It's Time to Reinvent the Index Fund

Bigger isn't necessarily better. That old trope has long since been disproved -- and in fact, I'd go so far as to say that you'd be insane to believe that "bigger" and "better" always walk hand in hand.

Yet the assumption that they do continues to govern the low-cost index fund industry, one that you likely have a good portion of your life savings invested in. My contention is that the flawed "bigger is better" reasoning that underlies index investing has exposed American investors to needless amounts of risk over the past few years and ultimately cost Americans billions of dollars of their hard-earned money.

Thus, I believe it's time for a change, and I have a plan for getting it done.

First, some history
The first index fund for individual investors was invented by Vanguard founder Jack Bogle in 1975. Bogle's contention then -- as it is today -- is that most active fund managers cannot outperform the market average and that even fewer active fund managers can outperform the market average net of the fees they charge investors to manage their money. This was true when Bogle made the claim in 1975, and it has remained true in the more than three decades since.

So Bogle created the Vanguard 500 Index to track the performance of the widely followed S&P 500 index -- minus a minuscule expense ratio. And the Vanguard 500 has been a smashing success.

The fund grew to be the largest mutual fund in the world by 2000 and today boasts more than $61 billion in net assets, and charges just 16 basis points per year in expenses. Even better, since its 1976 inception, the Vanguard 500 has returned 9.3% annually to investors. That performance, available to anyone who had the wherewithal to invest, would have turned $1 into more than $18 today -- one of the best and longest track records in the investing world.

Yet it's been a pretty bad year for the Vanguard 500. In fact, it's been a pretty bad three years, five years, and decade for the Vanguard 500. As of the end of February, the fund was down more than 43% over the past 12 months and has lost more than 3.5% annually over the trailing-10-year period.

Those are not good numbers. They're the consequence of a flawed methodology.

It's not Jack's fault
The problem is that the Vanguard 500 tracks the S&P 500, an index that was designed in 1957 to track the performance of the 500 largest companies in the United States. Back then, S&P decided that the influence each company would have on the index would correlate directly with its market cap. So the largest company in the group would have the most influence, the second-largest the second-most, and so on down the line until the smallest company -- the 500th company -- would have the least.

That's why, at the beginning of this year, the Vanguard 500's 10 largest holdings looked like this:

Company

Market Cap

Weight within Vanguard 500

ExxonMobil

$406 billion

5.1%

Procter & Gamble (NYSE: PG  )

$185 billion

2.3%

General Electric (NYSE: GE  )

$170 billion

2.1%

AT&T

$168 billion

2.1%

Johnson & Johnson (NYSE: JNJ  )

$166 billion

2.1%

Chevron (NYSE: CVX  )

$150 billion

1.9%

Microsoft (Nasdaq: MSFT  )

$149 billion

1.9%

Wal-Mart

$125 billion

1.6%

Pfizer (NYSE: PFE  )

$119 billion

1.5%

JPMorgan Chase

$118 billion

1.5%

Data as of 12/31/08.
Add it up and these 10 companies today account for more than 22% of the Vanguard 500's holdings just because they're the biggest companies out there, but not necessarily because they're the 10 best investments or the 10 highest-quality companies or the 10 best-run corporations. You own them -- if you own an index fund (and you likely do) -- because they're big.That doesn't seem like a very good reasonIf you don't have a problem with that flawed reasoning yet, just take a look at what the top 10 holdings of the S&P 500 Index -- and therefore the Vanguard 500 fund -- looked like in 2007: 

Company

Market Cap

Weight Within S&P 500

ExxonMobil

$513 billion

3.8%

General Electric

$424 billion

3.2%

AT&T

$258 billion

1.9%

Microsoft

$277 billion

1.8%

Citigroup

$232 billion

1.7%

Bank of America

$223 billion

1.7%

Procter & Gamble

$219 billion

1.6%

Cisco Systems (Nasdaq: CSCO  )

$202 billion

1.5%

Chevron

$199 billion

1.5%

Johnson & Johnson

$190 billion

1.4%

Data as of 9/30/2007.
And in 2006:

