Which Index funds to invest in?

Linton

GeoffTF said:

Cus said:

Deciding to invest based on market caps is to me an active decision similar to  deciding to invest based on other values, such as valuations, earnings, whatever.  I've no issues with that.  My concern is the perceived belief, based on a number of internet investment movements over many years, that investing in market cap based weightings is the default goto and will deliver the best long term results, and that an individual should not engage their own research as how can they beat a market.

If you buy a market weighted tracker, you buy the performance of the average dollar invested in the market (before costs). You also have very low costs. Additional costs compound up over time. After a market weighted tracker has been held for many years, it will have beaten nearly all the actively managed alternatives.

Consider a fund weights according to earnings rather than market cap (the most plausible of your alternatives). That is active investment by definition because it overweights companies with higher earnings and underweights those with lower earnings. If you bought such a fund, you would in effect saying that earnings are a better indication of a company’s value than its market weight. (Think about what would happen if a large proportion of the market - or all the market - bought that fund.)

Market weighted trackers do not trade, except when companies enter or leave the market, or in response to corporate actions. (If the stock price doubles, the market weight doubles too.) That keeps costs to a minimum and ensures that holding the fund does not affect market prices. A fund that weights according to earnings has to constantly rebalance.

Surely any particular market should ensure that all frequently traded stocks are priced according to the market's perception of their future returns. The price of a stock that was considered of lower than average value would soon fall and one considered of better than average value would increase (Efficient Market Hypothesis). 

In that case one should be free to choose any frequently traded stocks according to your own criteria without impacting expected future returns.  I agree that lower costs for cap weighted funds is a factor but it may not be the over-riding one.

The issue becomes more difficult across multiple markets where it is less clear that the EMH applies as many investors do not have the ability or the wish to trade in different markets in different currencies across the world.

GeoffTF

Linton said:

GeoffTF said:

Cus said:

Deciding to invest based on market caps is to me an active decision similar to  deciding to invest based on other values, such as valuations, earnings, whatever.  I've no issues with that.  My concern is the perceived belief, based on a number of internet investment movements over many years, that investing in market cap based weightings is the default goto and will deliver the best long term results, and that an individual should not engage their own research as how can they beat a market.

If you buy a market weighted tracker, you buy the performance of the average dollar invested in the market (before costs). You also have very low costs. Additional costs compound up over time. After a market weighted tracker has been held for many years, it will have beaten nearly all the actively managed alternatives.

Consider a fund weights according to earnings rather than market cap (the most plausible of your alternatives). That is active investment by definition because it overweights companies with higher earnings and underweights those with lower earnings. If you bought such a fund, you would in effect saying that earnings are a better indication of a company’s value than its market weight. (Think about what would happen if a large proportion of the market - or all the market - bought that fund.)

Market weighted trackers do not trade, except when companies enter or leave the market, or in response to corporate actions. (If the stock price doubles, the market weight doubles too.) That keeps costs to a minimum and ensures that holding the fund does not affect market prices. A fund that weights according to earnings has to constantly rebalance.

Surely any particular market should ensure that all frequently traded stocks are priced according to the market's perception of their future returns. The price of a stock that was considered of lower than average value would soon fall and one considered of better than average value would increase (Efficient Market Hypothesis).

I think you misunderstood what I was trying to say in the sentence that you have emboldened. If you add together every investor's portfolio, you have all the stocks in the market. The market as a whole clearly tracks the market weighted index. If you divide the market capitalisation of the market at time t by the market capitalisation a time t0, you have the performance of the average dollar in the market. In percentage terms that is exactly the performance of the market as a whole. It is also the performance of a completely cost free market weighted tracker. Sorry if I was not clear.

GeoffTF

Linton said:

In that case one should be free to choose any frequently traded stocks according to your own criteria without impacting expected future returns.  I agree that lower costs for cap weighted funds is a factor but it may not be the over-riding one.

You could say that if the market was completely efficient, any cost free portfolio should have the same expected return as the market. Nonetheless, that return could be a lot different to the market, and it could be a lot less. There would be no expectation that you would match the average investment in the market (before costs). There would also be no expectation that you will beat most active investors over time (after costs). With a market weighted tracker, you have that expectation, irrespective of whether the market is completely efficient. Active investing is zero sum game with respect to the market. Every dollar of out-performance is matched by another dollar of under-performance. It may not be glamorous to be average and cheap, but it works.

chiang_mai

EthicsGradient said:

Linton said:

Just noticed - the MSCI World Index is now 72% US, ie  2-3 times the whole of the rest of the world put together.  The magnificent 7 represent 23.5% of the index, about 1/3rd of the US component. Does this reflect the real world? Is it a safely balanced portfolio?

