Weakness of Indexing

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Weakness of Indexing

Post by Doug »

Almost all of my portfolio is in index funds. However, I'd like to comment on a weakness of indexing. At its peak, Nortel was 36.5% of the TSE 300 back in 2000. It had a P/E ratio of over 60. In 1989, the Japanese stock market had a greater value than the US stock market. The entire market had a P/E ratio of greater than 60 in 1987. At present, the US stock market is worth more than four times the Japanese stock market.

The Japanese stock market and Nortel (and to some extent the whole TSE 300) were overvalued. In both cases, it was obvious that future returns would not be good. In both cases, index investors faced a bleak future until valuations reached rational levels.

These situations will happen again, and I'd like to know what I can do about it. XIC deals with the problem by limiting exposure to one company to 10%. But that really doesn't address the problem. If Nortel was doing well, had a P/E ratio of 11 and was 36.5% of the TSE Composite, I'd like that very much. Any suggestions would be appreciated.
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Post by adrian2 »

It's easy to be smart in retrospect. What's the alternative? Did most fund managers who realized NT is overvalued outperform the index fund consistently?

Not to sing my own praises too much, but I did short Nortel in the proportion that I was holding it in XIU and other Canadian index funds; of course I did not capture the whole move down as I started the short at $102, watched it go up to $110, then covered my short in 3 tranches at $70, $50 and $30. So you can still say I was stupid enough to buy it (back) at an average price of $50, when I could have let it disintegrate to bankruptcy. As usual, YMMV, but this is a possible answer to your query - you don't like the index, you cook your own adjustments.
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Post by Doug »

I disagree with the comment that you had to be smart to notice that Nortel and the Japanese stock market were overpriced. Read books from Bogle/Bernstein/Malkiel, and you know that a P/E ratio of greater than 60 means poor future returns.

I agree with you that shorting a stock or market is a way around this. Even for sophisticated investors though, shorting is not easy. One can't predict how long a bubble will last. And for novice investors such as myself, they should stay away from shorting.

"What's the alternative?" That is my question. XIC has one solution, and you have another. What other alternatives are there?
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Post by like_to_retire »

Read books from Bogle/Bernstein/Malkiel, and you know that a P/E ratio of greater than 60 means poor future returns.
But at the time, many believed that we were in a new paradigm where the future earnings growth was unlimited for tech companies, and the old rules for P/E didn't apply any more.

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Post by Bylo Selhi »

I prefer to think of it as a weakness of criticism of indexing ;)

Before NT crashed and burned, the TSX handily outperformed actively-managed funds. Afterwards it was the opposite. Why? In large part because actively-managed funds aren't allowed to invest more than 10% of assets in a single security. As I recall during NT's run-up, many fund managers excused their underperformance on the basis that they couldn't invest more, i.e. get closer to index weight, in NT and other tech stocks. So it was their inability to join the herd and load up on NT that (for a while) saved their bacon, not their stock-picking skills (net of fees, at least.)

Consider also that only 10% or 20% of equity fund assets are indexed. So how could they cause the NT's stock price to soar? Shouldn't the other 80% to 90% of the stock-picking public not accept responsibility for their irrational exuberance? But I digress...

Yes, over short periods of time an NT (or Nokia in Finland) can play serious havoc with an index. But if you're a long term investor this should be mostly irrelevant to you. Consider the TSX vs. the average actively-managed Canadian equity fund over longer periods. Note (from GlobeFund, "Fund" is XIU) that the former has consistently outperformed the latter -- even after NT crashed and burned. So it seems that even a debacle of NT proportions was only a minor blip in the grand scheme of things.

