Why do Value Investors Like to Index?

I think I had some good things to say in the last post, but one commenter disagreed, and he had some good things to say:

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.

His main point is well taken.  Active long-only value managers have not done well versus the indexers.  I’ve stated that at other times.  This is also true for hedge fund managers, where survivorship bias is even worse.

That said, I have a few objections.

1) Index investing by its nature follows the return factors incorporated into their index (if cap-weighted) or enhanced index (if not).  Factors go in and out of favor.  Some factors are seemingly permanently in favor, like value, small size, low Net Operating Assets, and price momentum.

Occasionally, those factors can be overinvested, like in August 2007.  That doesn’t mean the factors should be abandoned — weak holders are getting shaken out.

2) Every investment strategy has a “carrying capacity.”  Indexed strategies are larger, as are value strategies.  But there is some point where value as a whole can be overinvested.  Value can become “too cool” for a time, and can get relatively overvalued.  Some market participants look at the range of P/E, P/B, or P/S ratios.  When they are thin, value is overpriced.  It’s like being a bond manager, and doing an up-in-credit trade, except that this is an up-in-growth trade: buy higher growth stocks when the difference in P/Es  and other valuation factors is relatively small.

3) Yes, I know about the many subindexes that underlie the whole of indexing.  That wasn’t my point in the prior article.  Indexers need some amount of valuation oriented  investors, whether they are portfolio managers, or that they investors willing to take the whole company private, or a public company that acquires it.  If everyone indexed to the market as a whole, there would be no price signals.  Yes, with subindexes, that is not so, but the more money you pour into a subindex, the greater the likelihood of overvaluation.

4) There is the possibility of an indexing bubble.  An indexing bubble would have a situation where stocks in major indexes are overvalued relative to companies that are not in indexes.  now, it’s hard to imagine an indexing bubble, because there is no leverage involved, and little speculation.  Now for subindexes, relative over- and undervaluation is normal.

Just as in commodity markets, you have commodities that trade on futures markets, and end up in indexes, and those that don’t, because they are less liquid, fungible, deliverable, etc.  Often the relative price difference between what is easily tradable can be an indicator of whether excess liquidity has warped prices beyond their fair value.  This can happen with stocks as well, where stocks less held by indexes those more held by indexes.

There will probably come a time when those that have invested in index funds have to liquidate to meet their long term goals, and there will not be enough new money to absorb the selling.  Unless this is disproportionately true of index investors (unlikely, but possible), this would be a whole market phenomenon.

The broader question is related to the markets as a whole.  Since most stock investing is done on an unlevered basis, the overall ability to hold a diversified stock portfolio comes down to time preference.  There is what stock investors as a group should have as their time-preference, which is largely based off of demographics.  The there is how they behave when markets get hot (optimism -> time preference lengthens) or cold (pessimism -> time preference shortens).  Note that this is the opposite of the way that absolute value investors behave.

Now, here is one problem with my thesis: DFA and Vanguard are clever traders.  In really small stocks, DFA is virtually a market maker and picks up some alpha doing it.  In my investing, I actually like it when Vanguard or DFA is a large holder, because it is an indicator of neglect.

Here’s the second problem with my thesis: the fees of active managers are too high.  Even if active managers can pick up on some inefficiencies, will it be enough to overcome their fees?  On average, impossible.  So I appreciate what the commenter said, even as I ply my trade as an active manager.  You need some degree of active management in the markets to keep prices in rough line with valuations.

And, maybe, just maybe this means that indexing will have to get to be a much larger proportion of the markets before active managers would have alpha after fees as a whole.  Until then, passive investing is a great way to go for most investors.