Indexing of Different Asset Classes

When it comes to stocks, index investing offers many advantages over other investment approaches.  However, these advantages don’t always carry over to other asset classes.  No investment style should be treated like a religion, indexing included.  It pays to think through the reasons for using a given approach to investing.

Stocks

Low-cost broadly-diversified index investing in stocks offers a number of advantages over other investment approaches:

1. Lower costs, including MERs, trading costs within funds, and capital gains taxes
2. Less work for the investor
3. Better diversification leading to lower volatility losses

Choosing actively-managed mutual funds or ETFs definitely has much higher costs.  For investors who just pick some actively-managed funds and stick with them, the amount of work required can be low, but more often the investor stays on the lookout for better funds, which can be a lot of work for questionable benefit.  Many actively-managed funds offer decent diversification.  Ironically, the best diversification comes from closet index funds that charge high fees for doing little.

Investors who pick their own stocks to hold for the long-term, including dividend investors, do well on costs, but typically put in a lot of work and fail to diversify sufficiently.  Those who trade stocks actively on their own tend to suffer from trading losses and poor diversification, and they put in a lot of effort for their poor results.  Things get worse with options.

Despite the advantages of pure index investing in stocks, I make two exceptions.  The first is that I own one ETF of U.S. small value stocks (Vanguard’s VBR) because of the history of small value stocks outperforming market averages.  If this works out poorly for me, it will be because of slightly higher costs and slightly poorer diversification.

One might ask why I don’t make exceptions for other factors shown to have produced excess returns in the past.  The reason is that I have little confidence that they will outperform in the future by enough to cover the higher costs of investing in them.  Popularity tends to drive down future returns.  The same may happen to small value stocks, but they seemed to me to offer enough promise to take the chance.

The second exception I make to pure index investing in stocks is that I tilt slowly toward bonds as the CAPE10 of the world’s stocks grows above 25.  I think of this as easing up on stocks because they have risen substantially, and I have less need to take as much risk to meet my goals.  It also reduces my portfolio’s risk at a time when the odds of a substantial stock market crash are elevated.  But the fact that I think of this measure in terms of risk control doesn’t change the fact that I’m engaged in a modest amount of market timing.

At the CAPE10 peak in late 2021, my allocation to bonds was 7 percentage points higher than it would have been if the CAPE10 had been below 25.  This might seem like a small change, but the shift of dollars from high-flying stocks to bonds got magnified when combined with my normal portfolio rebalancing.

Another thing I do as the CAPE10 of the world’s stocks exceeds 20 is to lower my future return expectations, but this doesn’t include any additional portfolio adjustments.

Bonds

It is easy to treat all bonds as a single asset class and invest in an index of all available bonds, perhaps limited to a particular country.  However, I don’t see bonds this way.  I see corporate bonds as a separate asset class from government bonds, because corporate bonds have the possibility of default.  I prefer to invest slightly more in stocks than to chase yield in corporate bonds.

I don’t know if experts can see conditions when corporate bonds are a good bet based on their risk and the additional yield they offer.  I just know that I can’t do this.  I prefer my bonds to be safe and to leave the risk to my stock holdings.

I also see long-term government bonds as a different asset class from short-term government bonds (less than 5 years).  Central banks are constantly manipulating the bond market through ramping up or down on their holdings of different durations of bonds.  This manipulation makes me uneasy about holding risky long-term bonds.

Another reason I have for avoiding long-term bonds is inflation risk.  Investment professionals are often taught that government bonds are risk-free if held to maturity.  This is only true in nominal terms.  My future financial obligations tend to grow with inflation.  Long-term government bonds look very risky to me when I consider the uncertainty of inflation over decades.  Inflation protected bonds deal with inflation risk, but this still leaves concerns about bond market manipulation by central banks.

Taking bond market manipulation together with inflation risk, I have no interest in long-term bonds.  We even had a time in 2020 when long-term Canadian bonds offered so little yield that their return to maturity was certain to be dismal.  Owning long-term bonds at that time was a bad idea, and I don’t like the odds any other time.

Once we eliminate corporate bonds and long-term government bonds, the idea of indexing doesn’t really apply.  For a given duration, all government bonds in a particular country tend to all have the same yield.  Owning an index of different durations of bonds from 0 to 5 years offers some diversification,  but I tend not to think about this much.  I buy a short-term bond ETF when it’s convenient, and just store cash in a high-interest savings account when that is convenient.

Overall, I’m not convinced that the solid thinking behind stock indexing carries over well to bond investing.  There are those who carve up stocks into sub-classes they like and don’t like, just as I have done with bonds.  However, my view of the resulting stock investing strategies, such as owning only some sub-classes or sector rotation, is that they are inferior to broad-based indexing of stocks.  I don’t see broad-based indexing of bonds the same way.

Real estate

Owning Real-Estate Investment Trusts (REITs) is certainly less risky than owning a property or two.  I’ve chosen to avoid additional real estate investments beyond the house I live in and whatever is held by the companies in my ETFs.  So, I can’t say I know much about REITs.  

However, I don’t think the advantages of indexing that exist with stocks automatically carry over to real estate without checking the details.  Someone would have to examine REITs to see if they can play a positive role in investor portfolios.  Do REITs have hidden costs?  Are other market participants able to exploit REITs when trading properties?  What are the costs of managing passively-owned properties?  Perhaps someone has examined these questions in sufficient detail, but I haven’t seen the analysis.

Some of these problems apply to stock indexing as well.  For example, there are circumstances where traders can exploit the way that index funds respond to changes in the list of stocks making up indexes.  However, major index ETF providers have responded with changes to how they do business that reduce such costs to low levels.  I don’t know if REITs are able to do the same.

Commodities, Hedge Funds, Venture Capital, Collectibles, Cryptocurrencies, other Alternatives

Any time I look at index-style investing in other asset classes, I find more questions than answers.  What answers I do find often keep me away from these asset classes rather than draw me in.  It would take a lot to convince me to make any of these asset classes part of my own portfolio.

Conclusion

I’ll never claim that how I invest is the best way.  I seek reasonable long-term results with a reasonable amount of protection against extreme events, such as stocks market crashes, high inflation, or outright corruption.  In some cases, I stay away from asset classes for well thought out reasons, and in other cases, I stay away out of my own ignorance.  I’m good with that.