Company

Market Cap

Weight Within S&P 500

ExxonMobil

$415 billion

3.4%

General Electric

$367 billion

3.0%

Citigroup

$247 billion

2.0%

Bank of America

$243 billion

2.0%

Microsoft

$280 billion

2.0%

Pfizer

$202 billion

1.7%

Johnson & Johnson

$190 billion

1.6%

AIG

$175 billion

1.4%

JPMorgan Chase

$166 billion

1.4%

Data as of 10/16/2006.
That's right, as of late 2006, your "diversified" index fund had half of its top 10 holdings in troubled financial stocks, four of which -- GE, Citigroup, Bank of America, and AIG -- now trade for less than $10 per share and two of which -- AIG and Citigroup -- have aggressively flirted (you teenagers know what I'm talking about) with total collapse.This is a problemThese companies are a significant cause of the Vanguard 500's dismal recent performance. JPMorgan is down 42% since October 2006, Bank of America 85%, Citigroup 94%, and AIG 98%. If you owned an index fund, you owned these four stocks. More troubling is that you had no good reason to.Remember, the only reason these companies were central components of the fund was their size. We know now that the reason they had gotten so big was because they were taking on extraordinary risk in the pursuit of short-term profits and bonuses and dangerously leveraging their balance sheets in order to squeeze out growth. While dangerous moves like that are hallmarks of big companies that have gone off the rails, they are not the hallmarks of good companies.

Yet the Vanguard 500 -- our country's most popular mutual fund -- is 100% quality-blind. And while The Motley Fool has long been a proponent of low-cost, long-term index fund investing as the best solution for most individual investors, we've also long said that the best way to earn good returns in the stock market is to buy and hold high-quality companies. Given the events of the past two years, it now seems impossible that these two methodologies have anything in common.

Where does that leave us?
The fact is that bigger is not better. Better is better. And index funds need to be reinvented for the better.

That's because over the past 36 months, individual investors who seem to have done everything right -- working hard, saving, and investing regularly in a low-cost index fund -- have found themselves dangerously overexposed to an ignoble and/or incompetent U.S. financial sector. 

Even if they were paying attention to the news and watched as Countrywide Financial, Fannie Mae, Wachovia, and Washington Mutual all imploded -- and they said to themselves, "Man, I'm glad I own an index fund and not any of those" -- it turns out that by late 2007, these troubled companies still made up a significant portion of the Vanguard 500. Financials on the whole made up nearly 20% of the S&P 500 index as of September 2007.

The news headlines around that time would have convinced even a daft individual investor that that was a dangerous amount. Key executives were departing these companies, mortgage divisions were closing, regulatory agencies were beginning to investigate, and a looming credit crunch was causing these companies to issue tepid outlooks. The Vanguard 500, however, did not catch on. Again, it's quality-blind.

Why would anyone own a fund like that?

A method to the madness
Of course, there is one spectacular reason to own the Vanguard 500: low fees. There is no cheaper investment option out there today, and history has proved beyond a shadow of a doubt that investors do better over time by limiting their frictional costs, such as taxes, trading costs, and annual expense ratios.

Further, there's nothing wrong with the government or media using the market-cap weighted S&P 500 index to track the health of our economy. The biggest companies will tend to be the biggest employers and have the biggest effect on commerce, so it's worth knowing when they're in trouble. My doubts are about its logic as an investment choice.

Here's what I propose instead: a low-cost, quality-weighted index fund of large U.S. companies. No such product exists today, but I believe it would prove to be immensely popular with individual investors. Moreover, by rewarding companies for having good corporate governance, creating value for outside shareholders, and treating their customers and employees well with inclusion in this index, we'd establish an incentive within the system for companies to do right by their constituencies rather than pursue growth at any cost (or GAAC!, which also happens to be the correct reaction if you encounter a company that's doing this).

After all, imagine if you were a CEO and you steered your company into the quality index. That would be a proud day. On the flip side, if you got your company kicked out, your employees, board of directors, and shareholders would have some questions for you.

Best of all, my preliminary research into this quality index indicates that it would have outperformed the Vanguard 500 significantly over the trailing one-, three-, and five-year periods.

Here's how it works
The challenge with a quality index is to devise the framework that would tell us if a company is worthy of inclusion. After all, it's not clear what factors make for a high-quality company, what factors are just symptoms of high-quality or low-quality companies, and what factors can be measured in an objective way.