Remember that the "MSCI World Index" is developed countries only (and they don't include South Korea in "developed countries", despite being a country that the USA now uses for high tech inward investment):

The MSCI World Index captures large and mid cap representation across Developed Markets countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country.

MSCI World Index

How to balance with developing economies, China especially, where much of the economy is not in internationally-publicly traded companies, is a debatable topic.

Just because it's possible to invest in every developed market doesn't mean that doing so is a good idea, nor does it bring any additional benefits, over and beyond investing in a few selected markets. I would argue that a world index spreads risk beyond the point where it's useful and at the same time, dilutes the any gain.

I think that a better starting point is to decide which markets you want to invest in and to set aside the rest. For example, I invest globally but the markets I actively invest in are the US, UK, Europe, Developed Asia, Japan, China and Emerging Markets (I intentionally distinguish between China and EM for control purposes). Once you've decided on the markets, the question becomes, how to invest in each one and the answer may well be different for each.

I let the L&G Index take care of the US which requires no further thought. I have a single managed fund that addresses China and also spreads the risk across EM and Developed Asia, job done. I think Japan requires a managed fund so that's what I use. The UK is addressed using a combination of the HSBC FTSE All Share Index  and a managed fund. I address the EU as part of a global dividend fund whereby Europe represents the lions share of that fund, simply because I find Europe to be so volatile. There are large parts of the global markets that I have no interest in investing in hence I ignore them, it's not necessary to achieve total coverage, nor is it necessary to stick to just index or managed funds, a blend works well. 

Lastly, just because the US represents over 50% of the global market, doesn't leave me feeling obliged to hold that percentage of the US in my holdings. Until recently my US allocation was 20%, today its 24%. The guideline for Japan is 6%, I'm currently invested at 11%. And just for info., I'm in China to the tune of 10%, as part of the fund I desrcibed earlier. UK centric investors may not think those ratio's represent a "safely balanced portfolio" which is to a large degree, subjective.

GazzaBloom

chiang_mai said:

EthicsGradient said:

Linton said:

Just noticed - the MSCI World Index is now 72% US, ie  2-3 times the whole of the rest of the world put together.  The magnificent 7 represent 23.5% of the index, about 1/3rd of the US component. Does this reflect the real world? Is it a safely balanced portfolio?

Remember that the "MSCI World Index" is developed countries only (and they don't include South Korea in "developed countries", despite being a country that the USA now uses for high tech inward investment):

The MSCI World Index captures large and mid cap representation across Developed Markets countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country.

MSCI World Index

How to balance with developing economies, China especially, where much of the economy is not in internationally-publicly traded companies, is a debatable topic.

Just because it's possible to invest in every developed market doesn't mean that doing so is a good idea, nor does it bring any additional benefits, over and beyond investing in a few selected markets. I would argue that a world index spreads risk beyond the point where it's useful and at the same time, dilutes the any gain.

I think that a better starting point is to decide which markets you want to invest in and to set aside the rest. For example, I invest globally but the markets I actively invest in are the US, UK, Europe, Developed Asia, Japan, China and Emerging Markets (I intentionally distinguish between China and EM for control purposes). Once you've decided on the markets, the question becomes, how to invest in each one and the answer may well be different for each.

I let the L&G Index take care of the US which requires no further thought. I have a single managed fund that addresses China and also spreads the risk across EM and Developed Asia, job done. I think Japan requires a managed fund so that's what I use. The UK is addressed using a combination of the HSBC FTSE All Share Index  and a managed fund. I address the EU as part of a global dividend fund whereby Europe represents the lions share of that fund, simply because I find Europe to be so volatile. There are large parts of the global markets that I have no interest in investing in hence I ignore them, it's not necessary to achieve total coverage, nor is it necessary to stick to just index or managed funds, a blend works well. 

Lastly, just because the US represents over 50% of the global market, doesn't leave me feeling obliged to hold that percentage of the US in my holdings. Until recently my US allocation was 20%, today its 24%. The guideline for Japan is 6%, I'm currently invested at 11%. And just for info., I'm in China to the tune of 10%, as part of the fund I desrcibed earlier. UK centric investors may not think those ratio's represent a "safely balanced portfolio" which is to a large degree, subjective.

What criteria or rationale do you use to decide what markets you invest in and in what proportion?

The benefit of a global index, be it total market or developed markets only (long term it will make little difference to returns and isn't worth procrastinating over), is that it requires no educated active selection (some may call it guesswork), you just buy the one fund and hold it forever and let the index adjust over time as individual markets wax and wane.

Perfect for the “no nothing” investor and will deliver perfectly reasonable returns.

