Index Capital Insights Final Issue

This is the final issue of Index Capital Insights as I’m stepping back to focus on launching a registered investment adviser firm. I have enjoyed writing the newsletter, and I thank you for reading it. I am very excited about my new venture and will communicate more about it on Linked In in coming months. I have always enjoyed writing and intend to make it an integral part of my advisory practice.

In the late Kenny Roger’s 1978 recording of Don Schlitz’s song “The Gambler”, which became a huge success on the country/pop music charts, listeners are counseled by the voice of an experienced gambler that if they want to “play the game”, “… you got to know when to hold ‘em, know when to fold ‘em, know what to throw away, and know what to keep….”.

Because investing in stocks is not a zero-sum game like gambling, index investing solves much of the “know what to throw away and what to keep” question.? It basically allows investors to hold (almost) everything, and thereby includes the relatively few long-term winners that emerge and constantly shift over time. However, indexing does a more complete job of representing the entire market for equities than it does for fixed income. Due to sheer numbers, variation, and limited liquidity, “total market” bond benchmarks and index funds tend to omit many securities as well as important fixed income categories such as TIPS, high-yield, and tax-exempt bonds. Note that if you cannot buy a fairly complete representation of the entire market in a given asset class and you still choose to invest, you are by definition an active investor in that asset class (even if you buy indexes of sub-categories).

With the problem of “knowing when to hold and when to fold”, here we have a zero-sum game with respect to portfolio returns versus total stock market return in any period. ?As noted frequently by indexing proponents, the logic of William Sharpe’s Arithmetic of Active Management succinctly shows that investment outperformance (relative to a total market benchmark) accruing to some investors must come at the expense of investment underperformance to others. Active stock portfolio management and market timing is frequently counseled against by market observers and financial professionals. Rather than timing entry and exit points, developing a sound strategic asset allocation and rebalancing periodically largely solves the “knowing when to held ‘em and when to fold, ‘em” question.

Indeed, strategic asset allocation, rebalanced and implemented with broad index funds across major asset categories, is a powerful, simple framework that serves investors extremely well. For many it may be all that is required to provide a lifetime of investing success.

However, it pays to consider the underpinnings of asset allocation theory. What are the necessary ingredients? To do it right, you need estimates of asset class expected returns, risk, and covariances. The estimates should be forward looking. The premise of strategic asset allocation is that risky assets like stocks deserve significant portions of investment portfolios precisely because they are expected to provide portfolio growth over time. It is logical, and indeed the foundation of portfolio theory, to size investment allocations according to expected return, risk, and contribution to portfolio diversification.

While strategic asset allocation and broad index funds offer an important tool set for all investors, the market portfolio of all risky assets remains a theoretical construct. Some investors have opportunities that others do not. Some may have great wealth through privately owned businesses, or larger portfolios with capacity to potentially gain from risk premia beyond the equity premium. All investors must make active choices in their asset allocation and align portfolios with risk aversion preferences that may evolve through time.

“Timing the market” has perhaps rightfully been undermined as a serious investment approach. But that doesn’t mean you should be price indifferent. On a micro level, stock investors are well served by avoiding the errors of poor security selection through broad indexing. But on a macro level, different markets offer different risk/reward payoffs that shift over time. As the supply of capital intersects with the demand of savers for returns, the expected returns and risks of markets diverge substantially. It is the core mission of every investor to assess such opportunities and allocate capital accordingly. Index funds are a great tool in that mission, but they are not the answer to all investment challenges. Think of buying a TIPS index when it offered a negative real yield versus 2% real - very different opportunities which have both been on offer in the market over the last couple of years. The same is conceptually true of all markets, and it is the mission of investors to avoid price indifference to capture a fair, risk-appropriate share of future market returns.