The other day, I was trying to explain to a friend why I invest in index funds. I came up with this example, which I’m not sure is perfect but I thought I’d share it.

Background: Market Cap Indexes
When you hear “index funds”, it traditionally means mutual funds that follow an index which holds companies proportionally to their market capitalization. If a company has 1,000,000 shares and each share is trading at $25, then its total market capitalization is $25 million.

Let’s take the S&P 500 Index. The market cap of Starbucks (SBUX) is $14 billion dollars, while Exxon Mobil (XOM) is worth $334 billion. So an index fund tracking the S&P 500 would hold 24 times as much Exxon as Starbucks.

The index fund is “passively managed” in that it does not make any of its own decisions on the value of each company, it simply accepts the value of the each company as determined by each day’s market trading between millions of investors.

An Alternate Universe

Let’s imagine an alternate universe where we only have two companies, AAA and ZZZ, that make widgets, the one thing people there buy. Both have a million shares outstanding. Company AAA makes widgets and has earnings of $1 million a year. It’s been around a while and is fairly boring, so the price/earnings ratio is 10, making the market cap $10 million. Thus, each share is worth $10.

Company ZZZ also makes widgets and has earning of only $500,000 per year. But it’s newer and makes stylish widgets that attract young people. People seem to think it has greater potential for earnings growth, so the P/E ratio is 20. Thus, the market share is also $10 million, or $10 per share.

An index fund is created to track this alternate universe, and based on market-cap it holds 50% AAA and 50% ZZZ.

So what happens in the future?

Scenario #1
ZZZ could keep taking market share from AAA with their cool and stylish widgets. AAA’s earnings go down to $500,000, and the P/E stays constant at 10, leading to a new market cap of $5m. ZZZ starts earning $1,000,000 per year, and with a P/E of 20 grows to a market cap of $20m.

What happens to the shares in your index fund? Nothing. No trades are made, because only the share values have changed. You hold the same number of shares of each. However, your fund’s value has grown 25% because the value of ZZZ has doubled, while the value of AAA has been cut in half. Your holdings based on market value are now 20% AAA and 80% ZZZ.

Scenario #2
Things are going along, but then a new medical study finds that ZZZ’s widgets cause cancer, and it turns out the CEOs have been covering this up for years. ZZZ tanks, and is now trading at a penny per share, while everyone is switching to AAA’s reliable widgets. AAA goes up to a market cap of $25m ($25 per share).

What happens to the shares in your index fund? Still nothing, even though you now own 99.96% AAA. Meanwhile, your fund has grown another 20% because of AAA’s growth, even with ZZZ’s collapse.

Summary
You don’t know what is going to happen in the future. There are a million different possible scenarios I could have chosen. AAA could have split off a small division called BBB and it could have taken over the world. The most important point is, whatever happens, with a market-cap index fund, you are guaranteed to own all the winners.

You’ll also have owned the losers, but remember you won’t know who they are beforehand. Buggy whip manufacturers used to be huge. Now, iPhone-making companies are growing. One day iPhones will be in landfills, and we’ll be onto downloading knowledge directly into our brains or something. Or maybe we’ll run out of oil and be back to buggy whips. Who knows.

“Don’t look for the needle in the haystack. Just buy the haystack.” – John C. Bogle

This is the power of passively-managed index funds. With low-cost index funds, you’ll even be guaranteed to beat the average investors’ performance because of investment expenses eating into their return.

In the wake of the recent stock market drops, there has been a increased amount of interest in certain market timing systems that would have told an investor to be “out” of the market during late 2008 and early 2009. Below are a sample of the more popular mechanical systems, which have clear parameters and are easy to follow using basic investing tools.

100-Day Moving Average (FundAdvice.com)
FundAdvice.com is run by Merriman Capital, which provides money management services using both buy-and-hold and market timing models. I’ve mentioned them before for their index fund model portfolios and the related “Ultimate” Buy-and-Hold Portfolio. The website has an entire market timing section, and I am specifically referencing the articles here and here from 2001 and 2002.