Recognizing those facts, here's the hypothesis that crack research analyst Nate Weisshaar and I started with: "A high-quality company is one that treats all of its constituents -- shareholders, employees, and customers -- well." The question then became: What existing data sets can we use and smash together to come up with a list of high-quality companies?

There are lots of answers to this question, and you may well have your own answer or criteria you'd like to add to ours (and if you do, please add them in the comments section below). This, however, is what we came up with.

A blueprint for better
When it comes to companies that value their shareholders and shareholders' capital, here are the measurable criteria we like to see:

  • Insider ownership between 5% and 50% of outstanding shares (showing a management team that's committed to the company but doesn't necessarily control the company).
  • Limited to no takeover defense provisions such as poison pills that protect entrenched management.
  • Limited shareholder dilution over time (indicating a respect for the company's owners).
  • Either good returns on invested capital or a common stock dividend (evidence that the company thoughtfully allocates capital).

When it comes to measuring how a company treats its employees, we looked for inclusion on Fortune's list of the best companies to work for anytime in the past five years, as well as long-tenured management and a senior executive team that has largely been promoted from within.

And when it came to measuring customer satisfaction, we looked for the company's inclusion as one of the world's top brands, a spot on the list of BusinessWeek's "Customer Service Champs," or a high net promoter score. In order not to bias our index toward consumer-facing companies, however, while we overweighted our index toward companies that delight their customers in addition to their shareholders and employees, we did not eliminate any companies from the index unless there was evidence that customers have a clearly negative opinion of them. In other words, if customers have no opinion, the company still made our quality cut.

What we ended up with
This methodology is not perfect and is a work-in-progress, but the early results are promising. We ended up including 85 companies in our Fool Quality Index (the FQI for short) and weighting toward the companies that have clear evidence of working in shareholders', employees', and customers' best interests. Here are the top 10:

Company

Market Cap

Weight within FQI

Marriott

$5.4 billion

3.6%

Nordstrom

$3.2 billion

3.6%

Microsoft

$153 billion

2.9%

Nike

$22 billion

2.9%

FedEx

$13 billion

2.9%

Wal-Mart

$195 billion

1.5%

Coca-Cola

$98 billion

1.5%

Disney

$33 billion

1.5%

Devon Energy

$22 billion

1.5%

Charles Schwab

$16 billion

1.5%


Is this a perfect list? Probably not. Is every one of our 85 companies a truly high-quality company? It's hard to know. But what we do know is that this index outperformed the S&P 500. Over the past year as of mid-March, while the Vanguard 500 was down 39.4%, the FQI was down 30.5%. Over the past three years, the Vanguard 500 was down 38.9%, and the FQI was down 27.9%. And over the past five years the Vanguard 500 fell 26%, while the FQI was actually up 9%.

But this makes sense. A diverse collection of well-run, high-quality companies should outperform a random collection of big companies over time.

What now
In almost every other industry, the demands of the customer are clear. We want better products at lower prices. In the financial industry, however, it's been the reverse. Over the past decade, for example, we've seen the rapid rise of the hedge fund -- unregulated entities that took leveraged risks and generally bilked investors for a 2% annual management fee and 20% of profits. These were largely inferior money-management products at higher prices, and yet wealthy investors snapped them up like hotcakes.

That's left the market-cap-weighted index fund as the best low-cost option available to investors, but the index fund is not as good as it should be. That's startlingly clear now given the enormous positions the Vanguard 500 index held in troubled financials in 2006, 2007, and 2008, and the losses that that quality-blind approach has caused for hardworking American investors.

It's time for the financial industry to reinvent the index fund -- to provide a low-cost, diversified fund that holds a portfolio of high-quality companies. This should be the future, but it will only happen if customers like you demand it. Do just that in the comments below.


Tim Hanson is co-advisor of Motley Fool Global Gains, but was able to make it through an entire (and fairly long) article without telling you that you need more foreign exposure as well (hint: you do). He does not own shares of any company mentioned. Special thanks to Nate Weisshaar for assisting with the research for this article.

Disney, Pfizer, Microsoft, Coke, and Wal-Mart are Motley Fool Inside Value recommendations. Johnson & Johnson is a current Income Investor pick, while Pfizer and JPMorgan Chase are former Income Investor recommendations. FedEx, Disney, and Schwab are Stock Advisor selections. The Motley Fool owns shares of Procter & Gamble. The Fool has a disclosure policy.


