(Morningstar reviews are at the bottom for $DODGX and $VWNDX)
I believe in indexing, and a large amount of my investments are linked to broad market indexes, which weight companies based on market capitalization. From an indexing perspective, the purest form of indexing would be through a fund such as $VTI (or $VOO), with $VT being even better, as it goes outside the US and contains every stock in the world.
I think this is the best approach to indexing the market, and ensuring you capture all of the gains. This ensures you own the exact proportion of each stock in the benchmark you wish to track, limits turnover, and thus lowers taxes and trading costs.
Thereās many benefits to traditional indexing, and theyāre the only evidence-based approach to maximizing returns while limiting costs, particularly in a taxable account.
Cap-weighted Value Indexing
While value indexes play an important role, I believe their primary use is as a tax-efficient vehicle for accessing a specific 50% portion of the market. The S&P value and growth indexes, when combined, are equivalent to the S&P 500. This makes sense on the face of it. If we want cap-weighted indexes, we should stick to that idea no matter which companies weāre investing in.
I donāt necessarily agree with this, however. I believe that thereās a choice to be made between having a traditional index and a factor-based approach to investing. The moment you add any growth or value exposure to your portfolio outside of the traditional indexes, youāve necessarily decided that the cap-weighted index isnāt ideal.
While I think this can apply to ANY factor, I think value provides an excellent example. The argument is made easier when the #1 holding in large-cap value indexes is Berkshire Hathaway $BRK.B, which is a great company, but contains the largest growth stock in the world due to its Apple $AAPL exposure.
For many investors, this is fine, but itās illustrative of a larger issue for me. When selecting for value, I use many measures, from profitability and free cash flow, to book value plus intangibles, EBITDA, yada yada yada. By using a value or fundamental screen, Iām able to weight companies to give them a āvalue scoreā.
For the case of this argument, if 100% of Apple is in the S&P growth index, then the equivalent amount of Berkshire should ALSO be in the growth index. So, how do we weight a value index?
The current answer, for most indexes, is to perform a basic value screen using measures like price/book and price/sales resulting in two separate indexes, one for growth and one for value. While this used to make sense to me, it stopped making sense a while ago. Berkshire stays the #1 constituent in value indexes, with or without $AAPL. Is it THAT cheap? I really donāt think so. I think Apple has become much more affordable, but if we use S&Pās definitions, this seems to be a flaw in the system. This applies to other major index providers, too.
So, Berkshire might be a value company, but is it where I should put the most of my money if I want to invest in value? What if I think Exxon is trading 40% below value? What if I think Apple is trading 35% below value? And what if I think Berkshire is trading 25% below value?
A cap-weighted index wouldnāt care about any of this. It only cares if Exxon, Apple, or Berkshire are in the index or not. After that, they let market capitalization decide the weight. Thereās other approaches that are more suitable to my needs. Iāve been experimenting with using non cap-weighted funds for value combined with a growth index fund, and seen excellent results.
This comes with a disclaimer; Iām always poring over the holdings and factor exposures, tradability, the management teams, fees, turnover rates, and everything. Itās very easy to pick a *bad* active value fund, and Iām somewhat blind to them. Theyāre all dead to me, I wonāt even look them up, because I donāt want them in my brain. If itās not managed by someone I respect, Iām only going to look at it if the fees are low.
I respect nearly everyone Vanguard works with, as I respect their process of using multiple management teams and a merit-based approach with performance-based pay. Vanguard employs management teams like Baillie Gifford Overseas and Wellington Capital, who are each titans of active management. They also have everything in-house, theyāre all one team. Itās efficient; great when you need analysis. You want your analysts to work for you, not some bank in another country. Vanguard gets them to do their work at cost. Itās good to be big, and Vanguard doesnāt have to profit.
I also have a lot of respect for Dodge & Cox; they stick to their guns, they invest in their own funds, they donāt waste money on advertising or marketing, they let their performance do the work. As far as I am aware, theyāre the highest cost active fund to receive 5 stars and a gold rating from Morningstar for $DODGX, their US stock fund.
Iām fortunate enough to have both $DODGX and $VWNDX, Vanguardās Windsor fund, one of their best, if not the best, actively managed mutual funds on the planet for US stocks. What I donāt have is a value index fund. This has been a blessing.
For the most part, and particularly the past couple years, both $DODGX and $VWNDX have smashed their value index counterparts to pieces.
This begs the question: if I can combine a value index with a growth index, what happens if I combined $DODGX or $VWNDX with a growth index? Well, you get something different. You keep half your portfolio in the cap-weighted growth section (where momentum is a big deal, anyway), but you take on active management risk in the hopes that you can beat the value index.
