Dissatisfaction with ESG

A top-five question I hear, whenever I help someone get started investing, is “Can I do socially responsible investing with my retirement funds?”
Inevitably, my answer disappoints: “Nope!”

A booming category, but mostly disappointing

At the beginning of the third decade of the third millennium, we still have no good way of both earning a solid “return on markets” through stocks, while simultaneously feeling good about our social consciences.

I’m not saying that because it’s a bad idea, necessarily, to accept a lower return on our investments in favor of living our values. That’s fine, very cool, it’s something we should aspire to. I have no problem with being willing to accept a lower return in order to sleep well at night, for any number of reasons. Some will even argue that sustainable investing should provide a higher return in the long run, which is a fine thing to believe, if slightly less plausible. 

I’m also not saying that Wall Street is unable to provide a set of products to satisfy this wish for socially responsible investing. 

On the contrary, starting a decade or two ago, Wall Street seemed to be on a solid path to providing that option for people who want to invest according to their moral values. The mutual fund category known as ESG – for Environmental, Social, and Governance – allows an easy way to identify companies that pledge to do good in the world. That category is in fact booming, following record year to date inflows to the tune of $17.6 billion through November 2019, more than triple previous annual amounts.

What I am saying instead is that it seems to me this type of investing – as currently available through the ESG filter – is extremely dissatisfying, at least for the people typically asking me this question.

Dissatisfaction starts with one important complication: If you put 5 social justice warriors in a room in front of a Bloomberg terminal, they will very likely not agree on what constitutes a socially conscious investment. 

Should we eliminate weapons manufacturers, casinos, alcohol brands and tobacco purveyors? Those seem at first relatively easy to agree on. But reasonable people could disagree on whether guns and gambling are good fun, while smoking and drinking are sinful. Or vice versa.

Those are all examples of ‘negative filters,’ in the sense that a mutual fund manager could filter out any company that is involved in a forbidden industry. Eliminate a bunch of industries and there are still many left over for investing.

A separate socially-aware method would be to attempt to invest in ‘positive’ filters, such as a company that tries to promote labor safety, or one that practices corporate board diversity. If those are your priorities, it is somewhat possible to find this through the ESG filter.

Still others would find it nice to be able to select positively for companies earning profits from fair trade, renewable energy, or manufacturing bioplastics, to crowd out industries considered less good for the planet or for people. We want that ‘positive’ filter approach to social investing to exist, although it is harder to find because it tends to be done on a small scale only.

At a future, later, stage of our late-stage capitalist system, these alternate strategies and disagreements in approach will matter more. 

But here’s the grim reality of where ESG is now. The billions flowing into ESG funds are going to not-very-inspiring investments. The reality falls far short of where I think social justice folks imagine it should be or that it is.

One investment firm early in the socially responsible investing space, Calvert Research and Management, boasts high rankings for its ESG-influenced approach. The top 10 holdings of their flagship Calvert Equity Fund are lovely companies that I admire and am a customer of. You’ll recognize brands like Visa, Mastercard, Dollar General, Alphabet (aka Google), and Microsoft in their top 10. But it doesn’t feel like I’m exactly saving the planet when I invest in worldwide leaders in credit card, low-end retail, and software companies.

It isn’t easy being green

Over at Vanguard’s FTSE Social Index Fund – “screened based on social criteria such as workplace issues, environmental issues, product safety, human rights, and corporate responsibility” –  here are the top ten holdings, in order of size: Apple, Microsoft, Alphabet, Facebook, JPMorganChase, Johnson & Johnson, Visa, Proctor & Gamble, Bank of America, and Walt Disney. Again – great companies – I’ve been a customer of all of them at some time or another. But my sense is that these are not exactly appealing recipients of the capital of social justice warriors worldwide.

Search for top ESG companies and the lists are always like this: Great, profitable corporations that operate far from the fuzzy feeling I might think I’m getting from “socially responsible” investing. 

In my most cynical moments, this feels to me a lot like greenwashing. Imagine you are in charge of a company that would like to attract the investment capital of ESG mutual funds. So you hire a Chief Equity Officer, or Chief Compliance Officer, and now you can be considered good enough to satisfy the ESG screen of many mutual fund companies. For a few hundred thousand dollars in salary you qualify to attract billions in capital. It’s an easy decision. 

