Why do Value Investors Like Indexing?

In general, most value investors like indexing.  Buffett and many others agree on this.  But why?

1) Most value investors that I have known want ordinary people to have an option of doing pretty well, without investing with them, because the minimums are too high — investing in index funds fits that.  Further, Vanguard, who acts in the interest of their investors is an excellent institution.  If I could have a fund there and be paid 10-20 basis points, I would do it in a heartbeat.

2) The second reason is less noble.  We like less competition.  Index money is thought-free money with respect to company and sector selection.  The more of a company that is held by index investors, the greater the probability that it is mispriced.

Now, that is not necessarily so crass on our part.  Look, good investing for most people is like holding a second job.  Do you really want to devote that much of your life to seeking out bargains?  Not many will want to do that.  (Note: there is a side benefit to doing value investing, no matter what sort of firm you work for.  You learn to think like an intelligent businessman — most employees don’t do that.  The ability to think like a intelligent businessman sets you up for greater responsibility, because you can not only do your task, but you can consider the deeper questions of business, making you a prime candidate for a promotion.)

But… there is another venue for mispriced stocks.  Some large stocks don’t get into the index because they are foreign, or have a large amount of the stock owned by a control group, which makes them less liquid.  The main idea is that stocks that few people think about are less liquid, and more likely to be mispriced, but the question remains: are they mispriced high or low?

That is the question for the value investor, and not for those that buy stocks as commodities, as many index investors do.

2 Comments

  • Conscience of a Conservative says:

    In my retirement plan I index, in my regular accounts I do not. In the latter I buy and hold both tax free bonds and a diversified portfolio of mostly large cap domestic and international companies. I seldom sell, unless the original reason I bought the company no longer holds or valuations make selling too compelling not to. What I have notice as my portfolio has grown to around 30 names is that my performance holds fairly close to the weighted blend of S&p 500 and MSCI indices. All I accomplished is making investing a little more interesting and perhaps avoiding capital gains from the trading of stocks active portfolio management brings. It’s really hard to fault indexers.

  • eric@servo says:

    Unfortunately, the premise of this article is completely flawed, as it assumes all “indexes” are simply S&P 500 or Total Stock portfolios. You are no doubt aware that Vanguard has Large/Mid/Small VALUE indexes as well, right?

    Further, for someone wanting more pure, targeted, and consistent exposure to the lowest priced value stocks, the “enhanced” index funds from DFA are close to unbeatable. Sorting on a simple metric of price/book and holding approximately the cheapest 25% (as opposed to 50% for Vanguard and most Value ETFs) of stocks in the respective asset class (while trading patiently, using fund cash-flows to rebalance, lending securities to earn additional revenue), DFA’s large/small value funds in the US, Int’l, and EM markets have trounced their active manager competition. Here are the stats on the % of active value funds in each asset class over the last 10 years (through November) that have been OUTperformed by DFAs simple “structured” approach, which for all intents and purposes are index funds:

    US Large Value (DFLVX) = 90%
    US Small Value (DFSVX) = 83%
    Int’l Large Value (DFIVX) = 91%
    Int’l Small Value (DISVX) = 100%
    Emerging Mkts Value (DFEVX) = 97%

    And not that it matters much, as these percentages are so high to begin with, but these #s don’t include survivorship bias — something on the order of 40% of value managers that existed 10 years ago have gone out of business, so this outperformance is only measured as a % of those professional value managers that survived!

    Somewhere, over some periods, I am sure we can find some value managers who have outperformed an intelligently structured value index portfolio, but the numbers are so small as to be almost irrelevant, and there is no persistence going forward in the # who have been able to pull off the feat.

    No, the case is actually quite clear, “active” value investing is dead. All investors would be much better off simply holding broadly diversified, structured/indexed VALUE portfolios. And stop confusing “indexing” with “cap weighted total market index portfolios”. There are a lot of index funds beyond the Russell 3000 and S&P 500.

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