On the ETF front, I respect Avantis a great deal and have read a lot of their writing. Their methodology is as sound as can be, and theyāre essentially a āDFA for the massesā. (Dimensional Fund Advisors are only available through certain advisors, and as such arenāt accessible to people who arenāt already with one of their advisors.) Their small-cap value fund is considered actively managed, but has many rules in place to limit turnover, and works more like a value-weighted fund that has occasional intervention from management to ensure nothing āweirdā happens. You donāt want to drop a company that just got an enormous contract with the pentagon, or add one that spiked in market cap due to excess call-buying. Thatās when active management can step in.
This was just meant to be a comment, so Iāll just wrap things up with a summary. All the evidence says that we can only get our fair share of market returns through low-fee indexing. I think thereās another way. While you may not be able to beat a growth index, perhaps itās possible to beat value indexes. When the market starts to feel like itās valuing things improperly, Iām more prone to go with actively managed funds, or a fund from Avantis. I even use some of Schwabās fundamental funds, as they avoid the pitfalls of a cap-weighted index.
I certainly canāt recommend this approach to everyone, and think sticking to S&P 500 and ex-US or world stock indexes without factor weighting is the easiest way to sleep at night while ensuring your returns are fair and uninhibited by taxes, turnover, awful management teams, high fees, or other nonsense.
As for me, Iāve enjoyed putting some funds with Vanguardās active management, as well as Avantis, and Iāve also found the Pacer Cash Cows $COWZ ETF to be incredibly useful. Itās not even remotely cap-weighted and is more like a deep-value mid-to-large cap fund. I like to pick groups of companies rather than companies, and this fit the bill for me. (Iāve been holding it for about 15 months or so, but will scale out of it).
So, those are my thoughts. Thereās another way. It just doesnāt have any evidence to back it up besides the past returns, which wonāt be enough for another few decades. Except for Windsorā¦ I think Wellington has beaten the benchmark for 95 years or so.
Past performance is not indicative of future returns. I may have no clue what Iām talking about and these funds implode tomorrow, and all their stocks got to $0. But for the past 10 years, this has been a winning strategy. Adding active growth with the right funds has resulted an even higher returns.
Hereās some more data from Morningstar on Dodge & Coxās US stock fund:
Comment on Cap-Weighted Value
Comment on Cap-Weighted Value
Comment on Cap-Weighted Value
The Strengths of Cap-weighted Indexing
(Morningstar reviews are at the bottom for $DODGX and $VWNDX)
I believe in indexing, and a large amount of my investments are linked to broad market indexes, which weight companies based on market capitalization. From an indexing perspective, the purest form of indexing would be through a fund such as $VTI (or $VOO), with $VT being even better, as it goes outside the US and contains every stock in the world.
I think this is the best approach to indexing the market, and ensuring you capture all of the gains. This ensures you own the exact proportion of each stock in the benchmark you wish to track, limits turnover, and thus lowers taxes and trading costs.
Thereās many benefits to traditional indexing, and theyāre the only evidence-based approach to maximizing returns while limiting costs, particularly in a taxable account.
Cap-weighted Value Indexing
While value indexes play an important role, I believe their primary use is as a tax-efficient vehicle for accessing a specific 50% portion of the market. The S&P value and growth indexes, when combined, are equivalent to the S&P 500. This makes sense on the face of it. If we want cap-weighted indexes, we should stick to that idea no matter which companies weāre investing in.
I donāt necessarily agree with this, however. I believe that thereās a choice to be made between having a traditional index and a factor-based approach to investing. The moment you add any growth or value exposure to your portfolio outside of the traditional indexes, youāve necessarily decided that the cap-weighted index isnāt ideal.
While I think this can apply to ANY factor, I think value provides an excellent example. The argument is made easier when the #1 holding in large-cap value indexes is Berkshire Hathaway $BRK.B, which is a great company, but contains the largest growth stock in the world due to its Apple $AAPL exposure.
For many investors, this is fine, but itās illustrative of a larger issue for me. When selecting for value, I use many measures, from profitability and free cash flow, to book value plus intangibles, EBITDA, yada yada yada. By using a value or fundamental screen, Iām able to weight companies to give them a āvalue scoreā.
For the case of this argument, if 100% of Apple is in the S&P growth index, then the equivalent amount of Berkshire should ALSO be in the growth index. So, how do we weight a value index?
The current answer, for most indexes, is to perform a basic value screen using measures like price/book and price/sales resulting in two separate indexes, one for growth and one for value. While this used to make sense to me, it stopped making sense a while ago. Berkshire stays the #1 constituent in value indexes, with or without $AAPL. Is it THAT cheap? I really donāt think so. I think Apple has become much more affordable, but if we use S&Pās definitions, this seems to be a flaw in the system. This applies to other major index providers, too.