Merriman recommends something called the 100-day moving average. For any given asset or mutual fund, you calculate the average of the most recent 100 days of closing prices. Each day, you’ll have a new average by adding the newest price and dropping the oldest price from the average. Then, you compare the current price of the fund with this simple moving average (SMA).

Each day the market is open, if the current price is above the 100-day SMA, you should buy the fund or hold it if you already own it. If the current price is below the 100-day SMA, sell it. After you sell, place your proceeds in cash (money market fund) until the fund price is once again above the average.

200-Day Moving Average (Faber)
The 2006 paper A Quantitative Approach to Tactical Asset Allocation by Mebane Faber explores a very similar but even simpler mechanical system. Here you take the 200-day simple moving average of any index, for example the S&P 500. But this time, you only calculate this at the end of each month. If the current price is greater than the 200-day SMA, then you buy. If the current price is less than the 200-day SMA, then you sell and move to cash (90-day T-Bills). This results in some impressive backtested results, but with much fewer trades than other systems.

By the way, you can track the 100-day and 200-day SMAs easily using most stock quote websites like Yahoo Finance. Here’s the chart for the S&P 500:

As you can see where the S&P 500 is below the green and red lines, you would have been told to “sell” and stay in cash during some of the big drops.

10-Year Trailing Average P/E Ratio (Shiller)
Prof. Shiller of Yale University is well-known for his book Irrational Exuberance. From Wikipedia: “Published at the height of the dot-com boom, it put forth several arguments demonstrating how the stock markets were overvalued at the time. Shiller was soon proven right when the Nasdaq peaked on the very month of the book’s publication, and the stock markets collapsed right after.”

Part of his argument was based on historical price-to-earning ratios, or P/E ratios. This indicator went throw some iterations and became known as PE10, which takes the current price of the S&P 500 and divides it by the average inflation-adjusted earnings for the past 10 years. Essentially, it is a 10-year moving average of the P/E ratio. If the current P/E ratio is significantly higher than the 10-year average, the market is overvalued.

You can find updated numbers and more at his Yale website.

Warnings about Market Timing
I haven’t taken the time to deeply analyze any of these systems, I am only presenting them here for debate. However, I think I should throw out a few quick warnings.

Depending on which stock market index you track, and the time period you track, all of the methods above reduce risk (volatility) without significantly reducing overall returns as compared to buy-and-hold. However, there have also been long stretches where timing underperformed buy-and-hold, which can make it a hard strategy to implement over the long run. The main reason we are talking about them now is only due to recent hot performance. In addition, market timing requires regular attention to stock market activity, increased trading costs, and tends to be much less tax-efficient.

Even Merriman states: “we have concluded that relatively few investors have the tenacity, discipline and faith required to be successful market timers.” But perhaps the same is true for Buy-and-Hold? It is possible that these market timing systems will outperform in the future as well. Or they may not, and you’ll be jumping in only after a recent hot run. I don’t have a well-composed argument either way right now, but I can say that I currently am not using any of the above systems.

With money market fund and savings account yields still pitifully low, it is very tempting to look for investments with higher yields. Indeed, the personal finance magazines know this all too well, dangling teasers on their covers like:

• Stocks That Pay 8% (Kiplinger’s Personal Finance, Oct 2008)
• How to Get 8% on Your Money (SmartMoney, Dec 2008)
• Grab These Bonds For 10% Yields (SmartMoney, Feb 2009)
• Stocks That Pay You 5% Or More (Kiplinger’s Personal Finance, Feb 2009)

I know that they need to attract casual readers to buy their issues off the crowded magazine rack, but I fear that these articles can hurt readers by focusing primarily on yields.

From tankers to pipelines to real estate stocks, we’ve uncovered the investments with the best yields.

