Portfolio Growth

[Owen` 2]

Folks,

 

Those of you who are using or plan to use personal investment portfolios as a source of living expenses might be interested in the following. Warning: esoterica follows.

 

A few months ago a study in the US emerged concerning the concept of index mutual funds. It has been known for some time now that most "managed" mutual funds, with costs embedded within the fund to pay for that "management", tend to underperform the overall market. In the US the index that measure the market is usually quoted as either the Dow Jones Industrial Average or more recently the Standards and Poors 500 Index. So what this means is that some managed fund from the Fidelity or TRowePrice fund family tends to underperform the index. In other words, since you can buy an S&P500 index fund, why are you paying managers to underperform it?

 

The same is true in the UK, I believe. The FTSE All Shares index is the equivalent. I don't know what y'all call mutual funds there but I suspect you have equivs.

 

Well, the study in question that emerged says this. The S&P500 (and the FTSE All Shares) index are capitalization weighted. A company that is a part of the index is given a divisor that reflects its capitalization share value on the day it is added to the index. What this then means is that at the end of a year the companies in the index that are most heavily weighted within that index are the companies that define most of the motion of the change of the index. It means that the index becomes concentrated and that the companies with a price run up are heaviest weighted (because their capitalization has increased).

 

It is not clear that this definition of "the market" or that this method of creating an index fund is in the best interests of investors. The issue is not so much what defines the market as what sort of index fund, with its very low costs, is best for investors who don't want to pay underperforming managers. In other words, according to Seigal in the link below it appears that there are indexes that are easily defined that in a non data mining sense can beat the S&P500.

 

Well, the debate has been underway in the US for about 5 mos. It has now reached the UK and they are on top of it like white on rice. Here's a link:

 

http://money.independent.co.uk/personal_fi...icle1189590.ece

 

A thought I'm toying with is carefully noting that it has been known for a long time that 7 selected, non covariant stocks can capture 97% of the variance of an index. In other words, I'm toying with the idea of creating my own index to seek the 2-4% advantage claimed over the S&P and paying no costs at all. The idea is not to pick stocks that will do well, but to pick stocks that emulate this non capitalization based index one might envision.

 

It's an interesting discussion underway and probably the first credible challenge to indexing that has emerged on The Street in 25 yrs.

[Owen` 2]

I'm gonna reply to myself because that was so badly written:

 

An S&P500 Index Fund would have given you about 5% gain last year (2005).

 

It has become customary to call that "The Market". People who think they can beat the market usually don't. Most fund managers fail to do so.

 

The S&P is a capitalization based index. Companies are put in the index and given a divisor. The divisor is capitalization based. When each company's price is divided by that divisor and all the 500 results of that are added up, you get the S&P500 index.

 

A study has popped up challenging whether or not an index fund reflecting the S&P500 is optimal for investors. Other indexes based on other criteria not only surpass the S&P500 in backtesting, but they do so for a clear and rational reason that is systemic and should work long term.

 

If instead of each company of the S&P500 having a divisor you merely made all the divisors = 500 then you have a 1/N index and it is no longer capitalization weighted. Such an approach beats the S&P500 in the last 40 yrs.

 

Note that no one changes the companies. They are the same companies. They are just no longer capitalization weighted. They are all equally weighted. An index fund that was based on this 1/N index would beat the S&P500 index by 2-4% / yr on everage over 40 yrs.

 

The same thing can be done to the FTSE 100.

 

Alternate index funds are being created for investment.

[Eneukman 1]

The problem with the FTSE100 (and presumably the Dow Jones index is ) is that if one large company does particulary well (or badly) this causes the FTSE100 to move up or down in a disproportionate manner. A large gain (or fall) could therefore be caused by 2 or 3 large companies only.

 

Alan

[EnglishPaul 3]

A thought I'm toying with is carefully noting that it has been known for a long time that 7 selected, non covariant stocks can capture 97% of the variance of an index.  In other words, I'm toying with the idea of creating my own index to seek the 2-4% advantage claimed over the S&P and paying no costs at all.  The idea is not to pick stocks that will do well, but to pick stocks that emulate this non capitalization based index one might envision. 

