Five Surprising Insights About Stock Indexes and Funds
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Walking the money for the rest of us. This is a personal financial on money, how IT works, how to invest IT and how to live without worrying about IT. I'm your host David stein today.

Today s episode 4 forty three。 It's title five surprising insights about stock indexes and funds. In one thousand nine hundred and ninety five, I became an institutional investment adviser. As we structured portfolios, they typically had large cap growth managers, large cap value managers. We would have the same on the small capture growth envy managers that invested in smaller companies in order to determine which managers to recommend to our clients.

We ve met with hundreds of managers per year, and we had a constant stream of investment managers on the stocks side, the bond side, and eventually other asset classes come to our office. The first manager I ever met with was anchor capital advisors based out of boston. They just celebrated their fifth anniversary.

When I met with the manager, I didn't really have any idea what ask them. They typically would have a presentation book. They would go through their charts.

I remember asking a fairly detailed follow up question about their strategy that require some additional work on their part, and I never heard back, so we didn't ever recommend them as a manager. I loved meeting with manager. I was intrigued by both growth star managers and value style managers.

And they were and IT both styles in our investment portfolios. I would follow their stock pics. Sometimes I would pair at their stock picks. Often IT wouldn't go very well. After about six or seven, eight years of doing that, I decided, well, what if we manage money by taking the high conviction stock picks of our top managers on a recommend list and put together portfolio, each managers top ten holdings? This was more of A A small to mid cap style portfolio.

And I back tested, I got the ideas, and I spent several months going through a back test to verify that the best ideas from our top managers would generate access return. And then we could struct portfolios, model portfolios or actual portfolio and manage assets in this way, IT didn't work. There wasn't any access return. And that was incredibly frustrating to me because potentially I meant we weren't very good at our job in selecting managers.

After spending more time figuring out what was really driving IT, I realized that and instruction this portfolio, I was using bara software to optimize IT and to reduce the tracking air, which is the deviation that a portfolio has relative to a benchmark in the way that you reduce tracking areas, you add additional holdings or you reduce weights s in particular holdings. And I had reduced the tracking air too much to around a beevers two to three percent tracking air, and effectively neutralized any bets in the portfolio, style bets, factor bets, value yield. And so I just had a portfolio that was made up a number of holdings, about one hundred, that closely approximated the index and under perform the index net fees.

IT was at that point, I thought, or what if I restructure a portfolio in a similar way, but using etf, which IT had only been around for a few years, and then we could allocate to those factors that were most attractive, be a value growth, yield or other elements that back test worked partner. I put up some funds to begin starting a track record. Track record didn't did well.

We attracted clients and and eventually grew that investment product over a billion dollars in assets, mostly certainly capital appreciation, but also new clients. In order to do the research, though, we needed a tool to determine which segment of the stock market and the bond market was most attractive. And IT was that point that we retained, net Davis research.

This was an institutional research firm that had some, for example, small cap valued charged to be able to see the historical vision growth and and many, many other charts. And Davis, the founder that firm, is seventy seven or seventy eight years old. He still goes to the office, I believe, a couple of times a week, going through hundreds of charts as how he used the markets.

And it's very much, child. I view the markets in terms of managing my own portfolios. And as we have some motor portfolio examples on money for the rest of us plus but charged so on the Davis research and the metrics and were never quite what I wanted.

And so after a few years of that, in my old firm, we started subscribing to russia, and Russell would send a spread sheet every month with evaluation data on the Russell one thousand valuing growth, which are a large cap indexes. The Russell two thousand growth and very small cap. I believe IT was primarily domestic.

They didn't have non us as part of that service. But the point is for many years, I was trying to get Better data, Better graphs, Better ways to analyze the market to see where IT was by various metrics such as the Price to earnings, the ratio that divided in yield, the Price to cash flow relative to its average. And this has been a several decades search.

It's been an ongoing frustration since I left my advisory firm. I continued with that Davis research. I pated out on my own pocket there for a couple years before we launched money for the rest of us, but the data was just never quite what I wanted until a month ago when we launched asset camp.

