Harry Newton's In Search of The Perfect Investment
Newton's In Search Of The Perfect Investment. Technology Investor.
AM EST Monday, January 22, 2007: I really like index
funds. My index funds have done better than many (not all) of my hedge funds.
And, best yet, they have avoided the losses in my biotech-specific hedge funds.
(Dumb. Don't ask why.) The local Vanguard index funds which I have and love
are (in approx. order of performance)
+ Total International Stock Index.
+ Emerging Markets Stock Index Admiral shares.
+ International Value Fund.
+ 500 Index Fund Admiral shares.
+ Mid-Cap Index Fund Admiral shares.
+ Pacific Stock Index Admiral Shares.
An index fund
typically mimics an index. This means the fund manager doesn't have to worry
about picking stocks. He simply buys what's in the index, which is typically
broad. Hence you get cheapness of management (the fees are low) and broad diversification.
But there are many indexes. Which one?
Don't buy one. Buy several. That's why I have six Vanguard funds in the
U.S. and am getting one in Australia -- the one there that mimics their top
There are new
wrinkles on index funds. To keep you informed (and confused), I've excerpted
a piece from the weekend's New York Times. Be aware that Wall Street
is a product -generation machine. Its job is to create new things for you and
I as suckers to buy -- irrespective of whether these things make any sense or
not. You can skim this piece. There's fun stuff below:
used to be simple. In fact, ever since indexing rose to prominence as an investment
strategy in the late 1990s, simplicity has been a big selling point.
index funds remove much of the emotion and ego from investing. You buy and
hold all the stocks that make up a market benchmark and achieve average returns,
rather than trying to beat the market through active stock picking. Theres
not much to it and thats been indexings strength.
But a group
of market theorists have emerged recently with a take on indexing that complicates
matters considerably. These so-called fundamental indexers say they can beat
the market, not just match it, a core assertion that certainly seems to inject
some ego back into the process.
indexers say its not a matter of being smarter than the market, but
of using common sense. They say it is possible to outperform traditional yardsticks
like the Standard & Poors 500-stock index simply by reconstructing
the benchmarks that the funds mimic by reweighting an existing index
or building a new one.
of traditional indexing, the very notion of trying to beat the market by indexing
the market is heresy not to mention illogical. It just doesnt
make sense, said John C. Bogle, founder of the Vanguard Group, which
started the first retail index fund, the Vanguard 500 Index, 30 years ago.
And to many
investors, the distinctions between fundamental and traditional indexing may
seem arcane. Both broad strategies call for buying and holding a diversified
basket of stocks for the long run. And both try to keep costs down by avoiding
active stock picking.
index funds tend to mimic indexes weighted by market capitalization, such
as the S.& P. 500 or the Russell 1000 index of large stocks. In a cap-weighted
index, stocks with greater market values have greater sway over the indexs
performance. As the price of a stock rises, a traditional index fund reflects
that rising value. Conversely, if a stocks price drops, the value of
the holding in a traditional cap-weighted fund will also fall.
wrong with this approach? Well, what if the market isnt always right
and misprices stocks from time to time?
Jeremy J. Siegel,
a finance professor at the Wharton School of the University of Pennsylvania,
said the bubble that formed in technology stocks in the late 90s really
began to show how far stocks can be pushed away from their fundamental value.
the biggest mispricing of equities in stock market history, he said.
Yet cap-weighted index funds put investors at risk by building their technology
positions as the market became frothier and frothier. Then, when the Internet
bubble burst, those investors saw those huge tech stakes get slammed.
just the nature of the beast, said Robert D. Arnott, chairman of Research
Affiliates, an investment management firm based in Pasadena, Calif., that
is a major proponent of fundamental indexing. With cap weighting, anything
that is overvalued is overweighted by the index, and anything thats
undervalued is underweighted.
Mr. Siegel and
Mr. Arnott say they believe that there is a better way. They suggest that
instead of building an index based on market capitalization, it is
better to use fundamental factors such as earnings, dividends or cash flow
to determine how much of a security the index fund should own.
