In support of indexing

I already wrote about that I support indexing. Here is more information about indexing compared to some other types of investments.  

There are many advantages of indexing. The two main advantages for me are the diversification and the inability to go down to $0 like individual stocks. Those two features appear to be protective in bear markets. 
Of course like individual stock the indexes will go down during depression times too but their come back up is more certain. For the broad market ETFs that works even better than for market sector ETFs.

Below I will compare index ETFs to actively managed ETFs and to individual stocks.



Tax efficiency
The turnover rate in index ETFs is lower compared to actively managed ETFs and that will generate fewer capital gains. If you buy individual stocks it will depend on how long you hold that stock. Different indexes have different turnover rates too and even using only index ETFs may still produce some capital gains.

Costs
First there are transaction costs (commissions) - costs of buying or selling stock or ETF. Those comissions are the same for both types of investments.  Some institutions offer commission free ETFs, for example E-Trade, Fidelity, Schwab and others offer commission free ETFs. I noticed that that is not always the best deal. Some ETFs will have large spreads (difference between sell and buy price) and if buying or selling a large position the amount you lose due to spread will be much more than a commission if you trade an ETF with a tight spread. The spread will be less important if the amount is small or if you plan to hold for a very long time.
 
Example:
A commission free ETF with a bid/ask spread of 10 cents. 
If you buy 500 shares, the "costs" due to spread will be $50. That means you will be immediately in minus of $50 and will have additional $50 to cover before getting into the green.

An ETF with a spread of 1 cent plus commissions.
If you buy 500 shares, the "costs" due to spread will be $5. The commissions are the additional $4-5. You will be down only $10.
The larger the position, the larger will be amount lost due to spread.
The worst case would be to trade ETFs or stocks with large spreads with a broker who charges high commissions.
The best case would be to trade a narrow spread ETFs or stocks with a low commission broker or to avoid commissions.  
And don't forget the expense ratio for ETFs. 

Stocks will have costs associated with every transaction of buying or selling but there is no cost for holding it.
The ETFs have expense ratios and in addition to the transaction costs there will be holding costs for the period you hold the ETF. The ratios vary a lot and can be very low, for example 0.03% for SCHB (broad market ETF from Schwab) and 9.26% for BIZD (VanEck Vectors BDC Income ETF). 

   
Diversification
The index ETFs do have built in diversification compared to a single stock.
The degree of the diversification depends on the structure of a particular ETF.
For example S&P500 is tracking 500 stocks and the Russel2000 is tracking 2000 stocks. Some of the stock held by different indexes overlap, for example the Apple stock is held by both SPY and QQQ.  
The stocks may be represented differently in an ETF. There equal weighted ETFs and non-equal weighted ETFs. You can read more about the difference between them in this post.
If you want to diversify your investments well with just stocks, that will definitely require more work.   


Risk control
Two risks are controlled with ETFs:
1. The risk of losing a substantial amount of money due to bankruptcy of a company which stock becomes worthless or falls very low and never recovers. The major indexes always recover even after severe depression.
2. Indexing eliminates the risk of mismanagement of your money by an active manager who can make wrong decisions which will lead your fund to underperform the market. Index tracking ETFs will market-perform.  
  

 

Equal weighted ETFs - better or worse than regular index ETFs?

What are equal weighted index finds?

If you look at the components of an index fund such as S&P500, you will see that large companies are overrepresented. Even if  the index holds 500 companies they are not equally represented.

As you see below in the example of SPY ETF which tracks S&P 500 index, Apple comprises 3.94% of the index and the top 10 holdings represent not 10% but 20% of the index.

Here is the example of QQQ and Apple stock is also overrepresented. The top 10 holdings represent over 50% of the ETF value.  

An equal weighted index fund will hold the same set of companies as its underlying index but the value amount be equally distributed.  

RSP is the equal weighted ETF corresponding to SPY and QQQE is the equal weighted ETF corresponding to QQQ.
The expense ratios are higher due to higher turnover and the equal weighted ETFs may produce more capital gain distributions. But are they a better choice for the investor?

The non-equal weighted indexes are weighted by market capitalization. When a stock is increasing in price, the index will increase the amount of stock that is going up. If the stock goes down, the index will decrease the amount of stock held. Basically it is going with the trend.