I am not the only one who finds this situation somewhat unsatisfactory. The Wall Street Journal reports that The US Securities and Exchange Commission recently began in inquiry into ESG funds.

The gist of the SEC’s inquiry is to verify whether fund criteria for investing and voting is consistent with stated ESG principles, while at the same time acknowledging that ESG principles are poorly defined. 

The SEC Commissioner Hester Pierce is quoted on record saying that:

“While financial reporting benefits from uniform standards developed over centuries, many ESG factors rely on research that is far from settled.” On another occasion, she has said about ESG: “I think that should be part of the discussion, trying to figure out to what extent ESG might stand for ‘enabling stakeholder graft.’ “

I think socially responsible investing is a worthy goal, but the means as of now are pretty unsatisfactory, at least through public company investing.

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Ask An Ex-Banker: Mutual Fund Investing


Editor’s note: Paul recently purchased The Financial Rules For New College Graduates, then had some followup questions regarding mutual fund investments. Readers of the book…feel free to pepper me with your followups…

Dear Mike,

I’m on board 1000%1 when it comes to 100% equity mutual funds, the questions in my mind now are: “Which one(s) and how many?”
1) I’m finding many front-end load (5.50%-5.75%) managed funds with anywhere from 0.89% Expense Ratio to 1.40% (with the 1.20% range being the most common). I’m assuming that the lower the expense the better, but am I overstating the importance of this number? 
2) Without splitting hairs about what the top 10 holdings are, the turnover within the fund itself, the risk and return vs category, how long the managers have been there and what their philosophy is, what are some of the key things you’d look for before settling on a fund?
3) I’ve compared the 1 yr, 5 yr, 10 yr and Since inception returns of the funds. Many funds have returned 7-9% while some are well into the 10% and even 11% range. Would you put any stock (no pun intended) in those numbers when comparing and contrasting funds? Are these funds even worth looking into when an Index fund, through Vanguard for example, matches virtually every move the S&P 500 has made, returning the same 10.33% without the commission charge and SIGNIFICANTLY lower expense ratio (0.04%!!!)?
4) And, of course, is 1 fund enough, or would you explore the idea of having several?
Thank you for being willing to even read through this! Hopefully I haven’t strayed TOO far away from the simple approach I’ve attempted to internalize with your teachings.

–Paul F, Boston, MA


Dear Paul,

All great questions, I’ll take them one at a time

1. Front-end Load, Back-end Load – From my (consumer-driven, not industry-driven) perspective, these are all terrible, terrible fees and should be avoided. Never get a fund with them. Basically unconscionable. Can’t justify them at all. Only reason to pay these is if you are totally captive to an employer-sponsored plan and you have no choice of a no-load fund. If you are setting up your own investment plan, just eliminate them entirely.
Keep-it-simpleOn the other hand, from an industry (sales-driven) perspective, load funds are great. Makes the salesperson rich at the direct expense of the investor.
About the annual Expense Ratio…at this point 1% is kind of the industry marker. Less than 1% is a reasonable deal for an actively managed fund, over 1% is a little pricey for an actively managed fund. As I say in Ch.14 of my book, I don’t actually think paying for active management makes sense, but if you really want it then 1% is kind of the inflection point between cheap and expensive.
And finally, you are NOT overstating the importance of these numbers. They are – especially in the long run – the absolute key to not turning over between 20% and 50% of your lifetime investment gains to your investment managers. That’s not an exaggeration, its just math you can model out in a spreadsheet.
2. Fund factors to look for – For me (my big bias) the expense ratio is the #1 consideration. After that, of course you want to understand how active versus passive they are (my bias is for passive), how quick turnover is (my bias is for low turnover as it reduces costs and increases tax efficiency), how concentrated they are within the asset class (a case can be made for either diversification or concentration, depending on your overall goals and the rest of your investment plan), where it is in the risk spectrum (for a 20-something person I think you want to maximize risk in all long-term holdings. I still do and I’m in my mid-40s, and I will continue to maximize risk for my whole life, but that’s my bias for all my investments).

