Leading index investing expert admits he doesn’t invest in all index funds.
I’m a diehard index fund fan. I’ve written books on index funds, lectured on index funds, co-authored an award-winning paper on portfolios of index funds, and Forbes even named me “The Indexer” when I began writing for them several years ago.
The problem with being “The Indexer” is that I don’t invest in all index funds. Truth be told, my portfolio is a combination of funds that follow indexes; quantitative funds that don’t follow indexes; and actively managed funds. I don’t even consider following an index as being paramount in portfolio management as long as you’re capturing the risk premiums you’re seeking in a low-cost and efficient manner.
I point out in All About Asset Allocation that the investments you select for your portfolio should have a unique risk. This unique risk should be investable at a low cost and expected to generate a positive risk premium over the long term.
How to determine if unique risk exists in an investment is where fundamental analysis comes in. You’ll have to dissect what makes the investment tick. This can take a lot of time and effort. If you’re not inclined to crunch numbers until your eyes turn red, I suggest Anitti Ilmanen’s excellent 570-page reference guide on the subject, titled “Expected Returns: An Investor’s Guide to Harvesting Market Rewards” (Wiley, 2011). You can download a free abridged edition of this book from the CFA Institute.
There are unique risks captured by broad asset classes and unique risks captured by strategy. My goal is to capture the diversified risks I choose to invest in using the most efficient manner. Sometimes that is best accomplished with an index fund and sometimes it is best accomplished with something else.
Buying a total market index fund captures the “beta” of an asset class at a low cost. Beta can be thought of as the overall risk and return of an entire market. It’s a risk that cannot be diversified away. The best example of using an index fund to capture beta is the Vanguard Total Stock Market ETF (VTI | A-100). This portfolio tracks the CRSP Total Stock Market Index, which had 3,699 constituents as of June 30, 2014, representing nearly 100 percent of the U.S. investable equity market.