Going New-School About Indexing

Over the weekend as I was putting the finishing touches on an article for TSCM I stumbled across a concept that is probably not new, relative to this site, but that I did (by accident?) articulate a little differently.

Over the last eight or nine years one could argue that domestic indexing has not worked. Since the start of 2000, SPY is down about 10%. Since inception (mid 2000) iShares Russell 2000 (IWM) is up a hair under 40% which works out to about 5% annualized.

While very unlikely, what if indexing fails again over the next eight or nine years? Allocating too much to index funds that go nowhere for a decade and half creates a real headwind for reaching financial goals. As I find portfolio construction, and its evolution, to be an interesting topic...

What if indexing doesn't work - or, more correctly, what could you do if you think it might not work? One solution could be some sort of combo of absolute return/low volatility vehicles and potentially more volatile narrow themes. The ratio of absolute to narrow would depend on the investor, but the combo chosen would need to provide a chance for long-term success and allow the investor to sleep. Putting it all into agriculture stocks would create too much volatility, and putting it all into a carry trade ETF would not provide enough growth (at least I don't think it would).

Unfortunately this would require a lot more work for folks who are accustomed to indexing, but if indexing does not work then indexers need to do something different.

As an example, if a portfolio was constructed to have seven themes weighted at 4% each and then 72% in absolute/low volatility; the selecting of the themes would take a lot of work. It may not take long to come up with seven (or six or eight) ideas but it would take some work to study and make sure they are not too closely related and thus vulnerable to the same thing. For example it is a good bet that Vestas Wind (VWSYF.PK) and Vietnam are not vulnerable to the same things but Potash (POT) and Monsanto (MON) (client and personal holding) probably are. To put it in Internet bubble terms, having a B2B stock, a data farm stock and a search engine stock does not make for a diversified portfolio.

Examples of themes could be commodities (broad or narrow), emerging markets (broad funds, narrow funds, or individual stocks), certain parts of infrastructure, alternative energy - broad like  Market Vectors Global Alternative Energy (GEX), narrow like First Trust Global Wind Energy (FAN) or individual stocks), agriculture, some big SPX sectors (like energy now or other things later), certain developed countries and there are plenty of others.

You could buy the ones you like with the hope of holding them forever, but I think there needs to be a willingness to sell or at least reduce exposure when they go up a lot. There must also be a willingness to admit to yourself when you get one wrong, and sell that as well.

Some examples of absolute/low volatility might include long short equities, some of the managed futures funds, carry trade funds, other currency products, Canadian hydro funds, certain parts of infrastructure and maybe farmland stocks.

I actually think the theme portion would be easier to manage. You already know what sorts of things fit there (this comment has nothing to do with anyone's ability to pick which themes to buy). It seems there are fewer categories to choose from and of course when there is a crisis the notion of absolute/low volatility may stop working for a while.

I'm not certain whether hydro funds belong in this conversation or not, but during the crisis many of them got hit very hard (debt-intensive businesses) and they also got hit before that in the fall of 2006 when the change in the tax law was announced. The shock is in, the move down made, and it is unlikely that they would be prone to yet another shock, but if a shock does come, I would expect them to go down a lot again.

I think that most of these sorts of things (those that are potentially in the absolute/low volatility category) will go down less than the market during bear cycles and up less than the market during bull cycles, but every so often the will deviate from this expected behavior. As with themes it would be very important to spread the risk. Managed futures funds probably have different vulnerabilities than a Canadian income vehicle.

This post was obviously a theoretical exercise. Long-time readers will know I work in a couple of these sorts of things into client portfolios because I think they help manage volatility.

Comments

[Prudent Man...:]

Why not just "drill" into the index and pick out the best stocks, get the full benefit or their performance without the baggage of the losers? Takes a bit of work but it is worth it and you can get all the info you need free or for pennies a day.

The current investment services model used by the major institutions, you know those firms who don't know the value of their own assets let alone others, is dead. No one needs them unless they are too lazy or dumb to choose their own investments. They should be in TIPS, the only true prudent investment and enjoy life with a good nights sleep. The stock market is and never was for the average person, including institutions. Remember the Prudent Man Rule? It is buying a lot of toys for security plaintiffs attorneys.

2008 Jun 30 11:39 AM

[oduis:]

It reminds me of discussions around 2000.
When the markets were doing great back then, everybody wanted to convince you to by index funds. If everything goes up anyway, the performance fee is considerable.
After the big crash, that some big old school asset allocator funds dampened a lot, they came back in fashion.
Same thing 8 years later...
The efficient market theory, the basis for indexing, has long been falsified.
So my recommendation is: mix some global asset allocator funds. Even if not one single one beats the markt all the time, the mixture will do it. And let you sleep better, since they take out the big backdraws.

2008 Jul 01 02:04 AM

[fredlu33:]

Try a read,Unconventional Success by David F. Swensen. I found it very much on point.

2008 Jul 01 11:51 AM

[ICouldBeWrong:]

I also have been enjoying this column and could become a regular reader.

In the long run (40 years). I'm an optimist on the economy. I agree with Warren Buffet that index funds make sense for most people. I think we will solve our energy problems (via Farnsworth/Bussard fusion reactors, sorry to use the f word), and the USA could even led colonization of the galaxy this century.

In the more immediate future (2-5 years) I'm very pessimistic. Both the credit crisis and energy crisis are real problems that aren't going to dissapear overnight. So I'm mainly in cash (AUD as that's were I happen to reside. I actually expect the AUD to fall in the short term, but at least interest rates are 7%ish, which is ok, and going up. And Japanese Yen JPY, for a carry trade play, as Jim Rogers says 'everyone should own some yen').

Being in cash I need an inflation hedge. So I'm also buying some commodities, even oil. Yeah oil is going to crash I agree, the question is will it go to 150ish and crash back down to 100ish, or will it go to 200ish and crash back down to 130ish. I'm beginning to think we are going to 200. (So really correct rather than crash)

I'm also still short the S&P500 and selected stocks. That's about it.

Please allow me to give a few links regarding the Farnsworth/Bussard fusion reactor. If you are feeling down about energy prices this stuff could really cheer you up.
video.google.com/video...
en.wikipedia.org/wiki/...
en.wikipedia.org/wiki/...
en.wikipedia.org/wiki/...
en.wikipedia.org/wiki/...

2008 Jul 01 11:30 PM

[blink0404:]

Hey Roger Nusbaum fans,

Here's a link to an Roger Nusbuam interview with Chip Hanlon on greenfaucet.
www.greenfaucet.com/no...

They discuss the market and why Nusbaum thinks there could more downside for stocks to come.

2008 Jul 02 03:54 PM