3. Time Horizon – For comparing returns, the 10 year and longest time horizons are the only relevant data points. I would ignore 1 to 5 year returns as essentially noise, since the right investment horizon is decades. If the manager is consistent in strategy, the long-term return will be what that particular market sector offers in the long run, which is all I’m looking for in an investment manager.

4. On Number of Funds – I’ll suggest a book for further reading by a guy I like: Lars Kroijer “Investing Demystified.” He doesn’t agree with me on my “risk maximization” point, but he and I agree on the efficient market hypothesis as a good starting point for most people. The reason I bring him up is he makes a case for owning a single “All World Markets” fund, which should be available from major discount brokers. After reading Kroijer you’d have a better sense of how many funds you’ll need. Whether just 1, or more.

As for me, I have just 3 funds in my 401K retirement account. All 3 are 100% equities:
1. US Small Cap,
2. Non-US Developed markets (Europe, Japan, NZ), and
3. an Emerging markets fund
I’m pretty happy with that and will probably never change it. Maybe I’ll re-balance once in a while if one starts to get too big relative to the others. But again, Kroijer’s book will probably explain well why that view makes sense to me.
I hope that helps!

Please see related posts

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  1. Not sure about your math there, but OK

ETFs vs. Mutual Funds

etf_v_mutual_fundMutual funds and exchange traded funds (ETFs) do pretty much the same thing, which is allow an investor, with a single purchase, to own a diverse pool of assets – usually stocks or bonds, but also sometimes commodities, currencies, futures, bank loans or other financial exotics.

Since they mostly do the same thing, the most interesting question is usually not “mutual fund vs. ETF?” but rather a question about “asset allocation” – that is, what things you actually own within an ETF or mutual fund.

Asset Allocation

I wrote a few months ago what I consider to be the final word on the asset allocation question. To repeat:

“You should invest via dollar-cost averaging in no-load, low-cost, diversified, 100 percent equity index mutual funds, and never sell. Ninety-five percent of you should do that, 95 percent of the time, with 95 percent of your investible assets.”

What about ETFs?

You probably noticed I said ‘mutual funds,’ not ETFs. Well, 95% of the time you could substitute ETF for mutual fund and get the same result.

The rest of this column is about the 5% of the time when it makes a difference. The factors that make up that 5% include timing, minimum investment amounts, costs, liquidity, and availability of assets.


I like to call ETFs “mutual funds with ADHD” because you can trade them at any time of the day that markets are open, including multiple times a day if you like. This contrasts with mutual funds, which you can only buy or sell based on the end-of-day price, after the 4pm market close.

This feature of ETFs is not an advantage from my perspective. Since the right holding period for investing in stock markets is somewhere between 5 years and forever, the ability to trade in the middle of any day, for an individual, should be wholly irrelevant.

Minimum Investment

Some mutual funds and some mutual fund companies require a minimum investment such as $10,000, or $5,000, or $2,500. Or, different prices apply for different minimum investments. ETFs, by contrast, often can be purchased for as little as $100.


As a result, for newbie investors with their first $500 or $1000, ETFs can be the first step needed to get ‘in the market.’ Which is nice.


ETFs and mutual funds come in both high cost and low cost varieties.[1] For myself, I almost always seek out the low cost flavor, which tend to be in ‘passive’ or ‘index’ funds, rather than ‘active’ or ‘managed’ funds.

Vanguard – the giant brokerage and mutual fund company – reports that among ‘active’ strategies the average ETF is cheaper than the average mutual fund. Among ‘passive’ strategies, however, the average mutual fund is cheaper than the average ETF.[2]

The key to understanding your costs, of course, is to go beyond the ‘average,’ and to actually figure out the specific cost of any mutual fund or ETF you’re thinking of buying. Depending on the size of your portfolio and the time you have to invest, minimizing management fees will save you tens to hundreds of thousands of dollars over your lifetime.

So, it’s worth taking those five extra minutes and figuring out the fees, for a return on your time spent of, like, infinity.