Read/Post Comments (32) | Recommend This Article (63)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 20, 2009, at 1:52 PM, pondee619 wrote:

    "quality-weighted" "'good' corporate governance," "treating their customers and employees 'well'" "companies to do 'right' by their constituencies"

    Seems awfully subjective to me. Why don't we just employ a managed fund and pay the fees? "it's not clear what factors make for a high-quality company" You said it Mister.

    But it would be nice to have an "index" fund that beat the market. If an "index" fund could beat the market, wouldn't more active funds do so?

    Say, let's just make up an "index" fund of stocks that just go up year after year? That would make the people happy.

  • Report this Comment On March 20, 2009, at 3:39 PM, TMFMmbop wrote:

    Why would you want to pay the fees if you don't have to? This would be a very passive fund just centered around large American companies that have shown themselves to be run well.

    An index weighted by market cap is just as arbitrary, and I think an overweighting in the financial sector this year -- especially in large companies that were being very poorly run -- clearly had negative consequences.

    The value of an index fund is in its low fees and diversity. It was also founded on the belief that big companies are stable players in the US economy. We want to keep the former, but the latter isn't necessarily the case.

    Tim

  • Report this Comment On March 20, 2009, at 4:52 PM, jvinijvini wrote:

    I like many of the Fool's articles, this is not one of them. First of all there are lower cost indexes than VFINX, look at the S&P ETF's.

    Second, what Tim is basically proposing is a large cap managed fund. He's using his criteria just like the manager(s) of FCNTX use theirs. Wisdom Tree did some interesting weighting with Indexes as well. As stated, quality is subjective.

    This is not a breakthrough concept, it seems more likely the seeding of a Fool Fund. Also, most people diversify among a variety of ETF's, small, mid, and large cap. Would there be a quality fund for each?

    Sorry, just not buying it. I'll stick with my agressive Coffeehouse (See RYR article) like portfolio and sleep well.

    -Jeff

  • Report this Comment On March 20, 2009, at 4:58 PM, TMFMmbop wrote:

    Jeff,

    You could apply quality standards to any and all market caps. My problem with the WisdomTree funds was that the fees were relatively high and that most of their offerings also weighted on raw, size-related numbers (the yield, the dividend) rather than on anything having to do with quality. Souther Copper, for example, was always a big holding of theirs.

    I'm not asking you to buy anything. I was just pointing out reasons why the S&P 500 methodology overleveraged unsuspecting investors to troubled financial companies and set about a way that might have solved for that problem. There's a better way, I think. This might not be the best, but recent events show there is danger in being quality blind.

    Tim

  • Report this Comment On March 20, 2009, at 5:06 PM, EggplantWizard wrote:

    This could make sense if you continued to weight by market cap by default, but adjusted that weighting based on a quality score (say a multiple 0.1 to 5, withscores below one reserved for "at risk" companies), the product would yield your new weighting.

    One way of assessing risk is the bond yield for a company. Another is the cost of puts. You'd have to make it sufficiently broad and sufficiently passive as to avoid bias. If someone offered such a fund at a reasonable (less than 0.75%, despite improved quality) expense ratio, I'd probably bite heavily.

  • Report this Comment On March 20, 2009, at 5:11 PM, Macademia wrote:

    I agree with you in principle however as pondee619 wrote above it is hard to quantify "quality." Although once you have an algorithm in place like the FQI you could have such an index fund. As an experiment it would be interesting to see retrospecitvely over the last 20 years which strategy outperforms investing a few hundred dollars every month in the FQI vs in an S&P index fund. Generating data showing that the FQI is better would provide some preliminary data to support your hypothesis

    P.S. TIAA-CREF has a social choice fund that sounds vaguely similar to what you are talking about however it hasn't done so great over the last 10 years

    http://www.tiaa-cref.org/performance/retirement/profiles/100...

  • Report this Comment On March 20, 2009, at 6:08 PM, bendonian wrote:

    I wonder how many of the big financials that have been slaughtered would have qualified for this fund in 2005-2006. Those that qualify for the "FQI" today may not have a few years ago and those that did a few years ago may not now. So to say that today's index would have outperformed the Vanguard 500 isn't really fair unless you go back and track the performance of the socks that would have been in the fund at each step of the way.