This is a stock index service gear tard, individual investors, that contains valuation charts and earnings charts. For at the time, IT was twenty seven stock indexes. IT does historical return attribution and expected return analysis. As soon as we launched that, we had a number of individuals join the service, and they point IT out we would really like to analyze growth and value and small cap.

And the reality is we should have launched with that, but we didn't because this was an entirely new software platform and we just want to to actually get IT to work and start getting feedback. And so last week, we updated acid camp with ninety additional indexes, and now we have value indexes, growth indexes, small cap, and that provided hundreds of more charts. And so we have forty six index now.

And in some ways it's a cliche, but I feel like a kid in the Candy store because I can analyze growth value cap, small cap, like I have never been able to do before, just be able to see the picture, to see where markets are. In this episode, I want to share some insights i've learned from spending time with these charts and attribution tables, and there's plenty more to learn. And that's what's so fascinating to me and what makes me so excited about this service, to be able to learn things about the stock market that I never knew because I never had the tools to be able to analyze IT in the way that I really wanted to analyze IT index providers like msci.

And this, the services based on si data. Mmc I has over two hundred and eighty thousand indexes. We're using forty six of them, but the forty six that we use cover ninety nine percent of the market.

And the way that msci and other index providers are similar is just that m sc I is unique just in terms of the sheer number and scope of their index. I believe they're the largest index provided in the world. They look at the market capitalization or size of all the publicly traded companies and then ranked them by size.

And market capitalization is calculated by taking a stocks Price per share Price times the number of shares outstanding. And and then they rank all of these stocks around the world and there's thousands of them. They're standard index. The ones that we launched the asia camp service with the geographic indexes contained about eighty five percent of the stock market and includes mid and large cap.

The large cap on its own is essentially the top seventy percent by size, but the top eighty five percent would be mid to large, their standard index, and then the small cap would be the bottom fourteen percent. So the totals about ninety nine percent coverage, that's how they do IT by size. And then they'll break out all these stocks into are they a value stock or a growth stock.

And they use different metrics. They do use what they call A M multivariate approach. So they're looking at, for example, on the value side, they look at the twelve forward earnings yield, which is the inverse of the Priced earnings ratio, and that's one of the insights will share here in a few minutes.

And they look at the divide and yield and and they look at the Price book value. So those are the things are looking forward to, and they're ranking every stock based on those metrics, and they're also ranking them on, on the grow style. So they're looking at the the growth rate of the earnings per share, both short term and long term, and they are looking at long term historical sales per share.

And so they look at every stock and they rank them based on these growth and value metrics. And they do this statistical analysis. Some are clearly growth stocks that they have a very high growth score, very low value score.

Others have a very high value score and allow growth score. Some are sort of in between. And for those stocks, they could be represented in both. The growth and value index is just that they are weight in each index combined with equal their weight, their percentage weight for their overall weight in the global stock market. But that how what's done in every index provider does IT differently.

We have found in looking at growth or value indexes, particularly if their size waited, market captivation waited, that essentially, there's a lot of overlap between, let's say, the msci USA index and the S P five hundred index or the rustle one thousand because that the theologies are similar, the size rated indexes. And so there's a lot of overlap. And that that means when you want to, for example, implement a particular index finder etf that covers a specific index IT doesn't have to be the exact index IT just has to be the right category, either small cap value or small cap growth, large cap value or growth.

That's how it's done. Now what about these five insights? The first is maybe more inside baseball, but it's realizing how distorted measuring the valuation of stocks by a Price earnings ratio, the Price divided by the earnings over the previous twelve months, for example, compared to doing the earnings divided by the Price, what's known as the earning shield on money.

For the rest plus are our premium membership community. We've always shown earnings yield calculations. It's a percentage. And with the learning yelled, the higher the earnings yelled, the more attracted the valuation. Whereas with Price to earnings, ings to ratio, the lower the pe, the more attract to the valuation.

