Some Frank Talk About That ‘Index Fund’ of Yours

Wall Street Journal / James Mackintosh

Passive investment is booming, but those who want to join the rush into index tracking can easily find themselves overwhelmed by the options. S&P Dow Jones Indices alone has more than one million indexes, and while the S&P 500 looks inherently more appealing than the Dow Jones Islamic Market Peru Small Cap Technology index (I kid you not), how can you choose?

Step forward economic theory. Finance for the past half-century has been underpinned by the Capital Asset Pricing Model, or CAPM, and variants, which have a simple recommendation: Buy everything. The math involved shows the best balance of risk and reward in efficient markets comes from the so-called “market portfolio” of all assets, held in proportion to their value.

The only way to be sure that the math correctly balances risk and reward is to ensure the portfolio really captures everything, because otherwise it may be far from the optimal split of assets. Rational investors who think markets work should be tracking an Everything Index.

So forget the S&P 500. It may be the benchmark for the world’s biggest market, but it represents only a fraction even of U.S. stocks, and none of the rest of the world. Instead, pick a global index including emerging markets.

Next, add in corporate bonds and enough government bonds to reflect the assets the state owns. Again, think global. Property is a must, ideally including commercial, residential, farmland and forestry. Private companies have to be included. Don’t forget art, gold and silver. You’ll need cars, furniture, even washing machines. Oh, and to reach the theory’s ideal portfolio, you need human capital, the value of training and education.

William Sharpe, who won the 1990 Nobel Prize in economics for his contribution to CAPM, says the closest thing to the market portfolio he has come up with involves four index funds, but misses out on assets such as property or private companies, let alone human capital.

“This is about 50% theory, 50% just pragmatism,” he said. “I don’t want to overstate the purity of this. But I think it’s better than the S&P or just the total stock market.”

His basic thesis—and one of the key messages of CAPM—is that more diversification improves the balance of risk and reward, as long as costs are low. To that end his version of the market portfolio holds four Vanguard funds, tracking a U.S. total stock-market index, the FTSE All-World excluding the U.S., and U.S. and global Bloomberg Barclays bond indexes. It is roughly equally split between stocks and bonds, and holds slightly more in the U.S. than the rest of the world, as it is weighted by value.

The lack of private companies, commodities and human capital means this is guaranteed not to be the optimal portfolio. Theoretically more diversification is better, as it reduces the risks of individual companies or sectors (or Sharia-compliant Peruvian small caps) running into trouble, but only the absolute maximum diversification across all assets is best.

Indeed, investors sold on indexing on the basis that it is the logical conclusion of the theory should think again, especially if they ended up invested in one or a few countries.

The idea of buying everything “is really wacky,” said Jason Hsu, co-founder of Research Affiliates and an adjunct finance professor at UCLA Anderson School of Management. “In a way it’s purely mathematical.” CAPM, he said, is “the most abused financial theory,” because a portfolio that leaves out some assets wouldn’t be optimal.

He is concerned that the ideas behind CAPM and the ideal portfolio have pushed big institutional investors toward indexes, encouraged by consultants relying on CAPM-based “efficient frontier” calculators to divvy up client assets.

“If a Nobel Prize winner says this is the optimal portfolio [it] leads you to say well I want optimal, I don’t want average,” he said.

The alternative argument for passive funds is much simpler. Forget theory, it’s just that trackers are cheap and give you what the average investor is getting. If you are an average investor, that’s good enough, and on average we’re all average. But study after study shows most of us think we’re better than average.

If you don’t have any special insights and merely want to put money away in line with the average investor, a broad-based index is the closest thing available to taking no view of your own, and Prof. Sharpe’s recommended portfolio is a decent place to start. Even better, it’s also cheap.