Whole stock market investments versus strategy skews


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Whole stock market investments versus investment strategy skews

Investors who decide to pursue passive equity index strategies still have a few very important strategy decisions to make. They can choose to buy the whole stock market or to adopt a “strategy skew,” when choosing stock index investment funds.

If an investor buys the whole stock market, they seek the market’s return without selecting any particular subset of the market or any investment strategy skew. Doing so is consistent with investment theory and the research evidence. The total stock market is expected to deliver an optimal risk-adjusted return less, of course, whatever minimal costs are associated with the passive broad market index funds chosen to implement this total market strategy. When winners are not identifiable beforehand, this strategy is optimal and efficient.

Without the details, certain factors or investment skews have been demonstrated in the research literature to have the potential to improve modestly upon the market’s risk-adjusted return. Sometimes known as the Fama-French factors, these investment strategy skews are:

These factors may enable investors to improve upon the risk-adjusted performance of the overall market and deliver slight to modestly improved returns. However, to implement these skews or strategies is not costless, and therefore the incremental costs and taxes associated with these strategies also need to be taken into consideration.

A section below will address the value versus growth and large-cap versus small-cap factors or skews. This is because it is practical for passive index investors to adopt such skews through index funds, if they wish and if they are willing to take on the additional risk and costs associated with these skews.

Momentum, which is the sometimes slight tendency of stock price trends to persist, cannot practically be invested in by individuals. If there is any persistence or price momentum, professional traders with very low trading costs, substantial capital, and ample computational resources are the only market participants who are likely to be able to capture this factor economically.

Selecting a broadly diversified investment portfolio WITHOUT any investment strategy skew

The first step in achieving a fully diversified investment portfolio is to choose from among only very broadly diversified and low cost mutual funds and ETFs. The second step is to choose a mix of investment funds that tends to approximate the broadest markets. The funds lists provided in my “Low Cost Mutual Funds and ETFs” book focus entirely on broadly diversified, low cost investment funds.

Various market participants and advisors advocate that investors favor one or more of a multitude of investment selection factors, when assembling an investment portfolio. Unfortunately, these selection factors often involve higher costs, lower diversification, greater risks, and more activity – without a reasonable assurance of improved total returns net of taxes and investment costs.

I suggest that investors own a proportional share of the global public securities markets by buying and holding passive, low cost, and very broadly diversified investment fund vehicles. To do so you would make investments in proportion to the capitalization or total market value of individual securities within the markets.

This is known as capitalization weighting. You can easily assemble a capitalization weighted portfolio by buying low cost, no load index mutual funds and ETFs. Such fund track broad market indexes closely by buying and holding securities in proportion to the capitalization-weighted strategy of the benchmark index. This is where you will also find investment funds with rock bottom fees and costs.

Selecting a diversified investment portfolio WITH an investment strategy skew

To adopt a portfolio skew toward some alternative portfolio weighting factors will require paying higher fees, trading costs, and taxes. To the extent that you “skew” you portfolio or deviate from a very broad and very low cost capitalization-weighted strategy, you should ask whether you are likely to be compensated on a risk-adjusted basis for the added costs of an alternative “skew” to your portfolio. Are you likely to be compensated with sufficient “excess” performance that is disproportionately higher than the additional investment risk that you will incur – after costs and taxes are taken into account?

My reading of the investment literature makes me skeptical on this point from the point of view of the individual investor. In general, the lowest cost and most broadly diversified investment strategy tends to have a better opportunity to come out ahead.

However, as an overview, the following are brief summaries of major skews that a portfolio might have:

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