Finally, depending on your brokerage company, purchasing some funds and ETF may incur ‘loads’ when you buy, and transactions costs when you buy and sell. Naturally, avoid if possible.


ETFs appear at first to offer better liquidity than mutual funds, because of the moment-to-moment prices for trading ETFs, rather than the once-a-day price of mutual funds. That kind of liquidity advantage, however, should be irrelevant, since your investment holding period ought to be measured in years, not hours or minutes.

In another sense, however, ETFs may in certain cases be less liquid than mutual funds. As you move on the spectrum from plain vanilla to more exotic ETFs, it’s possible that the illiquidity of the underlying assets raises the cost of transacting in ETFs.

During this past August’s market turmoil, for example, traders reported that certain ETFs in relatively illiquid assets such as bank loans or corporate bonds mispriced during the trading day.

As an individual investor, you should assume the ‘mispricing’ will not be in your favor in these situations. Market makers will raise the cost for investors of getting in and out of these illiquid ETFs through a larger wider gap between the price you can buy or sell the ETF, known as the ‘bid-ask spread.’

Availability of assets

Some brokerage or mutual fund companies where you do your investing may have a better inventory of products in ETFs versus mutual funds – or vice versa – making it necessary to buy one rather than the other. Because most of the time mutual funds and ETFs in the same assets do the same things, normally you can substitute one for the other without worry.

As always, the choice of ‘asset allocation’ – what underlying things you’re buying – matters more than the packaging, whether wrapped in an ETF or a mutual fund.


[1] To give you a benchmark for high or low costs, some active mutual funds and ETFs charge 1.5% fees or more, while some passive mutual funds and ETFs charge 0.15% fees or less. That’s an order of magnitude of ten times the cost between the low and high cost varieties.


[2] The average index ETF charges a 0.29% management fee, while the average index mutual fund charges a 0.14% fee. So index mutual funds are cheaper, on average, than index ETFs. The average actively managed ETF charged a 0.62% fee, while the average actively managed mutual fund charges 0.80%. So actively managed ETFs are cheaper than actively managed mutual funds, on average. Source: Vanguard webinar on ETFs v. mutual funds.


A version of this appeared in the San Antonio Express News



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More On Actively Managed Equity Mutual Funds

Lately I’ve taken to saying boldly and loudly to anyone who asks my opinion (and some who don’t!) that every academic study ever done on actively managed (high cost) mutual funds vs. passively managed index (low cost) mutual funds shows that, in aggregate, the actively managed funds under-perform the passively managed funds by approximately the difference in fees charged by actively managed funds.


That’s the central and ongoing conclusion of not just the first edition of Burton Malkiel’s A Random Walk Down Wall Street, but every updated edition since the book first appeared in 1973. Although Malkiel’s view has won the academic battle, still the combined marketing heft of the actively managed mutual fund industry has not yet conceded the war.

Investment strategist and  and nationally syndicated columnist Scott Burns of Asset Builder – points out in this post yet another important article debunking the usefulness of actively managed mutual funds, when compared to their admittedly doughty but nevertheless more profitable younger siblings, index mutual funds.

If you’re curious to dip your toe into these ideas, I recommend starting with Scott Burns’ post, then move on to the article itself.

Please see related posts:

Book Review of A Random Walk Down Wall Street, by Burton Malkiel

Book Review of Investing Demystified by Lars Kroijer


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Book Review: A Random Walk Down Wall Street

First published forty years ago, A Random Walk Down Wall Street by Burton G. Malkiel is one of those books – much like Benjamin Graham’s The Intelligent Investor – more referred to than actually read.

Malkiel’s central thesis – that equity markets are so efficient at pricing stocks relative to their risk that the vast majority of investors would do best to buy an index mutual fund rather than invest in individual stocks or buy an actively managed mutual fund – has utterly demolished the other side in the battle of investment ideas, even if the war of investment ideas rages on in the world, oblivious to the total intellectual victory of one side.

Since a majority of individual equity investors – in addition to institutional investors – do not yet embrace in practice the Random Walk’s Efficient Market Hypothesis, more should probably read this book to realize that the battle has already been decided.