Hi Owen

Followed and understood your post until this bit.

Any chance you could explain this a bit more please?

Many Thanks

[Owen` 2]

A thought I'm toying with is carefully noting that it has been known for a long time that 7 selected, non covariant stocks can capture 97% of the variance of an index.  In other words, I'm toying with the idea of creating my own index to seek the 2-4% advantage claimed over the S&P and paying no costs at all.  The idea is not to pick stocks that will do well, but to pick stocks that emulate this non capitalization based index one might envision.

 

 

Hi Owen

Followed and understood your post until this bit.

Any chance you could explain this a bit more please?

Many Thanks

 

Before I do, a comment re: Eneukman's point. And the comment is "exactly".

 

The point of the study is that the index is flawed. It may indeed describe "the market" in a broad sense, but not in a precise sense. The largest capitalization stocks are powerful in the index. It is possible that they should not be. 1/N addresses that and seems to outperform it.

 

Now, as for variance capture. If you have the index of 100 FTSE stocks or 500 S&P stocks, the overall price fluctuation of that index can be described by an average and a sigma (standard deviation). The motion from 1 and 2 and 3 etc sigmas to -1 and -2 and -3 sigmas can be called "variance". Mathematically, the vast majority of all price fluctuation is within 3 sigmas of the mean.

 

Within the S&P500 index, one can capture 95% of the variance with a "sub-index" of 7 stocks, carefully selected to be non covariant (meaning they are not customers of each other or partially owned by each other and are not interrelated in their share price movement). A study demonstrated this many years ago. In other words, you can emulate the S&P500 with a small subset of it.

 

So I am toying with the idea of examining a way to do the same sub-index thing with a 1/N S&P500 variant. If one can achieve 95% of the performance of the 1/N index with just 7 stocks, one does not need a mutual fund company to create a 1/N index fund for you to buy. You can just make your own.

 

The kicker can be practicality. Dividend reinvestment is free within an index mutual fund. You'd have to pay commissions for them in your own index. This may or may not matter.

 

Anyway, it's pretty cool. This is a bold idea of not accepting the S&P500 or FTSE 100 as being the optimal index for investors. It really does make sense systematically. Because of the emphasis on large capitalization shares, small caps are slighted, and over the long run small caps outperform large caps.

[av8r 0]

Thanks for your 2nd clarifying post Owen. I understood it much better. I've been a big fan of index funds for the last few years and would certainly be interested in improvements. Please keep us informed when someone comes up with a new indexing formula.

[cola4u 0]

I have been thinking about getting out of mutual funds and just buying stocks as well. Commission costs are so low now with internet brokers, the costs to buy and sell are insignificant. But, what stocks to buy, well that is the question that has kept me paying the percentage to the mutual fund company every year. Bad enough when the fund goes up, but hate to lose money and know that they still got their cut off the top.

 

Like you say, I think this strategy worked because the really big cap stocks have not done as well as the smaller ones for the last 40 years. Maybe just look at the holdings of a few smaller cap mutual funds and try and buy their biggest holdings? Maybe the next 40 years will be different. Not sure what strategy to try, but I really like the idea of cutting out the percentage paid to the mutual fund. Just not sure I can do any better on my own.

[EnglishPaul 3]

Owen

Thanks for your explanation.

Understood and follow your thinking.

Cheers

[Owen` 2]

Like you say, I think this strategy worked because the really big cap stocks have not done as well as the smaller ones for the last 40 years. Maybe just look at the holdings of a few smaller cap mutual funds and try and buy their biggest holdings? Maybe the next 40 years will be different. Not sure what strategy to try, but I really like the idea of cutting out the percentage paid to the mutual fund. Just not sure I can do any better on my own.

 

Be aware that an index fund, like Vanguard's or USAA's, charge about 0.18% for management. These are not "managed" funds. They are on autopilot and cost almost nothing. Managed funds can become insane and charge 5%.

 

The 2-4% being discussed here is not from the elimination of fees. An S&P500 index fund is dirt cheap at 0.18%. The 2-4% in question here comes from the index itself being flawed.

[av8r 0]

I use Vanguard for my index funds. I hope they come up with a less weighted version soon per your example.