Here is the thing though, and this is a function of the mathematics, when earnings get very, very low, that, say, during a global recession, that can really send the Price to earnings, ure issues super high. For example, of the world U. S. Small cap value index in january twenty ten had a Priced earnings ratio.

Of twelve hundred and fifty, so that the average Prices to earning asia over time of international small cat value is between nineteen and twenty eight depending on how we calculate IT was at twelve hundred and fifty, but that was the Price divided by the earnings. But if we did the earnings yield, the earnings divided by the Price IT was point of eight percent, so small, but not twelve hundred and fifty in some of our valuation charges there. There's Price to earnings ratios even higher than twelve fifty.

In fact, on the charts, we have to cap them at some level so that they were all chart doesn't get distorted and I didn't realize how big an impact that was. And IT IT matters because of some of those more extreme Price to earnings ratio. For some stock indexes, IT can bring up the overall average of the average P E.

For international small caves stocks is twenty eight point seven, but it's being driven by the very extreme p es. On uncertain period. The average earnings eld earnings about of about Price is five point two percent.

And if we do the inverse of that effectively, if we take the average earnings shield and convert IT to a Price to earnings ship issue, we get an average pe of nineteen that we say, well, the range goes from nineteen twenty eight based on how you calculate IT. If we calculate or if we derive an average Price to earning your issue for international small cat value, it's nineteen. But if we actually use the PS to calculated, it's twenty eight.

That was a surprising insight. And it's why I think using earnings yield on a trAiling twelve month basis and on a forward looking basis based on analyst estimates is actually, to me, more intuitive, takes a lot to get used to be. It's more intuitive because you don't get the extremes, but you can you can still see how many, for example, standard deviations, how far away a particular observation is from that average.

So that was the first inside. The second inside is that earnings are much more cyclical than I realized. And again, that insight comes from actually seeing a chart, some of the the charge that we show an asset campus as we show trAiling twelve month earnings four, we're looking earnings, but we also show that actually earnings themselves for the index over time.

And it's surprising if you see the actual earnings. So not a growth rate, but the earnings s themselves. You can see how cynical ico they are.

So world X, U, S, small cap value, international small can value again. So its earnings for ninety nine percent for the air ending january twenty ten. That's good job ously. But then earnings increased seven hundred and four percent for the year ending november twenty ten. So nine months later, we had earnings up seven hundred and four percent because they collapsed and then they rebounded quite significantly.

And as we've discussed in the past regarding the mathematics of compounding, when you lose money and lose ninety nine percent, IT takes a two hundred percent or more return to to recover that. And in this case, the recovery was much, much greater. But just with the the the Price earnings ratio because of the volatility of earnings IT can distort if we judge a particular segment of the market, let's say, international small cap value based on the average one year earnings because sometimes I fell IT fell ninety nine percent and then IT recovered seven hundred percent.

The average one year earnings growth for international smokeout value is fifty four percent, and that's not a number we want to plot plug in as an estimate for earnings growth, but that's based on the math. And so a Better measure would be the average five year earnings growth, which for international smokey value has been just over eight percent. The earnings themselves, if we go back to one thousand nine hundred and ninety four international small market value earnings have compounded at a seven percent rate and then the average five year earnings growth rates than eight percent, but the average one year has been fifty four percent.

And that's why when we're coming up with estimated returns in the models on asia camp, we give users different options. They can use the earnings over the past ten years. They can use analyst expectations for earnings over the next three to five years.

They can use the average earning per share on rolling five year basis in the whole ideas that we can estimate, expect to returns. Looking at a decade based on the diving in yield, the earnings growth and whether the valuations change or not. And those are the three building blocks of returns, one that I ve used as an institutional investor per decade as well as an individual investor and an educator.

And it's what we teach our money for the rest of plus and it's what we're using on acid camp. But that is the second insight, just how variable earnings can be and how that can distort the one year average earnings pressure. Before we continue, let me pause and share some words from this week.

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Sign up for your one dollar per month trial period at sharp fy dot com. Slash David. All over case, go to shop fy, that comes sas David. Upgrade your selling today sharp fy outcome slash David. A third insight is that currency has a much larger impact on returns of indexes, index, metro funds and E T, S.

