Supercharging an indexed portfolio

Let’s say you have made the breakthrough to indexed investing. You no longer believe that some swaggering Wall Street money manager can consistently beat the market for you. You no longer want to pay high fees to take that risk, and have decided on a more rational course.    Great—you’ve come to the conclusion shared by a lot of other very smart people who have a lot of sound research to back them up. Now, how do you do it?

Remember that the credo of indexers is “no rewards for taking risks other than the market risk.” That means trying to select individual securities, concentrating in certain sectors, or trying to time purchases and sales does not offer enough compensation for the risks you take. That should mean that the only sane way to invest is to buy the market. That is precisely the goal of broad index funds that buy a representative sampling of every stock in proportion to each stock’s relative weighting in the market. In such a portfolio, for instance, you would own more Microsoft stock than that of a smaller company, because the total value of Microsoft stock is so large. That’s a pretty good basic approach. Research shows you would probably beat the returns of many domestic stock mutual funds. 

But do you really own the stock market by owning a broad market index fund… Maybe not. You would be ignoring the rest of the world because over half of the world’s stock capitalization resides outside of this country’s borders. And you may even be making a sector bet in this country because the broad stock market index would tend to be dominated by a relatively small group of mammoth growth stocks. This strategy would have exposed you to a lot of extra risk from 2000-02, when large U.S. stocks suffered some of the bear market’s steepest declines.

What if broad stock market risk isn’t the only risk worth taking? Research by Professors Eugene Fama and Kenneth French has identified two additional risks that seem to compensate investors with extra returns. They are the risks of investing in small stocks and financially distressed stocks (commonly labeled as “value stocks”).

It appears that over long periods of time small and financially distressed stocks offer an average of 5 percentage points of extra return for bearing the risk of investing in them. Even more important, it appears that the risks of small and financially distressed stocks are largely unrelated to the risk of investing in the market as a whole. That means you can have periods when one risk class—small stocks, say—does well when the other two do poorly. This is precisely what happened during the recent bear market. The broad market, dominated by large growth stocks, declined more than did small stocks and financially distressed stocks. And those latter two risk classes have recovered to much higher levels than did the broad market over the past 15 months.

An investor who really wanted to index all worthwhile risks—that is, risks which truly reward an investor with extra returns—would want to spread out his indexing from the broad market and into the realms of small and financially distressed stocks. Such a strategy does not involve betting in sectors, but is a rational way to capture the best available returns.