The equal weighted indexes are more contrarian. The funds are divided equally between all held stocks. If a stock goes down in price, it will be bought and the opposite with the rising in price stocks - they will be sold to keep the equal shares.
This will lead to sell high and buy low. It also may lead to keep buying a stock which will never get up again. But since one possible big loser stock will only be 1/500 the risk is contained. During the recession when the stock prices are going down, more stocks will be bought at a lower price  buy the equal weighted ETFs compared to the non-equal weighted ETFs.

How did their performance compared during last recession? 
 
Here is SPY compared to RSP. This timeframe includes year 2009.

However in the last 5 years there is no significant difference in performance.  
 

 

And in the last year the non-equal weighted SPY outperformed the equal weighted RSP.

 

Now let's compare QQQ and QQQE. In this case the non-weighted QQQ over performed the equal-weighted QQQE in the long term.

The same for the last 5 years:

And for the last year:

Whatever the explanation is, the results are variable.

The expense ratios for equal weighted ETFs are higher (SPY 0.09%, RSP 0.20%, QQQ 0.20% and QQQE 0.35%).

The main advantage of the equal weighted ETFs appears to be in the diversification - they are more diversified compared to the non-weighted ETFs.  

Update on how much do I need to stop worrying

While I was working on organizing my non-probatable assets, I read few personal finance blogs.

All say about the same:
Trinity study is obviously the best or the most popular study to determine your withdrawal rate to make sure the money will last trough the retirement time. And that is 4% withdrawal rate on $3,000,000 saved.

Some people, especially in the comments section, were concerned about market downturns which no one can ever predict.

That made me think about the market downturns.
I went to the stock charts and checked how deep did the market go while recent market "crushes".

The drawdown was about 50% for indexes. It was more variable for stocks. 

Here are some of my thoughts on how to combat that:

Option 1: The downturns are temporary. I can sit them out.
Especially if I accumulated for many years and the average price will not be the top price. The 50% decrease will be  from the top price (and not from the average price) and that will not be as critical after years of accumulating. 
   
Option 2: I can increase my magic number from $3,000,000 to $5-6,000,000. That number appears to be difficult to reach, because I don't know if I even reach the $3,000,000. And I will have to call it the "super-magic number".

But if the downturn is about 50% only from the top price and it might be only about 30% from the average, I might need only approximately 30% increase in the magic number and that will be approximately $4,000,000. This is still very far out but looks more doable.

Option 3: I could create an additional source of income. Dividends would be one option. Dividends, in most cases, are paid during marked downturns and can help to bridge that time. I can't think of any other realistic options working full time.

Challenge "cash flow" - why?

Why do I want this challenge?


The most common advise is to do "indexing". That means to invest long term in an exchange traded fund or a mutual fund that tracks a major index like S&P500. I already do it in my 401k. 

But I don't feel like I am in charge of what is happening. It is a very passive position. I feel like I am carried by the waves on a flotation devise. 

Indexing is easy and the wave may take you up for a nice ride when the market goes up. Buth the wave can also take you down when the market goes down. 

Instead of just floating up and down with the wave I want to learn to swim by myself. I plan to add individual stocks and not be restricted to the ETFs.

So I am starting a new challenge: "Cash flow"

0. "Floating" = yearly expenses are not covered by investment income
1. "Swimming" = yearly expenses are covered ($50,000)
2. "Sailing" = double of yearly expenses is covered ($100,000)
3. "Motor boating" = anything over $500,000
4. "Cruise ship Capitan" = $1,000,000 and above (yes, as long I am dreaming why not?) 


It might not be a very wise decision to do more then just indexing. So many people support it and warn against individual stocks. 
I will carefully select stocks and keep them in a separate account where I will do no indexing. I will do that for a few years and compare the returns to the SPY. If I will not be able to beat the index within 5 years, I will just go back to indexing only. 

What is "Indexing"?

Indexing is a passive long term investment strategy.

Indexing can be achieved with mutual funds or exchange traded funds (ETFs) which closely tack the performance of the underlying index.


SPDR S&P 500 ETF (or SPY) is an example of an ETF which closely tracks S&P 500 index.
SPY holds 500 companies that make up S&P 500. 
People like indexing because with little effort this is a way to diversify. The 500 companies of the SPY are supposed to be approximately 80% of the overall US stock market.


With this method the investor will:
1. Achieve the same rate of return as the underlying index.
2. Will be exposed to the same risks as the underlying index.
3. Achieve a good degree of diversification.

Most of my investments are in index funds at this time. As mentioned above, it is easy, it is diversified and the return averages are acceptable. 

I have another post about how I do indexing for myself: Indexing simplified.