10 Sunday Morning Reads

Fundamental indexing can’t replace cap weighting in our lifetimes. It can only do that if the fundamentals drive the market cap for each stop which is the EMH assumption. Outperformance by the fundamental and value investors is predicated on their structure being different from the market cap weighting.

Arnott, Faber and others are trying to come up with algorithmic approaches to replace the human managers of Graham and Doddsville. Neither approach is passive. If you look at Vanguard’s small cap value index fund and Schwab’s RAFI small cap fund they had about 29% and 36% turnover last year which is not “passive”. This is because stocks were constantly moving in and out of the index as their companies’ fundamental performance improved or decreased with respect to price. At the large cap end, portfolio turnover was about an order of magnitude larger than the S&P 500 turnover. These are good approaches for retirement accounts but not necessarily so good for taxable accounts.

Bogle never argued that humans couldn’t outperform the market cap indices. He just argued that you wouldn’t know in advance which ones would outperform after fees and expenses were accounted for and that on average the average manager could not outperform the market because of the expense load. So the big question about the RAFI and other smart beta approaches is whether or not their algorithms mean that the fund expenses can be significantly lower than the typical 1%-2% that the humans charge. The Schwab RAFI funds charge about 0.3 to 0.5% of assets which is considerably lower than most of the human value managers charge. If the fundamental indexes can consistently get 2% outperformance of the cap-weighted indices that charge about 0.1%-0.2% then they are a great deal after expenses are considered. The Doubleline fund mentioned in the article is charging 1.24% in expenses. That is a steep hill to climb to get consistent outperformance, especially if held in a taxable account.

In my portfolio, I have had the human Graham & Dodd types of managers for a long time (since the late 80s) and they have been good, but expenses have definitely weighed on overall performance. I have also had cheap cap-weighted indices for quite a while, and have started experimenting with RAFI and Faber funds. We will see how the smart beta does to see if it worth the extra expense.

I see the same thing in the work place. Different teams approach things different ways. Some teams are very focused on figuring out the logical course of action quickly, making a decision, and moving on. They want to hear from the primary people tasked to understand that particular issue and get a specific recommendation that can then be acted on. Meetings tend to be short with very few decisions deferred to a later date.

I also end up on some other teams that are more like kindergarten sharing sessions where everybody is expected to weigh in regardless of experience or understanding. There are usually many more opinions which all have to be respected so that nobody on the team has their feelings hurt. Major decisions often don’t get made for 6 months or more.

Guess which projects tend to get done on budget, on schedule, and with a high degree of success.

It is semi-random. Teams are constantly being assembled and disassembled for different projects. You can be on multiple teams simultaneously. It is really more a function of what happens when you get semi-random team assemblies.

But no, there is very little after-action review in this business, largely because the highest degree of re-organization and turnover is at the mid-executive level. There will usually have been two or three different division managers during a decent-sized project.