Lately it does feel as if the tide is turning – as both more individuals and more institutions realize that although some individuals and some managers may ‘beat the market’ some of the time, few managers beat the market often enough to justify their fees. And further, that even if some managers did regularly beat the market in the past, it’s quite difficult to know in advance which ones will beat the market in the future. The resulting logical choice that more and more people make – despite the extraordinary marketing efforts of the Financial Infotainment Industrial Complex – is to purchase index funds.

 A Random Walk‘s impact

How important is Burton Malkiel and his book? One measure of his book’s impact is the index mutual fund industry.

At the publication of the first edition of A Random Walk in 1973, the ‘index fund’ did not yet exist, and instead was something Malkiel mused about:

“What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out, ‘You can’t buy the averages.’ Its time the public could”

Shortly thereafter, John Bogle at Vanguard proposed the creation of the S&P 500 index, which became available to the general public in 1976. Malkiel became a director at Vanguard fund and may take considerable credit for the intellectual authorship of this superior idea.

The Tide is Turning

After reading Malkiel’s A Random Walk, I was fascinated to learn about the following shifts in the mutual fund landscape in favor of indexing:

For eight years in a row leading up to 2013, domestic (US) actively managed equity funds experienced net outflows, while domestic index funds experienced inflows.

Steady Growth of Index Fund Investing. Source: icifactbook.org

Of the $167 Billion in net new money invested in mutual funds1 in 2013, $114 Billion went to index mutual funds.

As a result of these trends, equity index funds, as a share of all equity mutual funds, has hit a high of 18.4% in 2013, up in a steady increase almost every year from just 9.5% in 2000.

Malkiel’s book does not explain all of this shift, nor did it cause it, but it has provided the popular intellectual justification behind the investment of hundreds of Billions of dollars per year. That’s a pretty cool legacy that should at least be added to his Wikipedia page or something.

Great writing

Malkiel carefully navigates that difficult ridge line between technical writing that includes academic research, including probabilities and statistical methods, and fundamental security analysis – upon which he bases his ideas – and popular interpretations and advice for the average investor.

While stock prices may be random, his writing is anything but random. He’s careful and logical and subtly funny too.

I expected the academic case for the Efficient Market Hypothesis – for which A Random Walk is most famous – but I am pleasantly surprised at how practical, accessible and prescriptive the rest of the book is on constructing an individual’s investment portfolio.

How to value stocks – two ways

Malkiel posits two ways to determine the value for any stock.

Fundamental valueBenjamin Graham in The Intelligent Investor taught us the theory and technique for determining the fundamental value of securities.

In plainest terms, you have to determine all of the future cash flows of a security, and then apply the discounted cash flows formula to determine the present value of all future cash flows. The sum of all discounted cash flows equals the fundamental value of a security.

The great thing about this technique is that you can know the actual worth of a stock, for example.2

Furthermore, asset prices periodically revert back to fundamental values, so if you can do this technique you can know in a sense where prices are headed, at some point in the future.

Many investors – including probably the majority of mutual fund portfolio managers, Wall Street analysts, and stock-picking hedge fund managers – employ fundamental valuation techniques when selecting stocks. Certain bottom-up investors, also known as value investors, believe that they can achieve impressive results using fundamental valuation techniques.

This guy has practiced fundamental investing pretty successfully

Graham’s most famous student Warren Buffet seems to have done pretty well using this technique.

The terrible thing about this technique is that:

a)    Its incredibly hard – ok it’s impossible – to actually know what all future cash flows of a stock will be – so we end up adopting models of the future that include substantial guesswork about earnings growth (or shrinkage);

b)   The appropriate mathematical discount rate for determining the present value of all future cash flows is also always an estimate, introducing a further element of imprecision to what appeared at first to be a precise process, and;

c)    Market prices can remain widely divergent – above and below – from fundamental value for long periods of time. “The market can remain irrational longer than you can remain solvent” is an old Wall Street phrase that captures just this type of problem with fundamental analysis. It’s an unfortunate but true statement that sentiment and irrational factors – the eternal struggle between fear and greed – and technical factors such as the ebb and flow of investment funds – can set the price of stocks far away from fundamental value for long periods of time.