Then I realized if you are a dollar based invest, unless you specifically invest in a etf, a fund that hedges the currency risk, the compounded returns will show the impact of the currency. And if the us. Dollars strengthens relative to the rest of the world, a us.

Space investor investing overseas and those returns being translated back in the us. Dollars, they will have a lower return when the currency strengthens. So the return in local currency, you're investing in a japanese etf.

The japanese stock market returns are much higher over the past decade, and they are when those japanese returns are translated in U. S. dollars. And the impact can be huge.

And until we actually put together attributions over the past decade, and we run to do this once a month for all those indexes, and we look at here's the ten year return, here's how much of the return came from dividends. This is how much from earnings growth. This is how much, because of evaluation, address the index, expect more expensive or cheaper.

And then our forth is the currency impact. And if we can rank close and if we look of the past decade, the ten years ending july thirty first, twenty twenty three emerging european middle east, that current impact, those currencies weakening relative the U. S.

Dollar LED to a six percent return drag each year. So over the ten year period, six percent analyzed lower return was due to currency, which is why emerging europe, middle ast had a negative return a. Over the past decade, emerging land in america, the weakening and american currencies relative the dollar cost six percent also analyzed over the past decade japan's return.

Japan's currently the weakening of the yen LED to a four percent annual drag for investors that were invested in a japanese etf that was unheard for currency risk. And and I saw this in our model portfolio, ample es, and in my personal portfolio, in june twenty twenty, we add the wisdom tree, japan's small cap dividin etf D F J to our adaptive mono portfolio. We did IT on on head spaces, and we should have invested on a heads basis over the past three years, that etf has returned five point four percent analyzed.

But wisdom tree has the same etf, a hedged version that protects against fluctuations in the currency that return eighteen point three percent analyzed. So the currency over the past three years has cost thirteen percent analysts. Now hopefully that will reverse, and he has reverse some this years. But until we started doing these attributions, we weren't able to systematically see how big of impact currency can have.

The fourth insight that i've gotten from asset camp, now that we have growth and value indexes and able to see the different building blocks, the dividing yield over time for growth and value the earnings growth to change in valuations, is that value stocks earnings growth is highly competitive with grow stocks. In fact, in some areas, value stocks earnings grow faster than the grow style, investing in the whole point of of growth investing was that the earnings grow faster because the dividend yields are lower for growth stocks versus vice stocks. But that isn't always the case, and especially not the case outside the U.

S. If we look at the world X, U S value versus world X U S growth, the average earnings growth, this is the average five year earnings growth is two point six percent for international value and two point two percent for international growth. Now these average earnings gross i'm sharing, do you include the impact of currency? So the fact that the U.

S. Dollar has been an extended part of strengthening that will impact even these five year average earnings growth elements, which is why it's important to be able to use different methods. We can look at on a forward looking basis where the earnings expectations are higher.

But putting currency aside, international value every journey growth been higher than growth. The same holds true for international small, small cap value. Earnings over five year periods have grown on average eight point two percent per year for the small cap value versus international small cap growth, six point six percent.

So the value stocks earnings faster over multiple periods in the growth. The same holds true for emerging markets value. The average five year earnings growth for emerging y markets values in four point two percent versus two point nine percent for emerging markets growth.

And again, that includes the impact of the strengthening dollar. Only when you get to the us. Do we see the growth more meaningful. Ly outperform value.

So overall USA growth seven point six percent average five year earnings growth for just three point eight percent or USA value for mid cap and small cap growth for both of those has been around nine and half percent average five year earner's growth for mid cap growth in U. S. Small cap growth.

And it's been around six point six percent annualized for midcap value and U S. Small cap value. That's over average five year periods. What's interesting, no IT really depends on the time frame.

So if we look at the most recent decade and we can rank on acid camp all the different indexes by, we can rank them by dividing yield, earnings growth, valuation adjustment, the currency impact, the returns, the beginning and ending Price earning to issue. But if we rank, there's forty six index by the average earnings growth over the past decade. The first growth index is in spot number ten.