Having said that, contrary to many commentators on here, I am overweight US equities (through selective low cost index trackers) compared to the global index weighting and have been for many years and see no reason to change despite all the current hand wringing, furore and emotion surrounding the current President.

Reaper

michael1234 said:

nakie999 said:

I had the same wobble after loading up on S&P and Nasdaq, felt diversified until I looked under the hood and saw the same five names doing most of the lifting. I rewired the ISA to a plain global tracker with a small slice of short-dated gilts so I could breathe through the drawdowns

Let me guess, Apple, Microsoft etc ?

It seems difficult (for a laymen like me) to keep a geo balanced portfolio. The "all-world" fund mentioned above seems to be 65% USA based and that seems quite typical.

Yes if you invest in a world tracker 65% will be in USA and a huge chunk of that will be in a handful of grossly overvalued (IMHO) "magnificent 7" shares.

What I do to reduce the concentration is put some of it in an ETF that excludes the USA completely such as XMWX "Xtrackers MSCI WORLD EX USA"

chiang_mai

GazzaBloom said:

What criteria or rationale do you use to decide what markets you invest in and in what proportion?

The benefit of a global index, be it total market or developed markets only (long term it will make little difference to returns and isn't worth procrastinating over), is that it requires no educated active selection (some may call it guesswork), you just buy the one fund and hold it forever and let the index adjust over time as individual markets wax and wane.

Perfect for the “no nothing” investor and will deliver perfectly reasonable returns.

Having said that, contrary to many commentators on here, I am overweight US equities (through selective low cost index trackers) compared to the global index weighting and have been for many years and see no reason to change despite all the current hand wringing, furore and emotion surrounding the current President.

My rationalse for the choice of market is the availability of investing information in those markets and my personal comfort level. I wouldn't invest substantially in markets where I have no knowledge at all of that market and where information on it was hard to come by.  I lived in the US for 15 years and in Europe for 10. I was born and raised in the UK but have lived in SE Asia for 25 years and in China for 3.

The proportions are slightly more tricky. There's a lot of statistical data out there about what percentages people invest in which region so that can be a guide. Add to that your personal bias and comfort level and you'll arrive at a number. I have read repeatedly where it is said that investors should hold no more than 6% in Japan, because of volatility and risk. The emerging view is that it's not high risk to increase that to 10%....I hold 12%. Many UK investors will have home country bias and be overweight but I'm not happy with more than 15% or 18%. Ditto Europe, that's around 18% currently for me. EM can be 20% or more which including China, leaves me at 24 at present. The fact that your end allocation may be different from the percentages in say a global all world fund, doesn't mean much to me because they are usually based on capitalisation percentages. One mans meat etc. My decison to be sigificantly underweight USA is vested in US politics but is also a personal challenge to myself to try and achieve profit from places other than the US.....guess what, it's not hard to do hence there's no point in taking on US political risk, with the current regime. 

chiang_mai

I think it also helps to look at your holdings from as many different perspectics as possible and to model the impact of any planned changes. In addition to the obviouis geographic allocations, I also model and track my allocations by sector and by capitalisation. I try to ensure that all sectors are populated and that none are extreme. Historically, the technology sector has been overweight and currently the financial services sector is prone to extremes. With regards to capitalisation, I try to ensure a two thirds large/giant and one third medium/small allocation but I'm older and more risk averse hence my portfolio needs the stability of large blue chips. But I still have 24% in Medium sized companies and 11% in small, which is where the profit comes from. Lastly, I find it's worth paying attention to the Morningstar risk model ratings but they will give you a consistent view of risk across all your holdings. My portfolio currently averages 54 on the MS scale, which is appropriate to my age, younger investers will likely go for higher risk ratings.

AlanP_2

Reaper said:

michael1234 said:

nakie999 said:

I had the same wobble after loading up on S&P and Nasdaq, felt diversified until I looked under the hood and saw the same five names doing most of the lifting. I rewired the ISA to a plain global tracker with a small slice of short-dated gilts so I could breathe through the drawdowns

Let me guess, Apple, Microsoft etc ?

It seems difficult (for a laymen like me) to keep a geo balanced portfolio. The "all-world" fund mentioned above seems to be 65% USA based and that seems quite typical.

What I do to reduce the concentration is put some of it in an ETF that excludes the USA completely such as XMWX "Xtrackers MSCI WORLD EX USA"

Another option to consider is XUSE "iShares MSCI World ex-US" ETF at the same 0.15% fee

michael1234

So we're all sat here tweaking our fund portfolios.

Are we hoping the regions we've invested in will grow more than expected or are we hoping more folk like us will pour more of their money into the regions we're currently invested in ? Which is it ?