So fundamental value techniques, explained by Malkiel as well as critiqued by Malkiel, are a commonly used technique but not a panacea for stock market investing.

Investor Sentiment – Malkiel credits Economist John Maynard Keynes as an early proponent of the truism that the combined madness and wisdom crowds – also known as investor sentiment – can carry along the price of individual stocks as well as the general level of the market, irrespective of fundamental value. Believers in the theory of investor sentiment may invest with the idea that they can anticipate future interest in a stock or in the market by understanding investing crowd psychology.

When it comes time to sell, the price of a stock will be buoyed by other believers in the ‘story’ of the stock or the market, willing to buy in at the same or higher prices. Even for fundamental value investors, an owner in equities has to depend to some extent on the future participation of others in order to receive value in the secondary market for any shares sold.

This is sometime described by the shorthand phrase ‘The Greater Fool’ theory of investing. Meaning, I don’t necessarily need to know anything about a stock’s fundamentals as long as a Greater Fool than me is willing to buy my shares when I want to sell.

The great thing about ‘investor sentiment’ investing – which by the way I would posit 99.5% of all individual investors depend on much more than fundamental value investing – is that you don’t need to do much homework or heavy math. Just get a ‘feel’ for the direction of the market or the ‘story’ of the stock, and away you go. Again, this is basically how everyone invests in stocks in practice.

I mean, do you know any non-professional stock investors who model out all future cash flows and then apply an appropriate discount to obtain a present value? No? Me neither.

The problem with investing largely on this theory, however, should be obvious for a number of reasons:

a)    While irrational exuberance (and its evil twin “irrational lugubriousness”3) can dominate for some time, it’s a ridiculously blind way to invest. We all do it of course, but we’re blind. And we should acknowledge our blindness in advance.

b)   Bubbles grow out of Greater Fool theory investing, and the end of bubbles is always ugly and painful.

c)    Sentiment can and does change much faster than fundamentals, adding unwarranted volatility to markets as well as possibly to unwarranted activity in our own investing. We humans change our minds twice a day before breakfast and four times on Thursdays. That kind of volatility of sentiment tends to hurt our investment portfolios.

Financial bubbles arise from ‘investor sentiment’ investing

So which way of investing is right? Neither!

As investors we often adhere – at least in theory – to one of these two methods.4 But neither tends to serve us well, or well enough, to achieve an edge over any other investors.

Malkiel advances the Solomonaic wisdom5 that both theories are right, and both are wrong.

Certainly both fundamental value and investor sentiment do determine market prices in a confusing, seemingly random, combination. The problem is that with most stocks we compete with hundreds, thousands, or tens of thousands of extremely smart and knowledgeable investors. With so much competition to achieve the best returns for our capital, we rarely have the chance to outguess others in a profitable way.

We try and try, but as Malkiel’s and others’ academic research has shown, precious few professionals can achieve a better result than the market as a whole. As individuals we have even less chance to outperform than the professionals.

‘Tis The Gift To Be Simple

tis the gift to be simple

Malkiel’s famous conclusion in A Random Walk is that most people would do best by trying to simply earn the market returns of the broad market – rather than attempt vainly to ‘beat’ the market.

As the old Shaker dance goes, ‘tis the gift to be simple, ‘tis a gift to be free. The modest, simple, low-cost index fund beats managed funds most of the time, and it also beats an overwhelming majority of actively managed funds over extended periods of time.


Since all mutual funds in aggregate are made up of the entire market, logically the aggregate returns of all mutual funds will reflect the aggregate returns of the entire market. Roughly half will ‘beat the market’ in any given year, and roughly half will underperform the market. However, past performance – as the clichéd disclosure goes – does not predict future results.

With each successive year you compare actively managed mutual funds to market returns, fewer and fewer actually ‘beat the market.’

In practice this is what academic studies confirm, except for the fact that actively managed mutual funds tend to lag, in aggregate, market returns by approximately the fees they charge. Which fees tend to range from 0.75 to 1.5% of assets.