[mats 0]

This is a really interesting way of thinking Owen, let us know if you come up with something. I`ve been with Intel and some other dinosaurs for some time now and need something new

 

Mats

[zaphodbeeblebrox 0]

Index funds are an interesting way of investing in order to beat the S&P500. Take a look at the Russell 2000 or Russell microcap index funds. These funds have left the S&P index in the dust. I despise mutual funds. However, I identified a great mutual fund, without high load costs. Take a look at the Third Avenue Value Fund, which averages more than a 20% annual gain. My stock portfolio has averaged a 27% gain the past 3 years, but I treat investing as a second job.

[RedRackam 0]

Owen, nice post and interesting material.

 

I think you're right, it will just be a matter of time before you get these kinds of ETFs in the US but in the UK it will be a long time because most of the market is not very well educated.

 

That's why the majority of UK mutual funds can still get away with charging a front end load of 5%

 

a) can you believe that, and

b( can you believe how many mugs pay up as if their fund managers are really doing a great job when infact the majority of them are closet trackers of some sort.

[Owen` 2]

I think you're right, it will just be a matter of time before you get these kinds of ETFs in the US but in the UK it will be a long time because most of the market is not very well educated.

 

That's why the majority of UK mutual funds can still get away with charging a front end load of 5%

 

a) can you believe that, and

b( can you believe how many mugs pay up as if their fund managers are really doing a great job when infact the majority of them are closet trackers of some sort.

 

 

I had no idea that the UK did not have an equivalent mutual fund array, especially index funds.

 

Make no mistake, there are mutual funds in the US charging management fees and front end loads of 5%, but they are becoming few because the "no loads" have been so thoroughly studied and found to perform the same. The crushing study was the one that showed 80% of managed funds underperform the S&P500, and those 80% differ year to year and indicate no one really has a "knack".

 

There is a handful of managed funds that provide some value. TRowePrice and Fidelity have a few funds that charge < 1% management fees and in effect provide you with diversification and asset allocation in that they spread their money around industries and they always have both bond positions as well as stock positions. There are other fund families (Putnam, Oppenheimer, Franklin Templeton etc) that do the same, but in general they have all had the management fees forced down by the realities of the business.

 

As for ETFs, I'm not an enthusiast. A full 35% of long term gains from equity positions derive from dividend distributions -- and those are compounded only if you reinvest. Dividend reinvestment is commission free (in the US) for mutual funds, but for ETFs it would be just like any new ETF share purchase and commissions would be applied.

 

No free lunches.

[WelshFarang 0]

I had no idea that the UK did not have an equivalent mutual fund array, especially index funds.

I think we do have them. They are known as TRACKER funds. Management charges are low as there is no need to pick and choose which companies to buy.

 

If it is in the FOOTSIE then it is included in the fund.

[RedRackam 0]

Owen, no we do have an 'array' of funds including index funds it's just that the majority of them are very expensive with all the fees etc.

 

For example, many index tracker funds charge 1% 1.5% in fees, can you believe that (I think a few also charge a 5% load but not many, stll people pay.....)

 

You make a very good point about reinvestment of dividends with ETFs, I wonder why they're not automatically reinvested, I would think that would cut down on expenses as well as help everyone involved. Bet there's some legal reason for it.

 

So, if you have small holdings of ETFs, say £5000 or $5000 and the div yield is 2% that's an income of £100/$100 which makes reinvesting it back into the market very expensive. But if you're say using say ETFs for regular investment in the market (as part of a pension) and are putting say £1500 every 1/4 into the market then reinvestment of the div income is not so much of a problem.

 

In my mind though, whether index or ETFs it all comes down to how much they charge because the money you save on fees that is left in the market over multiple years can REALLY make a difference as you yourself well know Owen

Edited August 13, 2006 by RedRackam

[Alfred 26]

I would steer clear of index funds that’s are a personal opinion, they generate good returns from fees and performance fees for the banks and brokers who run them but the investor may get a decent return some years but compared to a well designed direct stock portfolio taking into account you individual needs and risk profile they fall well behind.

