves)

However ,if you stick to the simple Index fund - then its a simple Buy/Sell problem - however - its a complete unknown at that point what selection criteria to apply.

Anyway - long message - but you see I have thought about the problem - and the thing I proposed is NOT "OPTIMIZED" solution or anything. Its a simple common-sense "Expert ( I guess in this case I am the poor expert) Rule" promulgated by me - and simply tested on the performance basis.

It survives. You can test it. The reason is simple we had 2 bears in the last 10 years - Otherwise the Strong Bull from 1980s would make any "market-timing" ie Buy/Sell strategy redundant. Now that everyone understands the inevitable cyclical nature of the market - you need a simple enough strategy which in this case is DEFINITELY SUB-OPTIMAL but workable - which keeps you in the market ( this one with the graph theory directionals I mentioned) glossed over the 1987 crash and just had one exit-entry during the 1997 ( As I said it was an OUTCOME of the strategy - was not FITTED to it) and exited in summer 2000 and winter 2007.

Nothing great - but much less volatile. Do not worry it will work. Whether it'll beat the index in the next 20 years - answer to that is simple - will there be another BEAR?

I wish I had the time to develop/write a good optimizer ( you will need to work on Evolutionary methods which try to find more workable near-optimals - rather than overfitted so-called Optimals which dont generalize) - The biggest problem is you do not have adequate data going back - other than the index itself.

Incidentally, I'll call you hopefully sometime this week - looking forward

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#7) On January 25, 2009 at 8:16 PM, Imperial1964 (96.64) wrote:

John Mauldin is not a fan of market cap based indexing because a value investor (like me) believes in profiting by buying undervalued stocks.  If you believe value stocks outperform others, what sense does it make to blindly buy the stocks with the highest total valuation?

He has before mentioned fundamental-based index funds.  At the time I don't think there was such a thing, but people were working on it.  Like taking the 100 companies with the highest total sales.  While nothing is perfect, at least that way investor opinion, as reflected by the market capitalization, is taken out of the equation.

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#8) On January 25, 2009 at 9:23 PM, anchak (99.76) wrote:

Imperial...There are so many style based indices and funds based on them....I think that does not detract from the basic argument put forth by Michael that indexing is good and should be a core strategy. But perpetual "Buy-and-Hold" really is a Secular Bull strategy as defined by Mauldin.

However the alternatives put forth by him - as Michael points out that he his a hedgie - is not readily available to a lot of folks - and honestly is not even appropriate - mainly because of the lack of understanding/transparency ( which can be a killer ala Made-Off)

But as you say and really the premise of Value-based investing is not a "Buy-and-Hold" -its a "Buy Low and Sell High" ie a Timing strategy but if its built on a good rigorous metric and followed in a disciplined fashion can be great.

However, key question - What's value? If you went by Graham - you would have sat out a lot of the prior Bull. Even today - a lot would argue against S&P valuation.

Philosophy and Idealogy - and execution - well there is a decent amount of grey area between them.

Incidentally, Michael on his site ( Goode Value) has a link to an excellent paper by Piotroski - I am sure you are probably familiar - that is an Unquestionable Value - albeit risky approach - especially in this environment.

I am having some good discussions with some fellow fools on it.

 

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#9) On January 26, 2009 at 10:15 AM, EverydayInvestor (100.00) wrote:

Imperial - there is nothing wrong with fundamental indices. That being said, they are not efficient -- not everyone can own them. Their outperformance comes from a value bent. They have higher costs than market-cap weighted indices. They are innapropriate for those in high tax brackets because they are tax inefficient as well;

Bigfatbear - I agree with Anchak. It makes sense to have exposure to the whole world, for which I like VEA or VEU (or their mutual-fund equivalents).

 

Anchak - I understand the point of back-testing versus optimization. And the perils of data snooping can be minimized if you do not optimize and you have some theory that you backtest. Even without optimization, though, you still have the risks of staistical insignificance and data snooping.

First, there are not enough data to generate statistically significant results while leaving some data out of the backtest to attempt an out of sample test. This is true of any sort of long-term timing mechanism; how many sell signals would your system have generated over the past 100 years? Six? Ten? No matter what, the result is statistically insignificant, particularly when you consider that stock returns are not normally-distributed.

Second, there are implicit assumptions embedded within any timing mechanism that are unjustifiable, such as your use of a moving average ("(1) Enter/Exit based on 6 week MA ( ala 40/50 day MA) crossing with 30 week ( ala 200 day MA) on a weekly chart"). Why a 6 week moving average crossing a 200 day moving average? Why did you pick that? Any reason for picking that seems to me to be suspect and likely the result of data snooping, if not buy you then by someone else. This would of course further reduce your chances of your system (or any timing system) being meaningful and not just a statistical artifact.

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#10) On January 26, 2009 at 10:28 AM, anchak (99.76) wrote:

I do not agree with the inference - your statements are correct however. We'll easily have time to do this - in detail - hopefully this week.

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#11) On January 26, 2009 at 11:19 AM, GraemesPSP (99.69) wrote:

I read John Mauldins last letter yesterday, I haven't re-read it today.  But the point I took from his letter wasn't to do with buying indexes, his  point was a rebuttal of the buy-and-hold investing in individual stock.  That buy-and-hold investing might work with indexes, they go up over longer periods of time, but this doesn't apply to buying and holding individual stocks.  If you look at most companies that existed 30 years ago they no longer exist today.  If you bought one of those stocks on the index 30 years ago chances are it would be gone today.  He only used index components as a way of choosing the largest most important companies that existed at the time.

I think a more valid criticism of the article would be his implication that the companies no longer existing went to zero.  In fact a large number, possibly the majority, of those companies no longer exist because they merged or were bought out by other companies. 

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#12) On January 26, 2009 at 12:20 PM, FleaBagger (99.16) wrote:

Lots of hedge funds generate legitimate "alpha" year after year for decades, and even a few regular actively-managed mutual funds have, too. The latter are usually closed to new investors, though.

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#13) On January 26, 2009 at 1:36 PM, EverydayInvestor (100.00) wrote:

Graemes - you have a good point about buyouts. In fact, I recall some bank creating essentially an unchanging index fund back in the early 1970s for some pension fund. It just bought and held the stocks of some number of large companies. That fund outperformed the indices if I recall correctly, and expenses were almost nil.

Fleabagger - actually, there is no evidence of hedge funds as an 'asset class' generating alpha. The hedge fund indices that show great performance suffer from backfill bias, delisting bias, hindsight bias, and are not properly weighted. Michael Edesses has written about his in his book and on his blog (I met Michael over lunch at the St. Louis Raquet Club a year ago; the Club makes an excellent egg-nog). What the recent financial crisis has shown is that much of hedge funds' returns comes not from skill (alpha) but from leveraging up betas (whether standard or alternative betas).

Some top hedge funds generate great returns, such as Renaissance, but their awesome quant fund has been closed to investors for over a decade. 

As to mutual fund managers outperforming, just look at Bill Miller. By chance alone some investors should generate awesome long-term records. Any way you look at it there is no ability to predict which managers will outperform based on past performance. There is, however, decent predictive power for poor managers--those funds with high fees tend to underperform in the past and future.

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