Index mutual funds by contrast tend to charge 0.1% to 0.35% fees and so tend to underperform their respective markets by a much smaller amount.

Forty years later, hundreds of billions of dollars flow into index mutual funds annually, in large part due to Malkiel’s popular presentation of these simple ideas.


Final thoughts and caveats on index investing

S&P500 not entirely diversified

About one third of all indexed investment money currently resides in S&P 500 index mutual funds. The S&P 500 Index consists of the largest 500 US companies, which make up 75% of total stock market value in the United States. As such, this index serves pretty well as a proxy for market exposure, but investors should understand that it consists of only large companies and only US-based companies.

S&P500 share of Index Funds. Source: ICIFactbook.org

Investors in the most popular index fund do not get the diversification of ‘mid-cap’ or ‘small cap’ companies, many of which may ‘beat the market’ in any given year or even long period of years. Furthermore, some research suggests that smaller capitalization stocks may outperform larger capitalization stocks in the long run. This may be because smaller companies appropriately offer higher returns because they are smaller and possibly inherently riskier. I don’t think the research is definitive on this point, but at the very least investors in the S&P 500 should know that they’re only getting exposure to 75% of the US stock market, and only the biggest companies.

Perhaps more importantly, investors in the S&P500 index forgo exposure to the majority of public companies – approximately 60% – that are not listed on the US stock exchanges. S&P500 index investors miss direct exposure to the public companies of Europe, Japan, Australia, Africa, Latin America, China, and India – any of which may ‘beat the market’ represented by large cap US companies. Of course, equity markets are linked and responsive to one another, and the largest US public companies have extraordinary exposure to non-US growth, but the effects are indirect. S&P 500 index investors should know they are not as geographically diverse as they could, and probably should be.

Author Lars Kroijer argues in his book Investing Demystified, persuasively I think, that the logical approach for someone who embraces the Efficient Market Hypothesis of A Random Walk is to invest in an ‘all world equities’ index. This product exists, and offers a cheap, maximally diversified way to wholly embrace Malkiel’s approach.

Market-weighting indexes have drawbacks

The next problem with the S&P 500 index is that it is designed as a market-weighted index, meaning investors get their money allocated to the component stocks of the index in their current market-capitalizations proportion.

Here’s the problem with that. If Apple Inc makes up 3% of the S&P 500 index, and investor sentiment pushes up the value of Apple shares when the iShoe gets announced, such that the weighting of Apple becomes 3.1% of the largest 500 companies in the US, then index funds are forced to buy more Apple, to remain in line with market-weightings.

Admit it. You would totally buy the iShoe

This type of forced buying acts to further push up shares of Apple. A self-reinforcing market mechanism – when buying forces more buying – creates a troubling feedback loop that probably pushes the stock away from fundamental value and possibly creates opportunities for non-indexed money to take advantage of index money.

Its not terribly hard to see how the largest capitalization stocks could be pushed to prices higher than fundamentally warranted as a result of too much S&P 500 index money for example, which would tend to dampen returns for investors in the largest capitalization stocks.6

As Malkiel describes repeatedly throughout A Random Walk, certain smart investments cease to be as smart when everybody does them. The success of the S&P 500 index mutual funds in particular may make future investing in the S&P 500 index less attractive for the purposes of achieving broad market returns.

In this case a simple solution is to diversify into a broader market index like the Wilshire 5000, or the kind of total world equities index advocated by Kroijer.

a random walk

Please see related post, All Bankers Anonymous book reviews in one place!

Please see related book reviews:

The Intelligent Investor Benjamin Graham

The Signal and The Noise by Nate Silver

Investing Demystified by Lars Kroijer

And related posts:

Nate Silver on the Efficient Market Hypothesis

Lars Kroijer on Agnosticism over Edge



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  1. Defined by the report as “new fund sales less redemptions combined with net exchanges”
  2.  Or annuities, private companies, bonds, longevity insurance, oil and gas leases, or income-generating real estate. If a financial instrument has cash flow, this is the way to value it. By the way, as a side note, how do I know gold isn’t a real investment? No cash flow.
  3. Thank you. Thank you very much. In the future, when I am Fed Chairman, I will just whip that phrase out during a Great Recession to show how the market is excessively pessimistic and stocks are about to soar. Then later I will have it trademarked. Who wouldn’t buy my next book titled ‘irrational lugubriousness?’ It has a nice ring to it.
  4.  In practice, as I mentioned before, 99.5% of all individuals just punt with the investor sentiment method.
  5. By that I mean: Split the baby in half, leaving nobody happy.
  6. That, Alanis, is a much better example of irony than the proverbial black fly in the Chardonnay, which is really just an example of something that’s kind of a bummer.

