Graduate Level Investing – Understanding How Indices Work

I am on record—in statements, in practice, and in my personal portfolio—of having a bias towards using Dimensional Fund Advisors mutual funds.

Why is that? Two reasons:

• The philosophy that they use is based on Nobel-prize-winning research.
• The philosophy is so simple that it can be explained WITHOUT using Nobel-prize-winning explanations.

Basically, the idea is that there are four things that are persistent (have been true over time) and pervasive (have been true the world over):

• Stocks outperform bonds.
  • This makes sense to me as stocks = ownership vs. bonds = acting as a bank
• Small companies outperform big companies.
  • This makes sense to me as NOTHING can compound growth-wise continually over time (taxes excluded of course)!
• Value stocks outperform growth stocks.
  • This makes sense to me as buying overinflated “goods” (i.e., companies via growth stocks) does not “mesh” with my desire to find value in my life.
• More profitable companies outperform less profitable companies.
  • This makes sense to me as profit is a solid surrogate for a well-run company.

I prefer to leverage the above factors in my investment portfolios. Is this a guarantee of out performance? Absolutely, positively NOT! Has this approach been shown to produce higher expected returns?  YES. Do I believe that this approach will produce similar higher expected returns in the future? YES

The linked article goes into more depth about how to CAPTURE these factors systematically and the issue with using index mutual funds to do so.

In a nutshell, the issue is that indices are STATIC for periods of time, while the market is DYNAMIC and continually changing. When you purchase an index mutual fund, you are purchasing a STATIC basket of companies for some time period. At defined, known periodic intervals, the index will be reconstituted; and, accordingly, certain stocks in the fund will be sold and others purchased. This process introduces some known volatility in trading volumes, and the market has been shown to quickly move/reflect these pricing anomalies.

Does this mean index funds are “bad”? ABSOLUTELY, POSITIVELY, NOT!!!! I have often said—and I will stick to this—that an investment philosophy built around index mutual funds is a GREAT idea and—given a well-defined, implemented IPS—will likely outperform the vast, vast majority of investors. So, if you love index funds and use them to build your portfolio, keep going—you’re doing great!

For those of you that want to explore a bit more in depth how you might leverage more fully the aforementioned factors, take a look at this recent article from Jake DeKinder at DFA. It is well done and quite educational!

• Are you ready to take advantage of the factors that have been proven to deliver higher expected returns in investment portfolios?
• If so, would you like to partner with someone who uses these factors AND partners with the company and individuals that pioneered the use of these factors—and is the second fastest growing mutual fund company)?

Feel free to send us an email or give us a call. We’d love to have the opportunity to help you move up to graduate-level investing.

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