So, Berkshire might be a value company, but is it where I should put the most of my money if I want to invest in value? What if I think Exxon is trading 40% below value? What if I think Apple is trading 35% below value? And what if I think Berkshire is trading 25% below value?
A cap-weighted index wouldnāt care about any of this. It only cares if Exxon, Apple, or Berkshire are in the index or not. After that, they let market capitalization decide the weight. Thereās other approaches that are more suitable to my needs. Iāve been experimenting with using non cap-weighted funds for value combined with a growth index fund, and seen excellent results.
This comes with a disclaimer; Iām always poring over the holdings and factor exposures, tradability, the management teams, fees, turnover rates, and everything. Itās very easy to pick a *bad* active value fund, and Iām somewhat blind to them. Theyāre all dead to me, I wonāt even look them up, because I donāt want them in my brain. If itās not managed by someone I respect, Iām only going to look at it if the fees are low.
I respect nearly everyone Vanguard works with, as I respect their process of using multiple management teams and a merit-based approach with performance-based pay. Vanguard employs management teams like Baillie Gifford Overseas and Wellington Capital, who are each titans of active management. They also have everything in-house, theyāre all one team. Itās efficient; great when you need analysis. You want your analysts to work for you, not some bank in another country. Vanguard gets them to do their work at cost. Itās good to be big, and Vanguard doesnāt have to profit.
I also have a lot of respect for Dodge & Cox; they stick to their guns, they invest in their own funds, they donāt waste money on advertising or marketing, they let their performance do the work. As far as I am aware, theyāre the highest cost active fund to receive 5 stars and a gold rating from Morningstar for $DODGX, their US stock fund.
Iām fortunate enough to have both $DODGX and $VWNDX, Vanguardās Windsor fund, one of their best, if not the best, actively managed mutual funds on the planet for US stocks. What I donāt have is a value index fund. This has been a blessing.
For the most part, and particularly the past couple years, both $DODGX and $VWNDX have smashed their value index counterparts to pieces.
This begs the question: if I can combine a value index with a growth index, what happens if I combined $DODGX or $VWNDX with a growth index? Well, you get something different. You keep half your portfolio in the cap-weighted growth section (where momentum is a big deal, anyway), but you take on active management risk in the hopes that you can beat the value index.
On the ETF front, I respect Avantis a great deal and have read a lot of their writing. Their methodology is as sound as can be, and theyāre essentially a āDFA for the massesā. (Dimensional Fund Advisors are only available through certain advisors, and as such arenāt accessible to people who arenāt already with one of their advisors.) Their small-cap value fund is considered actively managed, but has many rules in place to limit turnover, and works more like a value-weighted fund that has occasional intervention from management to ensure nothing āweirdā happens. You donāt want to drop a company that just got an enormous contract with the pentagon, or add one that spiked in market cap due to excess call-buying. Thatās when active management can step in.
This was just meant to be a comment, so Iāll just wrap things up with a summary. All the evidence says that we can only get our fair share of market returns through low-fee indexing. I think thereās another way. While you may not be able to beat a growth index, perhaps itās possible to beat value indexes. When the market starts to feel like itās valuing things improperly, Iām more prone to go with actively managed funds, or a fund from Avantis. I even use some of Schwabās fundamental funds, as they avoid the pitfalls of a cap-weighted index.
I certainly canāt recommend this approach to everyone, and think sticking to S&P 500 and ex-US or world stock indexes without factor weighting is the easiest way to sleep at night while ensuring your returns are fair and uninhibited by taxes, turnover, awful management teams, high fees, or other nonsense.
As for me, Iāve enjoyed putting some funds with Vanguardās active management, as well as Avantis, and Iāve also found the Pacer Cash Cows $COWZ ETF to be incredibly useful. Itās not even remotely cap-weighted and is more like a deep-value mid-to-large cap fund. I like to pick groups of companies rather than companies, and this fit the bill for me. (Iāve been holding it for about 15 months or so, but will scale out of it).
So, those are my thoughts. Thereās another way. It just doesnāt have any evidence to back it up besides the past returns, which wonāt be enough for another few decades. Except for Windsorā¦ I think Wellington has beaten the benchmark for 95 years or so.
Past performance is not indicative of future returns. I may have no clue what Iām talking about and these funds implode tomorrow, and all their stocks got to $0. But for the past 10 years, this has been a winning strategy. Adding active growth with the right funds has resulted an even higher returns.
Hereās some more data from Morningstar on Dodge & Coxās US stock fund:
And Vanguardās Windsor fund: