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Against Index Funds, Part II

  • While passive investing leads to better expected outcomes for investors, index funds are suboptimal vehicles. Instead, incorporate the philosophy of indexing into a more thoughtful portfolio design and implementation process.

  • Because (1) smooth investment returns are preferable to chunky returns, (2) diversifying across multiple investments (that aren't perfectly correlated) can reduce volatility, and (3) all countries have similar expected returns...investors should not limit global diversification solely to large, multinational companies.

  • Small companies with regional footprints, and without global footprints, can deliver not-perfectly-correlated, positive expected returns to unique regions, and the distinct economic engines driving them.

  • Recency and familiarity biases cause many investors to only own stocks of companies and regions with which they're comfortable. But markets don't care where you live, what you know, or what you've been through — and prices are set so that companies and regions with easier paths to success will be priced higher, and companies and regions expected to struggle will be priced relatively lower.

  • This pricing mechanism should make investors indifferent amongst options.

  • As a function of their structure, index funds are unable to target tiny companies that drive economic activity across various unique regions of the world, and investors should not unnecessarily forego these diversifying sources of return.

Against Index Funds, Part II

The benchmark for Italian stocks (MSCI EAFE Italy) has 23 companies. Many would assume that these stocks reflect the Italian market, but a tradeoff of indexing is that in outsourcing your investments to a third-party list (in this case, MSCI), you accept that index list creators profit by investment companies licensing and tracking the lists.

E.g. Blackrock, the investment company, has an MSCI Italy ETF which tracks MSCI's list.

From a business standpoint, MSCI wants to make index lists easily trackable by holding underlying stocks that are liquid, and can be traded with scale ( that companies like Blackrock will license and track them). Index funds therefore tend to have stocks of large or midsize companies, occasionally small companies — but rarely do they own tiny companies that can be illiquid and hard to trade.

MSCI's list of 23 Italian stocks has several recognizable names, like Ferrari.

In 2021, Ferrari shipped nearly 6,000 vehicles to the U.S. and Asia combined, while less than 700 within Italy itself. Ferrari is Italian, but owning Ferrari stock isn't giving you pure exposure to the Italian economy. You're likely at the whim of wealthy people across the globe, like lucky gamblers going shopping in Las Vegas, Macau, etc...

Besides the business/legal environment it operates under as a corporation, there's simply not very much Italy in Ferrari stock.

You can't reach local cultures by indexing large, global companies that are headquartered there, but do meaningful business elsewhere.

Riccardo Squilloni is a Florentine artisan who, since 1978, has used a 17th century marbling technique to create stationary and art. These were the first drops of a piece he gave to my daughter, Olive. His company isn't publicly traded, but there are at least 100 stocks outside of the MSCI EAFE Italy index list, that are.

For some countries (including Italy), index providers have thankfully created a second "small company" index list. If you purchase both funds together, in appropriate weights, you can get closer to replicating the entire Italian market. Here are the returns of these indexes together, going back 10 years:

Focus less on that small Italian companies meaningfully outperformed their large counterparts — and simply on the fact that these two lines aren't exactly the same. You are visualizing a diversification benefit.

This way in addition to companies like Ferrari, you own Banca Monte dei Paschi di Siena (an old, tiny Italian bank), and Centrale del Latte della Toscana (an Italian dairy refiner and distributor).

When the Ferrari dealership in Las Vegas struggles, we expect it to be unrelated to whether Italians are taking out mortgages or drinking milky cappuccinos.

Even though the small cap index for Italy isn't perfect (there are still some small companies it doesn't own), it's far better than most countries that don't even have one. But such are the frictions of indexing. We are using someone else's tools (e.g. MSCI lists) to mold our own investment philosophy around.

If we instead reverse-engineered this problem, and started with our philosophy to then design an investment strategy, would we end up at this statement:

"Let's go find a third-party list and pay someone to track it!"

Of course not. But Vanguard's S&P 500 index tracks a list of 500 large companies designed by Standard & Poor's. SPDR Dow Jones index tracks a 30-company list from Dow Jones. This is how indexing works.

Indexing has become synonymous with passive investing, but it's a silly structure to implement the philosophy of passive investors.

If we are humble enough to realize we don't know which stocks will perform better than others, then we want to own everything, and especially small, regional stocks.

One strong sensitivity I have in writing this post is ensuring I delineate between silly and stupid. Index funds are not stupid. Indexing is an elite form of investing. It can be low-cost, diversified, tax-efficient, global, etc...all the things we want.

But index funds still just track someone else's list, and they cannot easily reach the underbellies of the global cultures to which we want equity exposure. They are fantastic, but not perfect (and kind of silly).

In the early 1980's, a few years after Vanguard launched the first retail index fund, Dimensional Fund Advisors (DFA) launched a U.S. mutual fund that gave investors exposure to small U.S. stocks. It had a passive philosophy (i.e. didn't attempt to forecast which individual stocks would do better than others), but also didn't outsource to a third-party list. And why would they? DFA wanted to buy all the small stocks. That's the list.

DFA is not the only company doing this, but they've had success for 40+ years.

As a quick comparison, the "Vanguard Total World Stock Market ETF" tracks the FTSE Global All Cap Index — "all cap" referring to stocks of all capitalizations (sizes). It seeks to own the whole world, and owns 9,543 global companies.

The "DFA Global Equity Fund" — the comparable DFA fund — doesn't track anyone else's list, tries to own the whole world, and owns 14,850 global companies.

This simple comparison is of the most expansive funds (ones that try to blanket the entire global market), but each company has other funds that target more discrete regions and opportunities. The song is consistently the same: a company like DFA can have a passive philosophy AND be more diversified simply by not tracking a third-party list. Because I don't know which stocks or regions will perform better than others in the future, I prefer to maximize diversification (especially to small companies).

Without the limitations of index funds, investors can better express the general philosophy of indexing.

It's not my intention to make a commercial for anything except an investment consideration here. I love Vanguard and I love DFA. But when possible, I want clients to own those extra thousands of companies that DFA can gain exposure to via a more optimal fund structure.

Will it lead to better performance? I can't promise anything.

But it's my expectation that this is the best way to design and implement a portfolio. I've intentionally left most math, past performance, and ratios off this piece and focused on what goes into an investment philosophy, and how I think about most thoughtfully gaining exposure to not-perfectly-correlated sources of returns.

Numbers can tell stories, but stories can explain intuition.

When I think about designing an investment experience, I start with foundational beliefs rather than starting with available products or tools. Otherwise it's like we are handed an axe and then determine that we should start chopping down trees. We should spend time first considering if we may want to plant seeds, instead. We need to identify goals, and goals should inform strategies.

Properly used, investment funds are just tools to express an investor's philosophy. They are the last part of the workflow.

The desired investment experience leads to them...not the other way around. And there are some great passive ones out there (beyond generic indexing).



My blog posts are informational only and should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in my posts will come to pass. They are not intended to supply tax or legal advice and there is no solicitation to buy or sell securities or engage in a particular investment strategy.

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