Index Funds
Indexing Strategies Revisited

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By Lokicious
December 15, 2005

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In response to some recent comments that I find lend to confusion...

There are two basic strategies to index investing that derive from the "efficient markets hypothesis": what I will call "pure indexing" and "slice and dice." (The efficient market hypothesis, in plain English, says that, although at any given time some stocks or market segments are over- or undervalued compared to their intrinsic worth, over time everything evens out.) Using just the US stock market, this means that over time all the sub-segments of the market (at least if divided into market cap and value/growth categories) will provide the same average returns. (This gets more complicated once we get into international and bonds, where we do not necessarily expect the same average returns, but which get included in asset allocation plans for other reasons, including lower correlation with US stocks.)

Pure indexing involves using a single, market cap weighted, Total Stock Market, index fund, with the idea of getting as close as possible to the average return offered by the US stock market as a whole. A market cap weighted Total Stock Market Index fund is very cheap, because it doesn't have to buy and sell stocks to keep in balance, other than money flowing in and out of the fund. It also generates almost no capital gains taxes, just taxes on dividends, which are going to happen, anyway, unless you want to avoid dividend-producing stocks. Thus, a Total Stock Market Index Fund (assuming you are using a reputable fund company, who isn't charging you loads or excessive fees), will get you, in reality, very close to the returns on the abstract Total Stock Market Index, where death and taxes do not exist.

Slice and dice also accepts the efficient market hypothesis, but it works from the idea that over shorter periods the market is inefficient, so different segments of the market get hot and cold in momentum swings. Therefore, if you put equal dollar amounts (including dripping in new money or taking money out) into a series of non-overlapping segments that cover the entire market, you can ride the waves and if you rebalance periodically, you will get a "rebalancing bonus" above the return you would get from a single market cap weighted index (which rebalances itself daily).

The problem with slice and dice is, in the real world, it entails greater expenses and, in a taxable account, generates capital gains taxes. The added expenses come from: a) slightly higher expense ratios on most index funds that represent parts of the total market, compared to the single, Total Stock Market Index fund; b) greater difficulty in achieving something like Vanguard's lower cost Admiral Shares, which you get from having larger amounts of money in a single fund; c) higher turnover rates (i.e., trading costs) of most market segment index funds; and d) added small balance fees, notably Vanguard's $10 per index fund with a balance of less than $10,000. My estimates suggest, not including the under $10,000 fees, the added expenses are between .25% and .5%. The under $10,000 fees would cost another .1 to .33%, now that Vanguard has upped its minimums in IRAs to $3000�some people were adding as much as 1% in added fees when they could buy fund shares for as little as $1000.

In a taxable account, the turnover rate of some of the funds will generate capital gains taxes: especially important with small cap growth segment and, probably, mid-caps. This hasn't mattered of late, because funds harvested lots of capital losses during the recent bear market, but this will matter down the road. I think 1% of the total gains, using market segment index funds, is ballpark for capital gains, which would mean a reduction in real returns of .15%-.2% (depending on whether the temporary 15% rate remains in place for good). Then, there are the capital gains from profit taking in rebalancing. Since market segments don't really track completely differently, rebalancing won't actually cause 100% of your gains to require profit taking, but of course the higher the tracking difference the greater your theoretical rebalancing bonus. So lets say a reduction in real returns of .7%-1%, with 15% capital gains rate.

The conclusion I've drawn (and, I believe, Vanguard's index managers, as well) is that the added costs and taxes will likely outweigh the rebalancing bonus in a taxable account. However, if you have enough money allocated to the US Stock Market in a tax-advantaged account to avoid the under-$10,000 fees, slice and dice with periodic rebalancing will beat pure indexing.

Now, there are other indexing strategies, including the Coffeehouse Portfolio, that do not work from the efficient market hypothesis. They use their reading of historical market returns to project that certain market segments will outperform others over the long run, and they overweight these segments accordingly.

There are also ways of trying to manage pure indexing versus slice and dice taking fees and taxes into account. For example, to avoid extra fees in something like a Roth (where there is little money available), we can start with just a couple of market segments that have, in the past, tracked quite differently, such as big cap growth and small cap value, or simply growth and value. Or, instead of trying to lump our entire portfolio into one package, we can do pure indexing with assets in our taxable account and do slice and dice with assets in tax-advantaged accounts, while still keeping our overall stock allocation where we want it (very hard for us old folks, who are downsizing overall stock %).

Another approach to avoid capital gains taxes is to try to rebalance by allocation of new money every month, without (or at least moderating) profit taking. This strategy will probably get enough of a rebalancing bonus to cover added costs and ongoing capital gains (generated by the segment funds themselves) if the amount of new money being added (or money being dripped out) annually is more than 10% of total assets in the funds (this would be for around 10% average annual gains); by time you get to 5% of assets, the added costs probably are too much to make this worth doing.

As a reminder, any of this must be done within the realities in which we work, such as whether we have access to useful funds in retirement plans, the need to have an emergency fund in a taxable account, trying to keep fixed-income assets in tax-advantaged accounts (which can get to most of such accounts as you near retirement), and dealing with RMDs at age 70.5.

Bur, at least let's make sure we understand the theory and expenses behind the strategies.

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