  • Report this Comment On March 20, 2009, at 7:21 PM, TMFMmbop wrote:

    bendonian,

    You're absolutely right that the backtesting here is not flawless. That said, I did go back and confirm that the big financials would not have qualified due to lack of management tenure, lack of promotion from within, lack of insider ownership, some dilution issues, etc. I did confirm that these quality metrics are pretty stable so there's not much turnover here, so the bulk of the FQI that would be in there today would have been in there in the past (ie, the same CEOs are the same CEOs own the same number of shares etc). So the data's not perfect, but it's preliminary and I think very interesting.

    rm,

    That Grantham fund is interesting. Do you know what criteria they look at? I hit a reg wall on the GMO.com links. I noticed they have Google in theirs. That's one that got thrown out of my hypothetical study because it has a super voting class of shares that got flagged as a shareholder unfriendly takeover defense. But thanks for the link.

    Again, I wasn't necessarily looking for quality operators as measured by profit margins or ROIC, but rather honest companies that seemed to treat shareholders, employees, and customers right. I thought it was an interesting exercise.

    Tim

  • Report this Comment On March 20, 2009, at 8:23 PM, jvinijvini wrote:

    Hi Tim,

    I was being facetious. I know you weren't trying to sell me anything and I always like reading your posts. I think the comments here are very valid that point out some of the weaknesses of your suggestion, but it seems that there are some funds that are doing what you suggested.

    I do think that hindsight is 20 20 and it's hard to say your fund would beat current indexes. There's always a lot of 'new' ideas when times are tough but to the Fool's credit they tell people to stay the course. I think I'm going to stay the index course and see what happens.

    -Jeff

  • Report this Comment On March 20, 2009, at 8:44 PM, bobbyabull wrote:

    Folks,

    This is my first time posting a reply to an article on TMF, though I'm on the website almost every day. I've learned an awful lot from all the "fools" out there and never begin building an equity position without checking it out on CAPS first.

    I truly believe you can do best by buying individual stocks. This year I'm buying blue chips (DIS, NKE, JNJ, PG, HNZ, KO, etc.) with p/e's below 13 and safe dividends. I also try to throw in a quality mid-cap or two (JOYG and TDW right now) with strong balance sheets and p/e's below 8. Dollar cost average in and pay attention to the market overall as well. When the S&P is below 700 I'm mostly long; when it's approaching 850 I'm in cash or short (check out SH or SDS, two ETF's that short the market.) If you have the time to do the homework, you can out-perform an index fund despite commission costs. The market isn't as efficient as people think it is (as ALWAYS, in my humble opinion!)

  • Report this Comment On March 20, 2009, at 9:31 PM, ipfmanager wrote:

    That's pretty utopian investing. You're basically saying to take good companies that will beat the market consistently without taking into account any objective data. Well, that's the magic formula the world has been searching for. Pretty wishful thinking. Best bet to index something that will beat the S and P is small caps as they have preformed the best over the past 90 years-not large caps. They already have that though...

    I like your line of thinking. And if you want to try to quantify "quality" Check out Zen and the Art of Motorcycle Maintenance and Lila by Robert Pirsig. Good insight into objectivity.

  • Report this Comment On March 20, 2009, at 9:51 PM, weg915 wrote:

    Due to an increase in 1099 income last year I'm looking into setting up a SEP IRA for tax reasons. I've just started looking into funds as I've never had one before.

    Other then some of the ones mentioned above, does any one have any strong recommendations.

    Have no fear, all funds will be looked into with due diligence and I will not invest off of anybody's recommendation. I am just curious.

  • Report this Comment On March 20, 2009, at 9:51 PM, rsiconcrete wrote:

    Schwab offers value index funds for both large cap and small cap stocks. They use certain criteria, p/e, book value, ...... They have a short video on their web site explaining the process they use. It sounds a lot like the selection process in the article.

  • Report this Comment On March 21, 2009, at 12:12 AM, anuvaka wrote:

    <i>"I propose instead: a low-cost, quality-weighted index fund of large U.S. companies. No such product exists today, but I believe it would prove to be immensely popular with individual investors."</i>

    You have defined the Process and the Problem. Define Quality. You can't. No matter how hard you try, Quality is something you know when you see it, not something defined simply, numerically, by an Index. So this would become a Managed Fund and the definition of Quality would become a moving target.