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My point is that, warts and all, indexing still remains the best alternative. To paraphrase Churchill, "Many forms of investing have been tried and will be tried in this world of sin and woe. No one pretends that indexing is perfect or all-wise. Indeed, it has been said that indexing is the worst form of investing except all those other forms that have been tried from time to time."
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Post by adrian2 »

Doug wrote:I disagree with the comment that you had to be smart to notice that Nortel and the Japanese stock market were overpriced.
If it's that easy, please tell us: is Research in Motion overpriced? I've flirted with the idea of shorting it when it briefly became the country's largest market cap and then decided to wait if / until it crosses an imaginary line somewhere around 20% of XIU. Where does that line lie? You tell us.
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Post by Doug »

Research in Motion has a P/E of 21.33. A P/E of 21/33 and a P/E of greater than 60 are very different.

Adrian, has anyone ever told you that you're mild mannered, retiring and diffident? You need to take a course in assertiveness training. :)
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Re: Weakness of Indexing

Post by Norbert Schlenker »

Doug wrote:I'd like to comment on a weakness of indexing. At its peak, Nortel was 36.5% of the TSE 300 back in 2000. It had a P/E ratio of over 60. In 1989, the Japanese stock market had a greater value than the US stock market. The entire market had a P/E ratio of greater than 60 in 1987. At present, the US stock market is worth more than four times the Japanese stock market.

The Japanese stock market and Nortel (and to some extent the whole TSE 300) were overvalued. In both cases, it was obvious that future returns would not be good. In both cases, index investors faced a bleak future until valuations reached rational levels.
To what extent is the bleak future averted by rebalancing a well diversified portfolio?
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Post by Doug »

My greatest concern would be if what happened in Japan happened in Canada also. Japanese investors in 1989 had a grim future in front of them. Rebalancing and diversification would make the future less bleak, but it was still bleak for those investors.
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Post by Norbert Schlenker »

Doug wrote:My greatest concern would be if what happened in Japan happened in Canada also. Japanese investors in 1989 had a grim future in front of them. Rebalancing and diversification would make the future less bleak, but it was still bleak for those investors.
You should put some numbers together to show that.

Take a typical Japanese investor in 1989, say 40% Japanese equities, 20% world ex-Japan equities (MSCI would call this a Kokusai index), 40% Japanese government bonds, rebalanced at year end.

I'd be interested in seeing just how bleak the compounded real total return, i.e. ex-Japanese CPI, in Japanese yen has been. I wonder if it's as bad as you suspect.
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Post by parvus »

Doug wrote:Research in Motion has a P/E of 21.33. A P/E of 21/33 and a P/E of greater than 60 are very different.

Adrian, has anyone ever told you that you're mild mannered, retiring and diffident? You need to take a course in assertiveness training. :)
:rofl: :lol:

In any case (to open yet another can of worms) you might wish to look into the fundamental indexing debates.
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Post by kcowan »

Doug wrote:Research in Motion has a P/E of 21.33. A P/E of 21.33 and a P/E of greater than 60 are very different.
Maybe just 4 years different.

In 2005, RIMM P/E was over 61. Since then their EPS has increased by a factor of 10x.
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Post by Doug »

Norbert, your point is well taken. However, I wouldn't be surprised if the average Japanese investor in 1989 had a lower portion of their stock portfolio allocated to foreign equities. Similarly, the average bond portfolio would be less than 100% government bonds.
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Post by Bylo Selhi »

Doug wrote:I wouldn't be surprised if the average Japanese investor in 1989 had a lower portion of their stock portfolio allocated to foreign equities. Similarly, the average bond portfolio would be less than 100% government bonds.
Are those limitations of indexing or of asset allocation?
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Post by parvus »

Which turns into an interesting question, namely, how do Japanese retail investors allocate assets?
Japan has long been seen as the most promising market for asset management companies. The combined assets of Japanese households are worth ¥1,410trn (US$14.6trn), yet 56% of this is held in currency and bank deposits and only 3.3%, or ¥47trn, is held in investment trusts. In the US, 16% of household assets are held in cash or deposits and around 12% is in investment trusts. The Nomura Research Institute estimated last year that only 21% of the financial assets of households, financial institutions and pension funds in Japan were under management—leaving a potential pool of assets that could be allocated to investment products of over ¥700trn.1
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Post by Doug »

"Using the TOPIX index (a cap-weighted, nearly total-market index), with dividends included, 10,000 yen invested on Dec. 31, 1989 would have become 6,788 nominal yen, or 6,182 inflation-adjusted yen, by Dec. 31, 2006."

