Capitalization-Weighted Index Funds: A Closer Look At “Smart Beta”

reminiscences of a stock operator pdf

by David Markel, CFO of the AlephBlog

Are index funds that are capitalization-weighted the best funds to invest in?  No.  So why do we talk about index funds so much?  Because they represent the average dollar in the market.  In principle, everyone could invest in a comprehensive index fund, and there would be no effects on the market.

But indexes can be enhanced.  Tilt your investments to:

  • Avoid the biggest firms, their growth opportunities are limited.
  • Buy cheap stocks, they out-earn growthier stocks, and have fewer disappointments
  • Buy quality stocks, again, fewer disappointments.
  • Buy stocks that have been running, they tend to do well in the future.
  • Buy stocks with conservative accounting, they tend to outperform.

But the moment you do that, you are an active manager, because not everyone can do what you are doing.  Also, each of the anomalies I have indirectly referenced can occasionally be overvalued.  As an example, the biggest stocks presently look cheap compared to smaller stocks.

Trying to create “smart beta” is interesting, but let’s just call it enhanced indexing.  And if too many people try to do enhanced indexing, guess what?  Those stocks will become overvalued, and will eventually sag, badly.

There is no magic bullet in investing.  There is the work of evaluating valuations versus future prospects, and that is a challenging task.

If you want average performance, which is better than most get, buy a broad index fund with low fees and hold it.  If you want better performance, tilt your portfolio to reflect factors that usually outperform.  If you want still better performance, ask what factors are overvalued, and remove them from your portfolio.

As for me, I am happy buying safe and cheap stocks and holding them for three years or so.  I’m happy with my picks, and so I adjust my portfolio in small ways quarterly. No need to over-trade. I just keep following my strategy.

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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