    I see failure looming and expenses increasing.

    jC

  • Report this Comment On March 21, 2009, at 10:02 AM, TMFMmbop wrote:

    Thanks, rm. So it looks like they're looking for quality/efficient operators.

    I'm trying to screen on honesty, transparency, and good corporate stewardship under the hypothesis that over very long periods of time, these companies will do right by their shareholders. I would expect this index to lag the S&P 500 in bull years when companies acting agressively are rewarded, but I would expect it to hold up better in bear years. Screening on squishy factors like this is tough, I agree, but I think we've hit on a few factors that can make it work (takeover provisions, internal promotion and tenure, dividends or good returns on invested capital...and I'm looking for others).

    Tim

  • Report this Comment On March 21, 2009, at 11:40 AM, drippinfool wrote:

    Tim,

    I think your investing "heart" is in the right place, but I see what you are trying to do as similar to the "Whack-a-mole" arcade game. If we only knew which companies to avoid. This time it was the financials, last time it was the techs. Who knows what it will be next time. I think I will continue to keep my equity investments spread as broadly as possible by owning a total stock market index fund.

  • Report this Comment On March 21, 2009, at 12:22 PM, rufianno wrote:

    HERE IS THE SECRET: LONG-TERM INVESTORS BENEFITS FROM SHORT-TERM INVESTORS.The efficient market theory is the casino and those that oppose it are its customers.Should i say INVESTORS VERSUS STOCK-PICKERS.HERE IS MY PROOF. SHELBY DAVIS SENIOR TURNED $50,000 INTO $900 MILLIONS BY SAVING AND INVESTING AND NEVER SELLING. If you follow this strategy, you will following the efficient market theory. the way a market-cap weighted index fund follows it.All known informations is in the price.Yes you will have some bombs a long the way but the WINNERS WILL OUTPACE THE THE LOOSERS.LET THE MARKET GROWTH YOUR WEALTH.

  • Report this Comment On March 21, 2009, at 1:03 PM, richardrollo wrote:

    I've owned Vanguard S&P 500 Index fund since 1997. I haven't put any money into it since 2000 for a variety of reasons. It seems to me that what we have here is the Myth of Sisyphus of investing. Sisyphus was cursed by the Greek gods to roll a rock up the hill only to have it roll back down again once he got to the top. That's what happened to me in 2000 and 2008. Not that I intend to sell the investment at this point. Once the damage is done, unless you are in dire need of the money, you might as well let it lay.

    But, I do not think much of this investment as a major part of a portfolio. It is essentially a bet that the bulls are right in the long run, based on post World War II history. If we are in a period like the 1930's, it could be an astoundingly bad bet. I also don't like the "live by the herd, die by the herd" aspect. Nobody ever makes any real money following what everyone else does.

    After 2000, I actually believed that we were going into a much more prolonged recession than we did. So I began buying utility stocks, which pay excellent dividends and they are only down about $5 per share from the top. The stocks I've chosen on my own have outperformed the S&P when it went down so I'm not much convinced that I'm dumber than the market.

    Following Warren Buffett's advice, I recently made a large (for me) purchase of Ford for less than the cost of 3 nights at a Las Vegas hotel. Very simply, I believe that Ford has already undergone successful surgery and is now in the recovery room, whereas GM is still in surgery and Chrysler is near death. If I'm wrong, in the words of W.C. Fields in the Black PussyCat Cafe: "Was I in here last night and did I spend a twenty dollar bill?" "Yeah" "What a relief that is to me, I thought I'd lost it."

  • Report this Comment On March 22, 2009, at 12:15 AM, statguy49 wrote:

    If you want to buy into the GMO fund, you must have done a lot of quality investing, or earned, inherited or won a lot of money: it's $10,000,000.

  • Report this Comment On March 22, 2009, at 6:10 AM, BimSkaLaBim wrote:

    Three Words:

    "Rule Maker Portfolio"

    At one time, the MF was for information exchange...then it went to a "for profit" mode. Not that that's wrong, but I can't help but question someone bashing an index method that has years of evidence.

    What we're seeing is an ugly reversion-to-the-mean...some day the beloved S&P 500 will come back, start generating decent returns, and THAT is when the press will begin singing its' praises of "solid, steady companies."