TOPIX is a Japanese stock market index. Over a 17 year period and taking into account inflation/deflation and dividends, the Japanese stock market declined 38%.

The Nikkei's peak P/E was 78.

http://socialize.morningstar.com/NewSoc ... 05518.aspx
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Post by Norbert Schlenker »

But the bottom of page 10 of parvus' link has quite an interesting graph. Japanese household assets are 5.6% in (probably all Japanese) equities, 3.3% in investment trusts probably half of which is bonds, and 28.2% in insurance and pension reserves, again probably half bonds. So the average Japanese household has an asset allocation with only about 20% in equities total.

So how big was the damage from the long bear market in Japanese equities?

Are you sure that it even comes close to the damage from exposure to Japanese real estate?
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Post by kcowan »

This raises one of my big concerns. How do you do due diligence on an ETF?

Do you trust the fund manager to adequately track?
Is he paid enough to do that well?
What if he leaves?
Do you steer by the wake in selecting a particular ETF to cover a sector?
Or do you just invest on faith?

As you can see from my questions, many of these are the same questions we might ask of a mutual fund manager. Except that the ETF manager is constrained, perhaps thankfully.
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Re: Weakness of Indexing

Post by Bylo Selhi »

This is as good a thread as any...

Why Dynamic’s Success Proves Nothing
Canadian Couch Potato wrote:In last weekend’s Financial Post, Jonathan Chevreau wrote an admiring piece about Dynamic Funds, one of the oldest fund families in Canada. The article profiled seven funds with 10-year track records of outperformance that 'leave index-hugging rivals behind.'...

Chevreau suggests that Dynamic’s excellent track record is a useful basis for investors who are looking to beat the market going forward. I don’t think it is. I’m not disparaging Dynamic’s managers, and I’m not prepared to write them off as dart-throwers who simply got lucky. These managers are undoubtedly skilled and they made some great calls. However, 10 years ago, investors could not possibly have known that these funds would have been winners. Here’s why:...

I’m happy to join Chevreau in tipping my hat to the Dynamic managers who performed so well over the last 10 years. But until someone is able identify who we’ll be doffing our caps to in 2020, active management remains a shell game that most investors will lose.
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Re: Weakness of Indexing

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Financial Times journalist John Authers authored a book on the financial crisis: The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How To Prevent Them in the Future.

One of the points he makes in the book is that widespread index investing causes overinflated stock prices because everyone and his sister piles in without regard to any underlying value. The result is market distortions and bubbles, which inevitably burst.
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Re: Weakness of Indexing

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I'm a convert to most of the indexing philosophy. However, it seems that an argument could be made that the small-cap market is less efficient and good mutual funds (particularly ones with lower than average MERs) can be competitive, if not beat index funds.

For example the TD US small cap, which isn't even one of the highest rated funds (Globefund gives it 4 stars) has a 10 year return of 2.77% versus 2.19% for the index. And when you consider that index funds underperform the actual index (due to fees etc.) the difference becomes even a little greater. I see similar results with Canadian small cap when relatively low MER funds are used. Admittedly the small-cap indexes do beat the average mutual funds and given that we can't judge future performance that may make indexing the safer bet. However, considering the average MERs are rather high, that is not surprising.
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Re: Weakness of Indexing

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It needs to be pointed out that both the Chevreau piece and CdnCouchPototo's response above discussed ONLY ONLY ONLY the dichotomy of choice between passive indexing vs. PAYING someone to manage your money actively (e.g. mutual funds). No conclusion on the general issue of 'active vs passive' are proved by looking ONLY at a subset of participants. Unresoved arguments.