In a momentum-driven
market like that of the late 90s, such a strategy could lag, fundamental indexers
say, because investors wouldnt be riding the wave. Conversely, the strategy
should hold up better in a falling market, because fundamental indexes were
not as likely to be caught up in market hysteria.
In a fundamentally
weighted index, you dont become a speculator, said Bruce Bond,
chief executive at PowerShares Capital Management, which recently opened several
exchange-traded funds based on fundamental indexes created by Mr. Arnotts
firm, Research Affiliates. Over the last year, the number of exchange-traded
index funds that adhere to this new approach has risen to around 50 from just
7, according to State Street Global Advisors.
But there is
no denying that this new approach forces investors to make several layers
after deciding that indexing and not active stock-picking is
the best way to go, you must decide which type of indexing to choose
fundamental or traditional. If the choice is fundamental indexing, you must
decide which fundamental factors earnings, sales, dividends or cash
flow, for instance are most important. Then comes another decision:
Which recipe for a fundamentally weighted index is best, based on those variables?
There are already
squabbles forming about whose theories of alternative indexing are superior.
Wilmington Trust recently opened two retail mutual funds that tracked fundamentally
weighted indexes. The indexes rely on three variables: dividends, free cash
flow and net income.
Mr. Siegel who serves as senior investment strategy adviser to WisdomTree
Investments, which has started 30 fundamental index funds prefers to
focus on dividends. Why dividends? They are just about the only valuation
metric where there is no dispute where theres no management manipulation,
he said. Mr. Siegel added that not only do dividend-paying stocks perform
better than nonpayers over the long run, they also tend to fare better in
BUT Mr. Siegels
competitors point out that WisdomTree recently filed to register a new set
of fundamentally oriented E.T.F.s that weight stocks based on earnings.
This would imply that WisdomTree doesnt believe that dividends are the
best way to weight an index in all circumstances. And Mr. Siegel agreed in
a recent interview that its wrong for me to say blanketly that
its the best for everyone at all times.
For his part,
Mr. Arnott said he thought that a dividend-only model, while potentially effective
in beating the S.& P. over the long term, could create portfolios that
were not as broadly diversified as other funds. As an alternative, Research
Affiliates has constructed several fundamentally weighted indexes using a
combination of sales, cash flow, dividends and book value. Based on records
from the last four decades, Mr. Arnott said, the Research Affiliates Fundamental
Index 1000, a large-cap index, would have handily beaten the S.& P. 500.
From 1962 to 2006, the RAFI 1000 would have generated an average annual return
of 12.5 percent, versus 10.4 percent for the S.& P.
But Mr. Bogle
said that these are hypothetical returns for the underlying indexes
that dont take into account fees, costs and taxes that would be
associated with running an actual index fund. Whats more, he said, many
fundamental index funds charge more in fees and have higher turnover rates
than traditional index funds like the Vanguard 500.
say that the fundamentals approach isnt really indexing at all. After
all, they contend, a fundamental index provider has to select a method for
weighting stocks that it thinks is superior to the collective wisdom of the
doing is active management, said Clifford S. Asness, managing principal
at AQR Capital Management in Greenwich, Conn.
of the emphasis on fundamental factors rather than market capitalization,
he said, it is a form of active management that tends to favor value-oriented
stocks and smaller stocks. Mr. Arnott argues that fundamental indexing is
a form of passive investing that it simply ranks stocks based on their
economic footprint rather than market capitalization.
Dodd F. Kittsley,
director of E.T.F. research at State Street Global Advisors, said that while
there were certain active components to this strategy, it remains
a version of indexing. But he wonders how recent market trends may have affected
the results of the approach.
think its ironic, he said, that a lot of these fundamental
index funds with a value and small tilt have come out at a time when value
and small stocks have been doing extremely well.
At the very
least, it may be too early to tell how good these fundamental index funds
are, especially because many lack even a one-year track record. Im
holding off to see if these funds perform all that differently at the end
of the day relative to traditional cap-weighted funds, said Sonya Morris,
editor of the Morningstar ETF Investor.
David R. Kotok,
chairman and chief investment officer at Cumberland Advisors in Vineland,
N.J., has begun investing some of his clients money in fundamentally
weighted index funds.