And that world X, U, S, A small cap growth is IT had nominal earnings growth of a point four percent over the past decade. That's an analyzed number. The index with the highest nominal earnings growth over the past decade was world actus.

A small cat value. Twelve percent analyzed earnings growth over the past decade, emerging that amErica also had just over eleven percent. International small cap ten point six U S. Small cap value nine point one percent. And there are a number other indexes, but the actual growth indexes are further down the list.

Again, reinforcing that fourth insight, that value styles don't necessarily have lower earnings growth than the grow star, which is why investing in value or awaiting value can be so profitable over the long term because you get the dividing yields, which are in many cases twice as high, three, four times as high, or divided yield with the value and exes, and you get with growth. And then if sexual earnings growth of the value inx is is competitive and you get a lower valuation, that's what leads to value outperforming growth over the long term, which brings up a fifth and site value isn't dead. Three years ago, up to two sixty one, that was the title is value investing dead.

And value had lagged the grow style investing for twelve and a half years, a very long time, and IT IT took a great deal of patience to be a value manager. In the whole premise, being a value manager is that growth investors are overly optimistic and the earnings don't come in as high as expected. And we've seen that.

But over time, growth can get more expensive and that can lead to the appearance of higher returns. Until those valuations correct, we can have lengthy periods of growth and value. And the the good news is, is since releasing that episode years ago, value investing has trust growth investing.

I shares M S C I if a value etf E F V that this is non us value has returned eleven point two percent analyzed over the past three years compared to the eyeshades mci ef a growth etf E F G return three point seven percent analyzed, the same holds for the us. On the U. S.

I. The vanguard growth y tf bug has returned nine point four percent analyze over the past three years, while the vanguard value etf has returned or teen point one percent analyst. So IT is possible for value to outperform growth. The underlying drivers suggest that more likely, once you factor in the dividend yield, earnings growth and the valuation. And that's where a tool like acid camp can be very valuable in calculating expected or returns and and analyzing what happens by doing attributions.

But also digging deeper and looking at these charts in conclusion then i've shared five insights from indexes that has have come from being able to analyze them in a way that I have wanted to be able to do for decades. And finally, can just starting last week, how many for the rest of us? We have a number of services.

We have the free podcast. We been doing IT for over nine years, lot to lots of free information that we have free investment guides on the money for the rest website. But we also have two premium services.

One is money for the restless, plus. This is a comprehensive education service that covers multiple asset classes. IT has a member forum. We have montepone fol examples.

I share my portfolio trades in what's going on there and additional educational items, including a weekly premium podcast episode just for plus members. That's our long standing service. Last month, we launched acid camp, which is different.

We use insights from acid camp and charge from master camp on the plus membership sites, specifically in our monthly investment conditions and strategy report that plus members get. Asa camp currently is just stock index focused. IT has closed to seven hundred visitations and earnings chart IT has performance attribution for forty six stock index, including regional country level value growth, small cap midcap.

We chose to keep a separate from plus membership because we had to build on a different technology platform and its tax treatment from sales tax is different than than plus members. A plus membership is a community and in most cases, isn't subject to sales tax. Asset camp is a subscription. The point of this episode is isn't to see you on either service.

There is a resource, if you would like additional portfolio help we have a comprehensive service like money for the rest of plus, if you just want to have a joyous time learning a time about stock index funds in eps, in the underlying drivers and what's going on, love looking at charts, Better understanding your index on investing than asset camps. For you, it's a much lower Price point than plus membership. You can learn more about plus membership at money for the rest of us dot com, and more about asset camp at asset camp 点 com。

We'd love for you to check out either service because these are the tools that we use. We use them because they weren't available anywhere else and now are making them affordable for individual investors. So please check those out.

There are five insights from Spark indexes and fun episode forty forty three. Thanks for listening. Everything I shared with you in this episode.

General education, i've not considered your specific risk situation, but not provided investment advice. This is simply general education on money investing in the economy. Have a great week.