    Don't get me wrong...I index the SP500, but also the Russell 2k, European co's, own several individual stocks, rental properties, REITS (ouch), and look forward to adding bonds and preferred stocks in about 10 years.

    "Rule Maker"

    Touted as something that would be better than an index fund...just one example of a complete failure (I admit I followed it and owned a number of the issues)...Yahell, Nokia, Gap, Coke (hey, at least the dividend has risen nicely-can't beat that), and JDS Uniphail...sorry, Uniphase. Had you abandoned your index fund for "Rule Makers," well...you can guess how you did.

    If this article makes you think about diversifying, good. It should - but diversify away from the Motley Fool. THINK FOR YOURSELF...and look for DIVIDENDS...GET PAID while you wait for cap gains that may come after you've willed your port to your kids.

  • Report this Comment On March 22, 2009, at 5:42 PM, timarr wrote:

    Hi Tim

    Just wandered over from the Fool UK site to do some research on index trackers and ran into this article. The weaknesses of market cap weighted index trackers are well known – they’re forced to overweight “popular” stocks and underweight “value” stocks and then lose out when mean reversion takes place. Fundamental indexing, such as those through the models of Fama & French, Rob Arnott or Jeremy Siegel try to avoid this problem by weighting on various “value” factors. In backtesting those models outperform but, as Bogle and Malkiel have argued, trying to secondguess the markets is usually an exercise in futility: if fundamental indexers become the norm then the models would probably self-destruct.

    Over here in the UK there’s an interesting little fund, called The Munro Fund, which is fundamentally indexing based on earnings forecasts – i.e. it’s looking at predictive future information rather than relying on historical data. Given the current unreliability of forecasts that’s a challenge, but it’s an interesting experiment. Certainly basing index weightings on objective criteria like these rather than subjective quality criteria seems a more reliable basis for passive index tracking. Qualitative indexing seems like a contradiction in terms, surely?

    We’ve also got to recognise that even ten years isn’t really enough to backtest against – the last decade’s been an exceptionally poor one for stockmarket investors. Twenty five years is the minimum duration we should be considering. According to the FT, Rob Arnott’s forthcoming research will show that bonds have now outperformed stocks over the last 40 years: probably bonds are in a bubble and stocks in a slump, but it makes you think ...

  • Report this Comment On March 23, 2009, at 7:51 AM, TMFCrow wrote:

    Back testing and quality assessment concerns aside I think this is a very interesting idea. Good work Tim.

  • Report this Comment On March 23, 2009, at 10:35 AM, IdahoAve wrote:

    I'd buy that index.

  • Report this Comment On March 23, 2009, at 10:38 AM, TMFSpeck wrote:

    Is "bigger is better" really a trope?

  • Report this Comment On March 23, 2009, at 10:43 AM, Deepfryer wrote:

    This is just more hindsight, the same as what we are seeing all over the internet and in the media. The author is basically looking back and saying "what if we invested in the S&P, but left out the financials?". That's easy to do today, but it would've been a lot more helpful if this article was published BEFORE the financials collapsed.

    Sure, the FQI would have outperformed the S&P over the last few years, but that's just "retroactive" investing. There is no telling how it will do in the future.

  • Report this Comment On March 23, 2009, at 11:20 AM, mikecart1 wrote:

    If you go the mutual fund route, you would find it pretty hard to find a fund much better than the Vanguard 500 performance and expense wise.

  • Report this Comment On March 23, 2009, at 11:44 AM, jpanspac wrote:

    I suspect a fund based on the criteria you outline would have too much churn to make a good index.

  • Report this Comment On March 23, 2009, at 12:10 PM, bhessel wrote:

    The reason index-based investing works is because the stock market is the mechanism for capital formation. Investors require a 10% compounded annual growth rate on their capital invested in stocks to compensate them for the greater risk in comparison with investing in real estate (which historically returns 8%), corporate bonds (6%), government bonds (4%), or savings bank accounts (2%). Sure, there can be booms and busts, but in the long run, the market could not exist without a 10% CAGR. The market is the hen that lays the golden eggs.

    Bogle's insight was that if the average return over time is 10%, the average mutual fund would underperform the market by at least the fees they charge...and by creating a passively managed fund with the smallest fees around, he would gain a competitive advantage. That actively managed funds on average underperform the market even without considering fees was gravy.

