Fundamental Indexing

On a trial basis, I've been trying to roll some of my non-retirement savings out of mutual funds and into ETFs. Let's say I've been taking whatever I'm reading in my finance books a tad too seriously! All skepticism aside, I don't like having to shell out the expense ratio, especially when you read that many mutual funds don't even beat market returns. See excerpt from Investopedia:

The Journal of Finance (Mar 1997) reports a comprehensive study by Mark Carhart on mutual funds over the period from 1962 to 1993. He states that "by 1993 fully one-third of all mutual funds had disappeared." Furthermore, in 1997 the Wall Street Journal reported that during 1982-1992 mutual funds reported average returns of 18.1%, but after calculating in survivorship bias, the report found that this return was whittled down to 16.3%, lower than the 17.5% return on the S&P 500 during the same period. In other words, when we take survivorship bias into account, the average mutual fund underperforms the market.

All that said, I probably will stick with funds like MINDX and MAPTX when it comes to investing in foreign/emerging markets.

With low expense ratios, ETFs are an attractive choice. But which ETF? Armed with new found knowledge about fundamental indexing (from Chapter 4 of BMA as well as Prof Percival's lecture), I did a bit of poking around.

In a capitalization weighted index, the weight associated with a particular stock is based on its market cap. In a fundamental index, that weight is based on some fundamental metric. Dividends appear to be a particularly good metric if you believe companies need to stop screwing around holding large amounts of cash, with no good projects to invest in.

See Prof Seigel's article on WSJ for a detailed description of the fundamental weighted indexes as the "next wave of investing".

The Fama/French world emphasizes low P-E and small cap stocks. Bogle et al in another WSJ article cite a few reasons about why you probably shouldn't be too eager to jump on the fundamental indexing bandwagon. They cite

1. Potentially high management fees for fundamental indexed funds
2. Equivalency of fundamental indexing to picking low P-E and small cap stocks (which Fama/French have shown produces outsized returns)
3. Turnover - say when a manager increases dividends, you're going to have to buy more of that stock. This is not an issue especially if you are investing your retirement savings.
   
4. Fundamental indexes constructed out of dividends as the metric may not be tax efficient. (Long-term capital appreciation enjoys favorable taxation compared to short-term gains such as dividends.)
   

Do your own diligence, but I'm trying out a couple of fundamental indexed funds from WisdomTree. I'm going with Dividend-Weighted ETFs instead of Earnings-Weighted ETFs.

Book Review: Magic Formula Investing - The Little Book That Beats the Market

A friend recommended Joel Greenblatt's Little Book about a year back. It starts out sounding like a joke or some kind of a hoax but it should takeall of 1-2 hours to read the entire book and I strongly recommend it - both for adults and teenagers!

Before I proceed to review the Magic Formula, the following points represent my underlying investing philosophy:

1. The market is noisy (capricious) in the short run, efficient (values companies efficiently) in the long run. I believe in mean reversion, that is, temporarily undervalued stocks are likely to rebound back to their 'true' values.
   
2. Given my net worth, I don't see any value in paying someone to manage my money. As a result, I am not too excited by mutual funds. I prefer ETFs.
   
3. I'm too lazy to keep constant track of my portfolio and I hate transaction costs. I therefore like buy-and-hold approaches.
   
4. Diversification globally is goodness.
   

Written in a tongue-in-cheek style, Greenblatt appeals to the child in you, quite literally, to educate you on time tested concepts of value investing. Overall a good book targeted at the mainstream public that not only builds an appreciation for the rationale behind value investing but also gives you an almost mechanical method to invest using the "Magic Formula." Here's a quick summary of MFI...

Greenblatt's basic theory is that its pretty hard for most people (and especially individual investors) to reliably forecast future growth. He therefore recommends that the individual investor simply focus on buying good companies at a good bargain. Good, as defined by MFI, is used for a company with a high ROIC (return on invested capital) and you separate a good bargain from a bad one by looking at the Earnings Yield (EY).

With ratios, its basically garbage in, garbage out. We need to look under the numbers and see how they're calculated. Greenblatt defines them as follows:

ROIC = EBIT/(Working Capital + Fixed Assets),
where EBIT: Earnings before Interest & Taxes
EY = EBIT/EV,
where EV, the Enterprise Value = Market Cap+Net Interest Bearing Debt

The reason he adds back debt to EV is to make sure the Earnings Yield is not affected at all by the debt-to-equity ratio. He also wants to compare companies at different debt and hence tax levels.

The basic steps to building an MFI portfolio is as follows:

1. Create a composite ranking of companies by ROIC and EY.
2. Buy stocks for 20-30 of them (you could do it gradually)
   
3. At the end of the year, review and:
1. sell losers 1 day before before the end of the year
2. sell winners 1 day after the year end
3. replace losers with new companies, go back to 1.
   

Based on back testing (17 years), the magic formula has yielded annual returns in excess of 30%. There hasn't been any 3 yr period with negative returns.

This method has some nice attributes: almost mechanical, focus on the portfolio and not individual companies/stocks, not much churn. Note that he recommends this for average individual investors who are not into doing a great deal of diligence on the companies.

Here's the best part. There's an MFI website, www.magicformulainvesting.com, which allows you to screen companies based on the ROIC, EY criteria.

ROIC or ROE or ROA?

ROE is return/book value of equity. This doesn't take into account the debt capital. ROA is return/book value of assets, which can include accounting gobbledygook like goodwill. In addition, Greenblatt removes uninvested cash from assets, and adds payables since in effect they are an interest-free financing of operations.

Not many have been able to reproduce the MFI screens. If you understand exactly how he calculates ROIC, do let me know!

Commissions?

As a Schwab customer, I'm looking at transaction costs of 25 (size of my MFI portfolio) times $12 = approx 300-600 depending on when you bought and when you started replacing them. Check out www.interactivebrokers.com or www.foliofn.com. I tend to holder longer than 1 year.

No Utilities, Financials & ADRs

To keep things simple the vanilla ROIC and EY don't apply to the capital structure of financials, possibly because they are usually highly levered.

Isn't Earnings an accounting artifact?

Earnings could be inflated temporarily by creative accounting! An equity from the MFI screen could be the subject of earnings restatement. I don't believe vanilla ROIC or EY can guard against that. Greenblatt remarks that sophisticated investors such as himself can calculate forward-looking versions of these parameters.

Macroeconomic factors

Capital intensive industries tend to be cyclical. The MFI screening criteria doesn't seem to account for business cycles that may affect industry fundamentals.

Micro ($50m-$300m) vs Small ($300m-$2b) vs Mid ($2b-$10b) vs Large cap ($10b+)

In my experience micro and small cap pickings from MFI have shown a lot of volatility AND negative returns. My recommendation is to stick with mid & large cap.