Why Your Problem Is Not Your Funds

In Monday’s post I looked at “smart beta,” which promises to outperform cap-weighted indexing strategies. I’m frequently asked if I think Couch Potato investors should dump their traditional index funds in favour of these tempting alternatives. Here’s why my answer is no.

I could rhyme off technical reasons for being skeptical about the outperformance of alternative indexes: the research ignores costs and taxes, the strategies may not work in the future, and so on. But I won’t go down that road, because the most important reason is not technical, but behavioral.

Everything beats the market—except investors

To recap, two recent papers from Cass Business School in London looked at US stocks from 1968 through 2011, a period when a cap-weighted portfolio would have returned 9.4% annually. (Canadian stocks had an almost identical return over those 43 years.) The researchers examined 13 alternative strategies—which favoured value stocks, small-cap stocks or low-volatility stocks—and found all of them outperformed, with returns between 9.8% and 11.5%.

For many people, the takeaway from these findings is, “I should use alternative indexes, because I can beat the market by a point or two.” My reaction is different: I want to know how many investors earned even 9.4%.

I touched on this idea back in May when I asked why there are countless strategies that beat the market, but so few investors who can make that claim. There’s little data on the performance of individual investors, though it’s safe to say only a tiny minority are likely outperform a simple cap-weighted benchmark over any period longer than five years. That’s my biggest concern about being seduced by smart beta: it encourages investors to focus on beating the market even though most can’t even match it.

The problem is not cap-weighting

Has there ever been an investor who fell short of his financial goals because he earned only the returns of a cap-weighted portfolio? “I did everything right,” we’d hear him lament. “I paid down my debt, lived frugally, and saved regularly. I built a diversified, low-cost, tax-efficient portfolio of index funds appropriate to my time horizon and risk profile. When stocks plunged I kept my head and stayed invested—I even rebalanced to get back to my targets. I ignored all forecasters and swore off market timing. Now look what happened: my cap-weighted funds underperformed the hypothetical backtested performance of several alternative strategies. Now I can’t have the retirement I hoped for.”

There are many reasons investors fail, but the shortcomings of cap-weighted index funds are not among them. The search for smart beta makes me think of an out-of-shape guy with a poor diet who’s convinced his biggest problem is he’s wearing the wrong brand of running shoes.

Check your priorities

So before you think alternative indexes will have a meaningful impact on your financial life, ask yourself these questions:

Do I have any consumer debt? Student loans, car loans, credit cards, a line of credit from your last reno or vacation: if you have even a dollar of non-mortgage debt, it may not even make sense for you to be investing, let alone trying to beat the market.

Am I saving as much as I can? The best way to grow your portfolio is not to seek a market-beating strategy: it’s to increase your contributions. Instead of hoping to outperform traditional index funds by 1%, try increasing your annual savings rate by 1%. This will almost certainly have a more dramatic effect, especially if your portfolio is small. It also comes with a 100% guarantee of success.

Do I get market returns now? Calculate your personal rate of return over the last five years and compare it to a comparable portfolio of cap-weighted ETFs. If you lagged even that simple portfolio, why are you worried about trying to beat the market? (Obviously this doesn’t apply if you are already a thoroughbred Couch Potato, but hardly anyone is.)

Will I really stick to one alternative? If you’re using cap-weighted funds now and you’re prepared to dump them, do you really believe you won’t switch gears again when the next new alternative comes along? The value and small-cap premiums are real, but they’re elusive: there will always be multi-year periods when these factors lag a cap-weighted portfolio. Are you sure you’ll wait these out?

As I’ve written before, I’m agnostic about alternative indexing strategies. It’s not that they’re bogus: it’s that even if executed perfectly they can do more than provide incrementally better returns. And by spending so much effort trying to collecting a few drops of rainwater, many investors are ignoring much bigger leaks in their financial lives.