    This is not to say that active management can't work (where "work" is defined as "beating the market"). LOL how many of us would be here - frequenting the Motley Fool website - if we didn't agree with that? Look at the results of the hedge fund industry: for the last 21 years, the S&P 500 is +6% on a CAGR basis (underperforming historic norms thanks to last year) and the average hedge fund is +13% (source = greenwichai.com). This is not a random walk effect; the "casino" is not unbeatable.

    So while I agree with the author that - in theory - it is possible to systematically do better than index investing, I don't agree that index investing is "broken", or that there is anything fundamentally wrong with that approach. In fact, if he were right, it would essentially mean that the hen is dead and ergo we all better redirect our trading skills to get the best cow we can for these magic bean seeds...or maybe go into tofu...'cause if the hen is dead, then there ain't no point in climbing up there and risking getting eaten by the giant.

  • Report this Comment On March 23, 2009, at 12:30 PM, SarahSA wrote:

    Tim, this is a great idea for a fund, and it actually already exists. It's based on the methodology of the University of Michigan's American Customer Satisfaction Index (ACSI). It's beat the market 9 years in a row in up markets and down with lower risk by buying companies that do well relative to their industry in the ACSI and shorting those that don't. Business Week wrote about it a couple of years ago which is when I first started following it.

    http://www.businessweek.com/blogs/personal_finance/archives/...

    There was a hypothetical portfolio that was back-tested in the Journal of Marketing, and there is also an actual fund (I believe open to qualified investors only, so we need a fund manager to manage it here in the US so we can all jump on board!)

    http://www.wealthmanagementexchange.com/articles/2/1/A-Wealt...

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=891590

    http://consumerist.com/tag/acsi/

    So no need to reinvent the wheel. There is an Index that is outperforming the Vanguard 500 by more than the FQI.

  • Report this Comment On March 23, 2009, at 1:31 PM, Melaschasm wrote:

    I like the idea of a 'quality company' index fund, but accurately quantifying the different factors would be rather difficult, if not impossible.

    I think a fund that invest equal dollars into each of the 500, 1000, or 2000 biggest compaines, rather than a market weighted fund would be a nice option. As an investor, that would provide me with greater diversity, and would be a true investing index.

  • Report this Comment On March 24, 2009, at 2:53 PM, TradePro1982 wrote:

    I came across this superb article on how to condemn the AIG fatcats, it actually made me feel quite good. One of the best articles I have read, well worth the copy and paste.

    http://www.bukisa.com/articles/48974_how-to-condemn-the-aig-...

    This made me laugh out loud, forward to anyone affected by AIG.

  • Report this Comment On March 27, 2009, at 10:51 AM, bhessel wrote:

    TradePro,

    You should be aware that the author of the article you link here has irresponsibly failed to do any homework on the issue of AIG bonuses (or, possibly, has and is purposely lying to score cheap shots).

    Most of the bonus money went to folks who are manning the sinking ship on behalf of us (U.S. taxpayers who have an 80% interest in AIG), trying to unwind the mess and minimize the damage. Very few of them had anything to do with writing the credit default swap contracts that crippled AIG and threatened us all with systemic failure. They agreed to do this work - many with reduced salaries and some turning down offers from healthier companies - with the understanding that these bonuses were safe, and indeed they were agreed to under Bush and confirmed under Obama (the oft-discussed amendment Senator Chris Dodd added at the behest of Treasury).

    Now that the bonuses have become a big tsimmis, the politicians are either running for cover or competing with each other to come up with ways to torture these folks, ranging from retroactive confiscatory taxes to threats to publish their names and addresses so their families can live in fear.

    Not only is the behavior unethical, mean-spirited, and poor leadership, but it is not in our own best interest. Check out this letter from an AIG employee published earlier this week in the NY Times:

    http://www.nytimes.com/2009/03/25/opinion/25desantis.html

    In driving folks with the expertise to ameliorate this crisis out of AIG, we are not only putting our $80B investment at risk, not only hurting our own company, but we are counteracting all we have done to avert systemic risk.

    I urge you to stop worrying about the $160 million and focus on the $80 billion. What happens with the latter will mean much more to all of us - and our children - than what happens to the former.

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