ITA Wealth Management

While we use either VFINX or VTSMX as benchmarks as comparison tools for measuring the performance of our “passive portfolios,” our preference is the VTSMX index as it is a higher bar to hurdle. The VFINX is a match for the S&P 500 and that index includes stocks that are a drag on the portfolio. In fact, both the VFINX and VTSMX funds suffer performance drags do to overvalued stocks. Let me extract a few paragraphs from Arnott’s book, “The Fundamental Index.” I will be surprised if this material does not carry a shock value to readers.

“The performance of the top 10 stocks in the S&P 500 illustrates the magnitude of the performance drag problem. …,on average, only 3 of the top 10 companies in the S&P 500 outperformed the average result for all 500 companies in the index over the subsequent 10 years, while 7 of the top 10 underperformed. That’s a darned lopsided coin toss, especially given 81 years and 800 coin tosses! Also, owning these top 10 names (equally) gave an investor an average of nearly 30 percent less wealth than owning the 500 stocks in the S&P 500 (equally) in just a 10-year span. This is a huge performance drag: With a cap weighted index, investors have an average of 20 percent to 25 percent of their money tied up in these underperformers.”

“Clearly, most of the top 10 companies lag the performance of the average stock in the S&P 500 most of the time. Why does this matter, and what does it mean? Maybe it’s a time-specific phenomenon for many of these 10-year spans. To test this possible explanation, we evaluated how often a majority of the top 10 companies bucked the trend and beat the average stock in the S&P 500. The most startling aspect of this lopsided behavior for the top 10 list is its consistency. Over the past 81 years, how often did the majority of the top 10 companies in the S&P 500 outperform the average stock in the S&P 500? Zero. Zilch. Nada. It never happened.”

Going back to Arnott’s original hypothesis, cap-weighted stocks carry high PE ratios due to optimist outlook on future growth. Overpriced securities are overweighted in broad indexes such as the S&P 500 and these overpriced stocks are a drag in cap-weighted index funds.

The question still remaining to be answered is this; is it possible to skew a portfolio toward value, mid-cap, and small-cap stocks, thus engineering a portfolio to do what PowerShares is doing but do it with lower fees?

Lowell Herr

Photograph: Peruvian child

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