 

Best way is to use a decent Stockbroker, and buy stocks with good dividend yields and have a history of increasing those dividends each year if you want a good steadily increasing income, some brokers also run portfolios tailored to either income or growth or a mix, if you need to switch out of a stock they will let you know.

 

Be prepared to hold stocks for along time don’t try and be a trader, its bloody hard and about 80-90% end up losing, were as long term investors who are patient and can ride out the markets ups and downs are the ones often well rewarded.

 

Compared to property IMO the stockmarket is much better, no tenants to worry about, no worry’s about no income if the property is vacant, a ready market to sell immediately if you need to, I could go on and on, also don’t forget if you need money in a hurry the stockmarket is quick, cheap and easy to dispose of stocks plus you don’t have to liquidate the whole lot to free up capital.

 

Property can be good and you may be able to borrow against the property if you need cash in a hurry but you will pay interest on those funds and have various fees and taxes to pay in most countries.

 

Cheers

 

Alf

[Gary 4,119]

I have always wondered why no one talks much about ETF closed end funds. I have five of them and they average about 9.4 percent a year. Until the dividend drops I'll be hanging on to them. They all pay the dividends monthly so they are very easy to keep track of. Since there are only the shares originally sold the share price isn't very volatile.

[Owen` 2]

Two comments. Alfred's post has the word "bloody" in it and that usually points at the UK, so I got nothing to say about his post or UK index funds, about which I know nothing.

 

In the US, an index fund has a cost of about 0.2%/yr as management fee -- because there are no decisions to be made. Active management funds . . . 80% each year underperform the index, and it's a different 20% beating the index each year so you can't pick the manager who pretends to have an edge.

 

Gary, as for ETFs or closed end funds, ain't nobody gonna argue with 9%. But if those were held outside a tax advantaged account you'd be paying taxes on every one of those dividends, and if the fund was holding the relevant stock for less than a year, you'll pay full tax rate and not the new, reduced dividend rate. That will eat into that 9%. Also, ETFs . . . in general when they pay a dividend like that, and you want it to compound, you have to reinvest the proceeds and there would be a commission on that. But I do think I've heard of some discount brokerages that will waive that (though I think it's usually the brokerage that is sponsering the ETF).

 

Clearly if you have the ETF in an IRA the tax point is moot.

 

Morningstar does some evaluation of funds as regards their "tax efficiency". Index funds do very well in those ratings because there is essentially never any trading. It's the buying and selling of stocks that generates taxable events.

 

As for closed end funds, they have the advantage of being able to see a book value and comparing that to market price. The concept of over or underpriced becomes less subjective that way.

 

But again, can't argue with 9%. I hope it continues.

[Gary 4,119]

They are indeed in my retirement fund so taxes are not a consequence. I DO take the dividends direct deposited in my bank account every month. I do feel they are safe BUT still have a stop loss of 15 percent of the purchase price. Historically they have been very steady. Mine are mostly invested in bonds.

[Owen` 2]

They are indeed in my retirement fund so taxes are not a consequence. I DO take the dividends direct deposited in my bank account every month. I do feel they are safe BUT still have a stop loss of 15 percent of the purchase price. Historically they have been very steady. Mine are mostly invested in bonds.

 

 

A point here worth mentioning. Gary is a sharp money guy (as evidenced by 9% while "professional money managers can't beat the S&P's 5% last year). As such he has stop loss orders in.

 

For the uninitiated, this means he has a sell order (good-til-cancelled) embedded in his accounts that automatically triggers and activates if the price of his item falls to touch a particular price. He says 15% of the purchase price -- but I'm sure he meant 15% down from the purchase price. No way a Gary is going to eat 85% loss. Just a typo.

 

Some nuances of this for the benefit of guys here. Stop losses can be moved. Gary's item is probably pretty stable in price and tosses off that 9% dividend each year (so hell, who needs price movement when you can get 9% in dividends). But you can do this with vehicles that move in price too. If you buy something that goes up, you can change your stop loss to follow it up, keeping it always at 85% of current price rather than purchase price. This is called a sliding stop because it slides upwards as the price of your shares move upwards. At no time will you lose more than 15% from your high, not just from your purchase.

