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Against Index Funds, Part II

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Summary

This article discusses the inefficiencies of index funds and the importance of designing an investment strategy based on an investor's philosophy rather than relying on third-party lists. It argues that index funds are suboptimal vehicles for investment because they limit global diversification to large, multinational companies and do not include exposure to small, regional companies with unique economic engines. The article provides an example of the differences between Vanguard's Total World Stock Market ETF, which tracks a FTSE Global All Cap Index, and DFA's Global Equity Fund, which does not track a third-party list and seeks to own the entire world. The article concludes that while index funds are useful, investors should prioritize creating an investment strategy based on their own goals and beliefs, and consider funds that do not track a third-party list, such as DFA's, for more diversification.

Q&As

What are the benefits of passive investing?
The benefits of passive investing include better expected outcomes for investors, smoother investment returns, reduced volatility, and global diversification.

How can investors diversify their global investments?
Investors can diversify their global investments by incorporating the philosophy of indexing into a more thoughtful portfolio design and implementation process, and by owning stocks of companies and regions with which they are unfamiliar.

What are the potential drawbacks of index funds?
The potential drawbacks of index funds include that they are unable to target tiny companies that drive economic activity across various unique regions of the world, and that they tend to have stocks of large or midsize companies, occasionally small companies — but rarely do they own tiny companies that can be illiquid and hard to trade.

How can investors gain exposure to more diversified sources of returns?
Investors can gain exposure to more diversified sources of returns by purchasing both large and small company index funds together, in appropriate weights, to get closer to replicating the entire market.

What is the best way to design and implement an investment portfolio?
The best way to design and implement an investment portfolio is to start with foundational beliefs rather than starting with available products or tools, identify goals, and let those goals inform strategies. Properly used, investment funds are just tools to express an investor's philosophy.

AI Comments

👍 This article offers an interesting perspective on investing and provides clear evidence of the benefits of diversification. The author also makes a compelling argument for considering a more thoughtful portfolio design for passive investing.

👎 This article is overly long and confusing, making it difficult to understand the author's point. The author also provides too much detail and too many examples, which makes it difficult to draw meaningful conclusions from the article.

AI Discussion

Me: It's called "Against Index Funds, Part II" and it's written by Rubin Miller, CFA. It basically argues that index funds are not the ideal vehicles for passive investing because they don't include tiny companies that drive economic activity across various unique regions of the world, and because index fund providers profit by investment companies licensing and tracking their lists. The article suggests that instead of indexing, investors should design and implement a portfolio that incorporates the philosophy of indexing but also includes exposure to not-perfectly-correlated sources of returns.

Friend: Interesting. So what are the implications of this article?

Me: Well, it suggests that investors should be more mindful about how they invest and think about the philosophy behind their investments instead of blindly investing in index funds. It also highlights the importance of diversification and global exposure, and suggests that investors should consider investing in small companies with regional footprints to gain unique returns and diversify their portfolio. Finally, it emphasizes the need for investors to be more aware of biases like recency and familiarity, and to make investment decisions based on market conditions rather than personal preferences.

Action items

Research and compare different passive investment funds to determine which best fits your investment philosophy.
Consider investing in small companies with regional footprints to gain exposure to unique regions and the distinct economic engines driving them.
Consider investing in funds that don't track third-party lists to gain exposure to thousands of companies that index funds may not own.

Technical terms

Passive Investing: A type of investing strategy that involves buying and holding a portfolio of investments for the long-term, rather than actively trading or attempting to time the market.
Index Funds: A type of mutual fund or exchange-traded fund (ETF) that tracks a specific market index, such as the S&P 500 or the Dow Jones Industrial Average.
Diversification: The process of spreading investments across different asset classes, sectors, and geographic regions in order to reduce risk and increase returns.
Correlation: A measure of how two investments move in relation to each other.
Recency Bias: The tendency to give more weight to recent events or information when making decisions.
Familiarity Bias: The tendency to favor investments that are familiar to the investor.
Pricing Mechanism: The process by which the price of a security is determined.
Benchmark: A standard against which the performance of a security or portfolio can be measured.
ETF: Exchange-traded funds (ETFs) are investment funds that are traded on a stock exchange.
Liquidity: The ability to quickly and easily convert an asset into cash.