The Froogal Stoodent Takes On Vanguard
In my constant search for better, easier, more profitable ways to invest, I've run into a fact that disturbs me more and more as I continue to think about it: most total stock market indices, such as Vanguard's VTSAX, are market-cap weighted.
What does that even mean?
Well, it means that a greater proportion of every investment dollar goes to the largest companies in the market.
At first glance, you'd think, "More of my money is going to the Apples and Googles and Microsofts of the investment world. Isn't that a good thing?"
Maybe.
But maybe not.
For the past 10 years or so, large-cap companies have done extraordinarily well, in no small part thanks to the money that has been flowing into such funds from people's 401(k) investments. Many target-date retirement funds are skewed to large-cap as well.
One could argue that the investment world has been inflating a bubble for large-cap stocks.
That's not to suggest that companies like Amazon, Facebook, Procter & Gamble and Visa are worthless, or that they're going to shed over half of their value in a severe crash. No, that's not my point at all.
My point is that, after a decade of huge institutional money getting pumped disproportionately into these uber-giant companies, their stocks might be overvalued. Even a 5% overvaluation could have enormous consequences on a decent-sized portfolio.
Wouldn't it be better for the index investor to divide his dollars equally among each of the over 3500 stocks in VTSAX, rather than putting almost a quarter of that money into the top 10 companies?
The top 10 companies—Apple, Microsoft, Amazon, Alphabet Inc [that is, Google], Facebook, Berkshire Hathaway, Johnson & Johnson, Procter & Gamble, Visa, and Nvidia—comprise almost a quarter of the value of the entire index!
This is why I say I'm "disturbed" by the market-cap weighted structure of the fund.
After all, isn't the whole point of index investing that nobody can reliably pick the winners?!
Vanguard's founder, John Bogle, taught that message so thoroughly that his followers have devote an entire website to sharing and debating this message.
Let me reiterate that VTSAX holds over 3500 stocks. But I just did some quick back-of-the-envelope math on the matter: the top 30 companies comprise roughly $337.4 billion of a fund that holds $921.4 billion. That's over a third of the value of the entire fund! In the top 30 companies alone!
That bears repeating: out of over 3500 companies, the top 0.85% hold around 36% of the value of the entire fund!
I'm getting too excited! I'm using too many exclamation marks!!!
Ahem.
Philosophically, as John Bogle so pithily phrased it, index investing isn't trying to find the needle in the haystack. It's just buying the whole haystack.
But in practice, funds like VTSAX are essentially betting that the big companies will be the winners. Granted, it's using a low-cost, passive approach to do so, and I suppose the alternative involves some degree of rebalancing, which would involve more trading—this would reduce the tax efficiency of the fund.
But it would appear to be a fairly trivial programming matter to automatically rebalance these funds, say, once a year. Or every six months. Or once per quarter. Whatever the fund managers deem best.
Perhaps this is a contributing reason why the CAPE ratio has gotten so high for U.S. stocks. Because people keep pumping more money, week after week, into companies with already-inflated stock prices.
Equal-weight alternatives exist. You can find funds like iShares MSCI USA Equal Weighted ETF, which holds shares of 618 different companies. This fund has a fairly low expense ratio of 0.15%, almost 4 times higher than VTSAX's 0.04%.
Invesco has an equal-weight S&P 500 fund with a slightly higher expense ratio of 0.20%.
I'm starting to wonder if a fund like one of these isn't worth the extra expense.
Lyn Alden is an excellent researcher who started her career in engineering and now analyzes the market for value stocks and other profitable opportunities. You can tell from reading any of her articles that she really dives deep and checks things out thoroughly. In this example, she analyzes equal-weight funds vs. market-cap weighted funds: https://www.lynalden.com/equal-weighted-index-funds/
It's worth reading the entire page for yourself. But the short version is that equal-weight funds often have an edge. Not always, but often enough that an equal-weight S&P 500 fund would beat a market-cap weighted S&P 500 fund, even accounting for the higher fees on the equal-weight fund.
In one part of her analysis, Lyn analyzes funds for different sectors, like tech, energy, health care, and industrials. Her analysis leads to this data-driven gem:
The conclusion for this case study is likely that equal weighting does better with high-quality companies with low catastrophic failure rates, while market weighting does better in winner-take-all environments with high catastrophic failure rates.
Basically, when a sector has a couple huge winners and a lot of companies that drop to zero [think tech], market-cap weighting does better. But when a sector is less cutthroat and you have many modest winners and only a few losers, equal-weighting does better.
In your estimation, which of these does a total-market fund resemble?
I can't find an equal-weight Vanguard fund. Perhaps Vanguard should re-think this policy.
Support the Froogal Stoodent blog by checking out these headphones;
anything you buy will generate a small commission—at no cost to you! Thanks!
No comments:
Post a Comment