The Problem With Index Funds

Don’t let this blog title fool you.  I am a huge fan of index funds, mainly because of their low costs and passive investment philosophy.  But I do think there is a better way to invest.  There is a story at ETF Trends about the Greek stock ETF that validates my reasoning.  You see, the number one job of an index fund is to minimize tracking error against a benchmark index.  So, for example, the Vanguard S&P 500 Fund will have done its job well if it performs exactly in-line with the index.  But what if there is a flaw in the index?  Here is an excerpt from the story:

Part of GREK’s surge is attributable to a broader resurgence by Europe ETFs, but there is far more to it with GREK, the lone Greece ETF. On Nov. 27, 10 Greek companies, including some GREK constituents enter the MSCI Emerging Markets Index and investors have been bidding up Greek shares in anticipation of that move.

Index funds often announce or publish their methodology for how and when a stock will be included in the index.  In anticipation of every index fund having to buy that stock (to of course, minimize tracking error), the stock will get bid up.  In the past 90 days, the Greek stock ETF is up over 20%.  That means shareholders of the Emerging Markets Index mentioned above get to buy it at a price 20% higher than where it stood just a few months ago.  Now, I am not saying that the sole reason Greek stocks have gone up 20% is because they are getting included in the MSCI Emerging Markets Index, but studies have shown that stocks tend to perform well right before they are added to an index, then see their performance trail off after inclusion.

Rather than getting pigeonholed to invest directly in an index, we believe a better alternative is to own all the stock in a specific asset class in order to gain broad exposure to that asset class.  Not being forced to buy something (especially after its price has run up) helps investors long-term performance.  By changing just this one variable but keeping the other attributes of index funds (low cost, passive management), investors can see much better returns.  The best company on the market doing this type of investing is Dimensional Fund Advisors.  Their performance speaks for itself.

The Opportunity In China

I saw this great chart this morning that shows how big China’s auto market could become.  Over the next five years, China’s GDP per capita is expected to grow by over 50% based on statistics from the IMF.  This chart shows how GDP per capita corresponds to cars purchased.  Considering that China has a population of over 1.3 billion people, this is a big deal.

china car penetration

 

This is not just good news for cars.  As more of the emerging market population move towards the middle class they will be buying cell phones, televisions, real estate, and eating out at restaurants.  While many people think that this is only good news for emerging market stocks, this is actually great news for US and other International stocks as well.  Companies like McDonalds, Walmart, General Electric, Apple and Nike are all US companies that stand to profit significantly from this phenomenon.  

Reversal Of Fortune

For the first half of the year the only investment that seemed to be working was US stocks.  We had some clients ask us why their portfolio was underperforming the S&P 500 so dramatically.  The reason:  diversification.  With asset classes like bonds, commodities and emerging markets losing money, it wasn’t hard to see why portfolios were lagging the only asset class with double digit returns.  Our response to those clients at the time was to keep the faith.  While we may have wished that we had loaded up on US stocks at the beginning of the year, there was going to come a time very soon that we were thankful that we didn’t put all our eggs in that basket.  Well that time has come:

Chart foriShares MSCI Emerging Markets (EEM)

 

The chart above shows the US stock market (red line) compared to the emerging markets (blue line) and the foreign developed market (green line) for the past three months.  The US market has languished while the other asset classes are showing remarkable resilience.  Here is the thing about diversification:  you are always going to have something to complain about.  There will always be an investment that has done better than your portfolio and always one that has done worse.  No one can consistently pick winning asset classes to rotate into so keeping a balance of asset classes in your portfolio tends to be a winning strategy over time.

Is China Making A Comeback?

One of the big stories for the first half of the year was the potential hard landing China was going to experience.  While the economic data never got to be horrific, it was widely believed that much of that data was being manipulated by the government.  Today we saw fresh new data from China that refutes the hard landing story.  Retail sales, fixed investments, and industrial output all beat expectations.  For those that don’t believe the information coming out of China, one of the other metrics used to gauge economic activity is power generation.  The story goes, that if economic activity is happening, then power generation must be increasing.  A metric you can’t manipulate.  Here is the chart from the last few years:

Screen Shot 2013 09 10 at 7.31.14 AM

 

So, why is this important?  China is the second largest economy in the world and will most likely surpass the US as the largest economy in the next decade.  In addition, many experts predict that an additional 200 million Chinese will enter the middle class by 2015.  These statistics show that much of our world’s growth will be coming from China and other emerging markets over the coming decade.  Data showing continued expansion in China is not only welcome news for China, but for all global investors.

The Divergence Continues

One of the big themes we have been discussing with clients this year is the divergence we have been seeing across asset classes.  In a world where globalization seems to tie things even more closely together, the opposite has been occurring in the investment markets.  Here are the numbers from The Capital Speculator:

082813a.gif

Many of us in the US have been watching CNBC with the belief that the markets have been on an upward climb this year, which is only partially true.  The US stock market has been, but the rest of the world has fallen behind.  In addition, with rising interest rates, the normal safe haven of bonds has been compromised.  So what should investors do now?  Looking backward, those of us with diversified portfolios probably wish we had put everything in the US stock market at the beginning of the year.  Since we can’t go back in time, we still encourage investors to maintain diversification across multiple asset classes.  There will be a time in the not to distant future, that those who remain diversified will be thankful they didn’t have all of their money in US stocks.  When you adequately diversify your portfolio you may not outperform the top performing asset class, but you also won’t underperform the worst.  For the majority of investors, this is the best strategy when developing a portfolio.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.