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:
- value versus growth,
- large capitalization versus small capitalization, and
- momentum.
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:
- “Value versus Growth” — In general, value strategies beat growth strategies over the long-term, although there can be extended periods (think years) when one or the other is in relative ascendancy or relative decline. A growth or value skew can lead to results that deviate unpredictably for sustained periods from the overall market return during the course of market cycles. Furthermore, growth and value investment vehicles often have substantially higher costs. Therefore, I suggest that people select total market investment vehicles with the lowest costs that cover the broadest range of securities.
- If you feel compelled to adopt a value or growth skew to your investments, the investment research literature supports implementing a value skew rather than a growth skew in a portfolio. If you are willing to accept sustained deviations from market index returns, a value skew tends to win over the long-term. Since the costs of value strategy can be significantly higher than a passive full market, capitalization weighted strategy, adopting and managing a value skew might turn out not to be worthwhile.
- Simultaneously, you need to be prepared to maintain faith in your value strategy and accept deviations from a market return. Value strategies tend to win when things get ugly or the markets move laterally. The hardest periods for value investors are when everything seems peachy and the stock market is rocketing ahead, because that is when value strategies tend to trail the broad market and growth strategies.
- While it is beyond the scope of this book, you should also note that discussions about how to implement stock selection methods for passive value strategies have become more heated recently. For example, the best method to select a value-based subset of stocks from the universe of stocks is not clear. Nevertheless, the greater the investment management cost differential, then the higher the cost hurdle that a value strategy must overcome. This is a primary reason that I suggest simply sticking to whole market funds without any particular skew.
- Note that, while the name “growth” may sound good, the actual long-term results of a growth skewed investment strategy might not be as appealing. This is akin to the naming of the “delicious” apple. Many people are under-whelmed by the taste of delicious apples, and they prefer the flavors of many other apple varieties. However, naming apples delicious is a great marketing strategy. The same might be said about growth investment strategies – good naming, but better long-term risk-adjusted out performance? Not so much.
- “Large versus Small Capitalization” – Investors gravitate toward investments in large companies, while perceiving them to be less risky. Perhaps the securities of larger firms are somewhat less risky, but small capitalization stocks sometimes have exhibited better returns historically.
- In general, if you chose to invest across all sizes of firms and you can invest at very low costs and in proportion to securities market capitalization, then you will be more broadly diversified and you can participate is the relative ascendancy and relative decline of all size groups. (However, you should also read the section in the chapter above on diversification that is entitled: “Choose the broadest available, whole market diversification.” Skewing your portfolio toward small or large companies is not a reliable recipe for gaining superior risk-adjusted returns when compared to a passive, whole market investment strategy.)
- Within the US equity securities markets, large capitalization stocks, measured by the S&P 500 represent about 70% to 75% of total market capitalization. Roughly speaking, “mid-cap” stocks represent 15% to 20% of total market capitalization and “small-cap” stocks represent 5% to 10% of market capitalization. This information is provided for those who wish to assemble a US equities portfolio using large-cap, mid-cap, and small-cap investment funds in rough proportion to overall market capitalization.
- “Domestic versus International” The total market capitalization of non-US equities markets is now greater than 60% percent of total world markets. If you hold at least 50% international equities in proportion to the capitalization of equities securities markets across the world, then you are also quite diversified from a global geographical standpoint.
- Note that when you hold both domestic and international equity mutual funds, for some years you may see relatively dramatic, even double digit percentage increases or declines in the value of international stock holdings. This does not necessarily mean that there is a similarly large disparity between domestic and international economic growth rates or local stock market returns.
- When you own international stock holdings, returns are denominated in a wide variety of foreign currencies, which must be converted back into US dollars for investment fund reporting purposes. Currency exchange rate fluctuations can amplify or dampen returns percentages both positively and negatively. To understand what really has happened, you need to compare stock market return percentages denominated in local currencies prior to the exchange rate conversion of foreign returns into the local currency of the investor.