Stock dividends and bond yields are certainly a very important component of return. But with such significantly higher yields, the real question should be why the yields are high, as there is definitely higher risk. If your investment spits out 5%, but the actual investment decreases in value by 5%, um… you don’t make any money. You would have made more money at a bank. And if it does worse…

“Earn 8% or More” becomes “Earn 8% or a LOT LESS”
I bring this up because I was just reading the June 2009 issue of Kiplinger’s with an article entitled (surprise!) Where to Find Top Yields. But as I read, they first meekly admit that their last “yieldfest” article missed the mark. So I found it, and did a little before-and-after comparsion:

In Earn 8% or More (July 2008), they wrote:

Shares of First Industrial Realty trust (FR), a national developer and operator of warehouses and light industrial buildings, more than doubled between November 2002 and November 2006 but have since fallen 33%, to $30, over concerns about flat rents and the firm’s high debt. The stock trades below First Industrial’s net asset value per share and pays 10%, one of the highest yields among long-established REITs. There is still ample cash flow to maintain dividends.

Pays 10% yield, ample cash flow, a long-established REIT. Almost sounds stodgy and safe. Fast forward to June 2009:

Credit-market chaos wreaked havoc with the recommendations in our previous “yieldfest”. Our best picks, emerging-markets bond funds such as Fidelity New Markets Income and Pimco Emerging Markets Bond, dropped about 10% over the past year through April 9. Pipeline stocks, such as Kinder Morgan Energy, also held up reasonably well. But we had our share of disasters. For example, First Industrial Realty Trust cratered by nearly 90%, while Genco Shipping & Trading dived 73%.

Their best picks still dropped 10%? Most were in the disaster category. Another pick from July 2008:

For example, look at First Trust Strategic High Income (symbol FHI), which borrows to invest in bank loans, mortgage-related securities and junk bonds. Its share price plunged from $20 in early 2007 to less than $10.50 eight months later, as its underlying assets fell victim to the credit crunch and the real estate recession. But the shares have rebounded to $12.25, and the fund’s net asset value per share, now $10.38, has stopped crumbling (unless otherwise noted, all figures are to May 12).

But even as the fund was collapsing, it kept paying out 16 cents a month. Based on the current share price, the payout (which doesn’t require borrowed money or represent a return of capital) comes to a yield of 15%. We generally don’t recommend closed-end funds selling at 18% premiums to NAV, but First Trust’s yield is too luscious to pass up.

From a share price of $12.25 at the time of recommendation, the share price of FHI as of 7/13/09 was $3.38. Including those “luscious” dividends, the 1-year total annualized return was -57.3%

They also neglected to mention the fact that FHI has management fees of 2.21% plus “other fees” of 2.11% for total annual expense ratio of 4.32%. Ouch.

Both of these are extreme examples, but an important lesson can be learned by reading the entire 2008 article first, and then reading the 2009 article. The story is always very convincing. You’ll get high yields, historical stability, and some sort of reason why things are looking up. It will be tempting. But remember, this part of your $5 magazine is selling sizzle, and won’t reimburse your losses when there’s no steak.

* p.s. Don’t get me wrong, I don’t think that these magazines are all bad. They often have very useful articles, which I read and link to regularly. I am a paying subscriber, after all. However, I do think that these “yieldfest” articles are written primarily to increase their own revenue, not the investment returns of their readers.

In a recent Money magazine article about ETF Investing, there is a nice illustration of a simple and diversified portfolio made entirely of ETFs by author/money manager Rick Ferri:

Put simply, ETFs are essentially mutual funds that trade like stocks. (Note the ticker symbols included above.) Hence the name Exchange Traded Funds! You tend to get lower annual expense ratios than mutual funds, but you must also pay a stock commission on each and every trade. They also tend be better in taxable accounts because they often don’t shed as many capital gains. Since there are now a million types of ETFs out there, it’s good to remind everyone about the great portfolio building blocks out there.

If you trade large amounts at a time or have cheap enough trades, then ETFs can be a good option. Otherwise, even $10 a trade can really add up. If you have $25,000 of total stock value, you can move your account to Zecco Trading for 10 free trades per month, or to WellsTrade (by Wells Fargo) for 100 free trades per year (special PMA checking account required).

Done this way, the total cost of this portfolio would be under $20 a year for every $10,000 invested. Less money in a broker’s or manager’s pocket means more for you.

* Update: Here are 8 more model portfolios that you can replicate with ETFs these days.