Category Archives: market news

Trees are Obstructing My View of the Forest

Those of you with interesting lives may have missed out on the conflict between providers of traditional index investing and providers of new indexes that weight holdings by fundamental criteria like cash flow or dividends instead of market capitalization. The traditional sponsors are playing the role of Spanish Inquisitors, aghast with fury at the open heresy of these upstarts. The mood is captured nicely in this column from Bloomberg:

Arnott, 56, says Bogle inspired him to set up Research Affiliates LLC less than a year after that dinner. Arnott then went on to shake the foundation on which the older man built Vanguard: indexing that allocates equities based on market capitalization, Bloomberg Markets magazine reports in its July issue.

Arnott debuted in 2005 a new type of indexing that uses fundamental measures such as cash flow to pick stocks — a methodology that the father of indexing would later denounce as “witchcraft” in an interview with Morningstar Inc. (MORN) because of its similarity to active management and higher costs. By 2011, the innovator’s brand of stock indexing had produced better returns than Bogle’s.

Why is a capitalization weighted index the only proper definition of the market? Why is it important to match the return of this abstract construct of some batch of eggheads in Manhattan? This presumptuous arrogance is maddening, although this column from IndexUniverse makes the attitude easier to understand:

It’s no coincidence that index funds—which are the foundation of Vanguard’s US$1.8 trillion asset management business—started to become popular at around the same time as CAPM established itself as the leading financial theory.

And capitalisation-weighting still provides the basis for the portfolio holdings of the vast majority of passive funds, as measured by the assets allocated to them. Beyond the index and exchange-traded fund market, cap-weighted indices are also used as benchmarks by most active funds.

The problem?

An attack from a different angle is offered by those who focus on CAPM’s (and finance theory’s) inaccurate measure of risk. CAPM is based on a mean-variance framework, which defines the distribution of stock returns over time as a bell curve, implying that risk (measured as standard deviation from the mean) can be measured precisely and predictably.

Nothing could be further from the truth, argued Benoît Mandelbrot in a 2005 book with a tongue-in-cheek title, “The Misbehaviour of Markets”. Those damn markets (those messy human beings acting in aggregate, in other words) keep refusing to fit into our nice mathematical models, says Mandelbrot, going on to show conclusively that the actual behaviour of stocks is far wilder than classical finance theory presupposes.

When the most famous mathematician in modern times shows conclusively that the foundation of your theory is bunk, you have a problem. Trillions of dollars invested in this theory makes it a big problem.

Investors that are accustomed to viewing active management with (justifiable) skepticism, would be well-served to apply similar skepticism toward the idea that the only “proper” way to invest is to allocate money to the right index funds and then hold them forever, regardless of market conditions or economic circumstances or conflicting evidence that demonstrates the flaws in that strategy.