The Giffen Good Concept Applied To Investments

Editor’s Note: A version of this post appeared in the San Antonio Express News “So…Money” column.

The only “C” I got in college was in Intermediate Macroeconomics, but I remember one economics term that I really loved — the “Giffen Good.”

With ordinary, rational, economic behavior, we expect that when prices go up, people buy less, and when prices go down, people buy more. We buy more things, for example, at Wal-Mart and Costco because of their low prices. We buy fewer things at Nordstrom because of their higher prices. Makes sense, right?

Sir Robert Giffen

A Giffen Good — named for a 19th Century Scottish economist named Sir Robert Giffen — is an odd thing. It’s something that people buy more of as the price goes up. With a Giffen Good, people act in exactly the opposite way we would normally expect them to in response to the price of things.

When you look up Giffen Good in Wikipedia — as I just did to refresh my memory — you read that little evidence exists for Giffen Goods in the real world, and people do not generally purchase more of something when the price goes up.

When it comes to our investments, however, I totally disagree with Wikipedia.

Ever since learning about Giffen Goods, I see them everywhere, as well as what’s known by analogy as “Giffen Behavior.”
Outside of the investing world, I remember reading with much interest the story of a guy trying to get rid of his mattress. He posted a “Free Mattress, Used” notice on Craig’s List, and got no responses. When he posted “Mattress, used, just $10,” he had to turn away interested buyers who lined up with their trucks to try to take advantage of a great bargain. That’s a Giffen Good.
Here’s an example of a Giffen Good from the art world: Imagine if I landed on Earth knowing nothing about art and somebody offered me the Edvard Munch painting “The Scream” for $1,000 to hang in my living room.

I’d offer you $75 for this, because I love a bargain.

I don’t know about you, but I might just think, “Whoa, that’s kind of a lot of money, and although there’s something neat about the painting, it’s still a bit creepy.”
And then I might think, “How about I give you $75 for it?” Because I love a bargain.

Of course, knowing that somebody else paid $120 million for it last year changes its attractiveness to me. Would I sell every single one of my worldly possessions right now to own “The Scream?”

Duh. I’m a finance guy. Of course I would. That painting is the ultimate Giffen Good.

Shifting from the absurd to the irrelevant, a concept like Bitcoin suddenly became everybody’s most desired tulip bulb last year when the price starting shooting upward, making it the Giffen Good of 2013.

And now lets return to the core of ordinary investment behavior: Discretionarily-managed equity mutual funds typically charge 0.75 to 1.5 percent management fees, while equity index mutual funds typically charge one-third of that amount in management fees, despite offering the same long-term results, according to every academic study that’s ever been done. Like, ever.

Most investors figure — wrongly — that if the fees on the discretionarily managed equity funds are higher, they must be a better product. The lower-priced index mutual funds just seem less attractive. That’s a Giffen Good.

In fact, much of the time, the entire stock market is an example of a Giffen Good. We really don’t want to own stocks when they fall in price. On the other hand, we really, really, really get interested in stocks after they’ve jumped 10 to 15 percent a year for a couple years in a row. This is madness, of course, but it’s also exactly what drives much investing activity.

Most of the time, indexing wins

Beware of your own Giffen Behavior.

Final note: Real, live economists reading this may object to my imprecise adaptation of an economic term for the popular illustration of a personal finance concept. In anticipation of their objection, I can only show them my previously mentioned “C” on my college transcript. Also, lighten up, dismal scientists.


Please see related post: Guest Post by Lars Kroijer – Agnosticism over Edge

A book review of Investing Demystified by Lars Kroijer


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