Index vs managed funds the great war

Linton wrote: »

The problem with index funds is that almost all are wedded to investing on the basis of market capitalisation.

That is generally my problem with them too.

What if I want to allocate my equities money in a diversified way around the world but don't want over 40% to be in companies based in or listed in any one country? Can't use a world index then. What if I want a nice broad allocation to a hundred companies or more in my region of choice, so I don't want over 3% in any one company? Can't use FTSE UK All Share or FTSE North America then. If I want small companies and I'm sold on indexing I can probably find a "small cap" index fund that will allocate most of my money to the very biggest of those small companies. Seems far from perfect.

However if you raise such points to fans of indexing they will generally tell you that obviously they accept there are certain flaws with cheap cap-weighted indexes which they have been promoting to all and sundry... but not to worry because you could instead use the more expensive "smart beta" products which are relatively thinner on the ground and more expensive but address the reasons why traditional index funds are beaten by their active brethren (e.g. size factor, value factor, quality factor etc).

Those 'better index funds' haven't been in existence for as long and may not be as widely available, but supporters can point to certain longer time periods in which they delivered great theoretical results in a backtested scenario.

Although, when a supporter of active management points to the decent fund managers who have *actually* had great results in outperforming mainstream indexes by following their equities research and own personal strategies - which might include smaller companies, bottom-up evaluations of suitability of individual companies from a valuation perspective, etc etc - the index fans will poo-pooh all that and say it's all just luck and taking greater risk, and even if it isn't luck or higher risk there is a lot of competition and you wouldn't have known that the manager was worth following all those years ago.

I have generally lost patience with fans of indexes who can't see beyond the last book or bit of research they read that was published or sponsored by someone with a vested interest. But don't think I'm biased, I'm also impatient with people who think active management is always best. So I try not to get involved in "active vs passive" threads, having already been on the boards for over a decade and seen the same stuff regurgitated time and again.

Generally within a few posts into a thread, you generally end up with an argument between agnostics who will meet you halfway and say that active is best in some situations and passive can be better in others, versus hardline evangelists who say you should basically use passive in every situation and if a passive fund doesn't exist for a situation, it isn't a situation you should try to get into.

It is easy to overweight an area with minor tweaks - how does one underweight it without having separate funds that cover all other areas?

With difficulty. If you don't want something held within an index, the only way to avoid it is to buy more and more of everything else on the planet, to drown it out.

The 'fans of passive' would say if it exists in the index you should buy it, the fact it has a valuation at all is proof that it's valuable, and the market is efficient. However, the market is fickle and can change its mind over what it's 'fair' valuation should be within a matter of days. There are some terrible companies limping on with bad performance, terrible corporate governance and so on, that get money thrown at them by index participants who haven't made any judgements and just want to pay money for a company because it exists and is large.

So, in some markets I prefer to pay an experienced manager with an on-the-ground research team, to not waste my money buying those stocks. The payment to the manager can save on payments to the former owners of underperforming companies.

bostonerimus wrote: »

It is perfectly possible to come up with your desired allocation with low cost indexes and is done by DFA. French and Fama would approve of your asset allocation strategy, but would recommend you do it with low cost index funds.

As board members of DFA you would hardly expect them not to endorse doing it the DFA way. Can DFA funds be accessed by the general public through mainstream cheap brokers these days? In the old days they were targeted at an institutional investor base, being non-retail and only available through expensive wealth managers and investment advisers.