 

Another thing, and Gary maybe a heads up on this for you. Stop loss orders are not perfect. Many are set up as "touch" orders. This means if the item (stock, fund, etf, whatever) price moves down and "touches" the limit price you set, that triggers the sell order to activate. Well, in hugely volatile crash-type markets, the price of your item can fall so rapidly that it jumps over your limit price and that price is never "touched" and your order never activates and when you check price that night, or end of that week or whenever, it could have fallen way under your sale target and no sale ever happened. Not good.

 

Another frown is the nature of the sale order that is activated. If your target price is "touched" and the sale order is activated, that order is a "market" order -- meaning the price you get that instant for your sale is the going rate for trading that exists that moment. In a major crash, there may be no buyers at your limit price and you might wind up selling for many points lower than the price you thought you would get.

 

So these are caveats worth mentioning, but heads up guys, they are caveats that would be very rare and they are caveats that are not so debillitating that they render the concept invalid. Gary has done very wise things putting these stop losses into place. 99.9% of market environments will see those sale orders executed successfully very close to that desired price. So Gary's model is a good one to follow. Just be aware that it is not perfect. Nothing else is either.

[mrstein 0]

Forex and 1st trust deeds are the ONLY Way to go.

 

Many currency funds are having gains over 30-40% for years now.Up till 1996 you had to have 10 million just to play in the game !!!!!!!!

 

1st trust dees placed in the correct company can net you gains pre-tax of 12-13% annually.

 

Forex in the right fund the Sky is the limit.

 

I know of 2 funds in Forex one by RJO futures out of chicago that are doing Net gains of 24-28% yearly for years now.

 

Once again Folks who have limited knowledge of these instruments ALWAYS Protest them.

 

True wealth can be built quickly if You have 400-500 grand to start YOU will never work again and Live a Nice lifestyle pretty much anywhere ESP in the LOS you would live like a Small king.

 

Stocks,Mutual funds Ira"s and Etc are a waste of time,Esp in the USA sector right now. Returns annually Esp when you take out commission"s and taxes You Yeild Nothing Just a tad better then a bank cd.

 

Funds ahahahhahaha When Janus highest earning fund is their Olympus High yeild fund at 8% per year hahahahahahahaha, They are scoring 30-45% and Giving you 8% WOW Jezz Tks..... Once again another USA Controlled fund where the TOP brass take all the profits and Leave Us Scraps.

 

Consider this FOREX is a 2 trillion dollar a DAY market. CAN all the Central banks and Forbes 500 companies ESP Citibank which is its 2 largest player and has had profits in the last few years in the Billions.

 

Can George Soros and William Buffet be wrong ??????

 

The 21 st century is bringing more opportunties to investors that are Savory then ever in History.

 

But then again I have been saying this for a while now.

 

Hello GO long on Oil at 100.00 a barrel that alone will get you Wealthy.You think Hitler JR I mean Bush jr isnt going to invade Iran in the next year ???? Take that to the bank.

 

How do you think Goldman sachs, scwabb, and the list goes on of investment companies making Billions in profits. Keeping the average investor SCARED. Dont try this and that. Yeh right.

 

Do you realize How many folks are going to get RICH off this Slowdown of Real estate ????????This is only 1 sector to be in.

 

Another one for ALL OF YOU. Metzler/Payden Funds Its European emerging markets fund is paying 38% since inception in 2002 its at 44.19% You are still talking about US stocks,bonds hahahahahahaha

 

Not to mention its a 5 star fund on Morningstar. Call them 1 866 673 8637

 

You Boy"s Need to WAKE UP

 

Mrstein

[ginseng 0]

MrStein,

 

What you post is very interesting, I encourage you to post more, particularly about how to profit off a real estate decline.

[Gary 4,119]

Thanks anyways mrstein but I'm quite happy with my 9 percent annual dividends and I sleep well.

 

And YES, my 15 percent stop loss is 15 percent below the purchase price. I was going to make it 10 percent but since I'm in them for the monthly dividends I decided if they drop 10 percent and still pay well, I'll hold on to them for a while longer. I do look at them almost every day and if I see the dividend start to slip I'll probably dump them before the price goes down 15 percent.