But he has refrained
from shifting his entire strategy to them, he said. These are new vehicles.
We just dont know for certain how theyll perform.
+ Don't bother locking
your suitcase. I watched a TSA lady blithely
break open a lock on a piece of luggage. She was using the largest bolt cutters
I've ever seen.
+ Some airline clubs now have showers. They make traveling almost civilized.
+ Most airports and airport lounges have Wi-Fi Internet access. Most charge
like Starbucks. But some are free -- especially the international airlines, like
Air New Zealand. For most traveling, you no longer need a dial-up account. Finally.
+ Jet lag is the worst. Today is a week after I came back from Australia.
And I still have jet lag.
announces the iPhone:You must watch this video. It's hysterical.
from the telecom industry: You must
watch this video. It's Comedy Central's Steve Colbert reporting on the new AT&T
and the old telecom industry. What's most fascinating is that his take is actually
the light on buying bulbs: This is the MR16.
Decorators love it because it's small and concentrates light. In reality, it
blows constantly and costs the earth. You can easily pay $10 at your local hardware
store for one MR16 bulb. At Bulbs.com
(and other places on the net), you can pay as little as $1.49 for a non-branded
but equally good bulb. The good news is they're now making MR16s in LED which
should last longer -- but cost as much as $20 a bulb. I'm going to instal a
few of the new LED MR16s and see what happens. For LED bulbs, click
browser for me? Microsoft's Internet Explorer or Mozilla's Firefox.
Don't decide. Get both. They're both free. They both now have tabbed
browsing -- meaning you open many sites simultaneously and you can flip between
them. It's their best new feature in eons. For Mozilla Firefox 2, click
here. For Internet Explorer 7, click
Note: some web sites only work with Internet Explorer. When using Firefox,
these sites give weird error messages. Personally I prefer Firefox for most
of my browsing.
side-benefit: Personally I love high definition TV, especially for
nature wild life pieces. But it's not all rosy in the hi-def world. According
to today's New York Times, "Pornographic movie studios have found
that the high-definition format is accentuating physical imperfections in actors."
Jesse Jane plans cosmetic surgery to hide imperfections newly visible on
Hi-Def, according to today's New York Times.
Why does this
story amuse me?
relate to this silly story:
A man feared his wife was not hearing as well as she used to, and he thought
she might need a hearing aid. Not quite sure how to approach her, he called
the family doctor to discuss the problem.
The doctor told
him there is a simple informal test the husband could perform to give the doctor
a better idea about her hearing loss.
you do," said the doctor. "Stand about 40 feet away from her and in
a normal conversational speaking tone see if she hears you. If not, go to 30
feet, then 20 feet, and so on until you get a response."
the wife was in the kitchen cooking dinner, and he was in the den. He said to
himself, "I'm about 40 feet away. Let's see what happens. "
In a normal tone
he asked, "Honey, what's for dinner?"
So the husband
moved closer to the kitchen, about 30 feet from his wife, and repeated, "Honey,
what's for dinner? "
Still no response.
Next he moved
into the dining room where he was about 20 feet from his wife, and asked, "Honey,
what's for dinner? "
Again, no response.
So, he walked
up to the kitchen door, about 10 feet away. "Honey, what's for dinner?
Again, there was
So he walked right
up behind her. "Honey, what's for dinner?"
the 5th time, "CHICKEN!"
This column is about my personal search
for the perfect investment. I don't give investment advice. For that you have
to be registered with regulatory authorities, which I am not. I am a reporter
and an investor. I make my daily column -- Monday through Friday -- freely available
for three reasons: Writing is good for sorting things out in my brain. Second,
the column is research for a book I'm writing called "In Search of the
Perfect Investment." Third, I encourage my readers to send me their
ideas, concerns and experiences. That way we can all learn together. My email
address is .
You can't click on my email address. You have to re-type it . This protects
me from software scanning the Internet for email addresses to spam. I have no
role in choosing the Google ads. Thus I cannot endorse any, though some look
mighty interesting. If you click on a link, Google may send me money. Please
note I'm not suggesting you do. That money, if there is any, may help pay Claire's
law school tuition. Read more about Google AdSense, click
here and here.