I see four weaknesses with indexing.
1) The information available on the index is poor and/or misleading. Basic info like the P/E ratio is purposefully calculated in a way to ignore and omit information. Instead of adding up all the earnings and adding up all the prices (weighted) and then dividing one by the other ..... they calculate the ratio for each company and then essentially throw out the negatives and big positives and weight the average of what is left.

2) I am a believer in top-down investing. The first decision is "are you invested or not"? I think 2008 was the perfect example of 'wrong' passivity, as indexers just 'did nothing' when a basic understanding of what a 'run on the bank' is should have prompted them to sell (NO NOT at the bottom) back in Sept/Oct.

The subsequent recovery has ingrained in a whole generation of investors the religious belief that "markets always recover". They have completely blocked out what almost happened when the US Congress refused to bail THEM out the first time. Witness the Tea-party who now want to dismantle the Fed, refusing to even think about what would have happened if the Fed had NOT bailed out investors.

3) Another example of the 'wrong' passivity engendered by indexing was shown when inflation first because a worry recently. The first time in a generation really. It quickly became obvious that the passive indexers had never bothered to learn the basics about interest rates, inflation, duration, yield curves, corporate risk premiums etc. They had obviously told themselves that indexing mean "you don't have to learn anything".

4) The passive indexing websites have made it clear that the human need for excitement and betting has NOT been squashed by indexing. It has simply been redirected to the two decisions that indexing allows. The endless discussions about the best way (ie by which to beat the market) to rebalance, and the best indexes (ie to outperform the large-cap home-country broad indexes) to choose, prove this.
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Re: Weakness of Indexing

Post by IdOp »

One of the points he [John Authers] makes in the book is that widespread index investing causes overinflated stock prices because everyone and his sister piles in without regard to any underlying value. The result is market distortions and bubbles, which inevitably burst.
IMO this is a highly specious argument. If there were no index funds, then those "bubble-driving" indexers would just be doing what their actively managed neighbours are doing, i.e, throwing money at closet index funds and all other variety of funds that still add up to the index. Indexes just mirror what the active segment is doing. Indexing is just a cheaper way to participate in a bubble, when there is one. There have always been bubbles, and there always will be another, whether or not index funds existed or exist.
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Re: Weakness of Indexing

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SAMUELSON’S DICTUM AND THE STOCK MARKET
JEEMAN JUNG and ROBERT J. SHILLER*

(Paul) Samuelson has offered the dictum that the stock market is ‘‘micro efficient’’ but ‘‘macro inefficient.’’ That is, the efficient markets hypothesis works much better for individual stocks than it does for the aggregate stock market. In this article, we review a strand of evidence in recent literature that supports Samuelson’s dictum and present one simple test, based on a regression and a simple scatter diagram, that vividly illustrates the truth in Samuelson’s dictum for the U.S. stock market data since 1926.
Even if true, still doesn't really solve the problem of how to predicatably take advantage of this...
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Re: Weakness of Indexing

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MaxFax wrote:2) I am a believer in top-down investing. The first decision is "are you invested or not"? I think 2008 was the perfect example of 'wrong' passivity, as indexers just 'did nothing' when a basic understanding of what a 'run on the bank' is should have prompted them to sell (NO NOT at the bottom) back in Sept/Oct.
This is basically a suggestion for market timing. All of the academic research I'm familiar with shows that most investors perform miserably over the long run if they attempt to market time.

I have no reason to believe that my market timing skills are any better than the average investor. So I don't attempt to time the market.


The subsequent recovery has ingrained in a whole generation of investors the religious belief that "markets always recover".
Not for me.

I'm well aware that some markets can go down and stay down. Which is why I'm global diversified in the hope that all of the worldwide markets don't go down and stay down for the long term. And if they do, this may be a sign of a long term decline in the human race and I'll probably have other things to worry about than my investments.

Besides even if markets do perform badly, I'll still expect to outperform the majority of non-indexing investors. Indexing does guarantee great returns, if just provides very good odds that you will outperform a large percentage of non-indexers.
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