If I was an index investor

As many of you may already know, I am an active investor. However I have often asked myself what I would do if I had to switch toward a more passive, low-fees index fund approach.

I hope these few elements will bring some food for thoughts and I am happy to discuss them if you find some flaws in the reasoning.

But first, some theoretical points.

Look for quality

I believe that the most important thing for the long-term equity investor is to look for quality companies. What do I mean by quality? I mean a business that can provide a high return on capital employed, superior to its cost of capital .

It makes sense at a personal level: if I borrow money at a 10% interest rate and i can get returns at a 20%, i am getting richer. Inversely, if I borrow at 10% to get returns of 5%, I am getting poorer.

This is the same mechanism at the business level: a company create value when it earns returns above its cost of capital, and destroys value when its returns are below its cost of capital.

How do you know the cost of capital of a business? When the capital is made only of debt, it is straightforward: that is the debt’s interest rate. But of course the capital is also made of investor’s equity, who expect an adequate return. This expected adequate return is a lot more difficult to measure, and even academicians disagree about how to measure it. But at the end it does not matter: in the same way that you don’t need to know the exact weight of a person to know that he is obese, for some businesses the returns on capital are so high that you know they are way above the cost of capital:

  • Games Workshop earns a return on capital of 90%: for each dollar invested in the business, it will return $0.90. Surely this business is creating value.
  • LiveChat Software earns a return on capital of 150%.
  • MSCI and SPGI earn returns on capital way above 20%.

In each of these cases, the returns on capital are so high that we can be confident that they are way above their cost of capital: they are creating value.

Note that return on capital is really more important than the growth in Earnings Per Share (EPS). EPS growth does not tell you how much capital you needed to generate these earnings, and it is possible that the amount was so enormous that the capital would have been better used elsewhere. In a similar, diminishing outstanding shares with share buybacks (bought at fair value) will increase EPS, but not alter the value of the business. So in some cases EPS growth is good, but only if this is achieved with a high return on incremental capital.

And I am not inventing this. In its 1979 letter to shareholders, Buffett was already saying:

The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share. In our view, many businesses would be better understood by their shareholder owners, as well as the general public, if managements and financial analysts modified the primary emphasis they place upon earnings per share, and upon yearly changes in that figure.

When you put your capital in a bank account, you care about the interest rate it pays on this capital. Buying a share is buying a portion of the company’s capital, so why wouldn’t you care about the return you are earning on this share capital?

Now there is a second element to look for: our ideal business should have also room for growth at these attractive returns. If the business reinvest its high returns at the same rate of returns, you have a compounding machine . If the returns on the incremental capital are disappointing, the management team should have used these earnings elsewhere (see my other article on capital allocation).

Finally, ideally you would like to achieve those returns without too much leverage. If the business has to borrow a lot of money because the initial return on shareholder equity is not satisfying on an unlevered basis, it means that the business is not so great and could suffer badly if any unexpected accident occurs (i am looking at you, COVID).

In a nutshell, we are looking for:

  • High return on capital
  • Room for growth at attractive returns
  • Reasonable or low financial leverage

Considerations about price

This is all good, you might say, but since those businesses are earning so high a return on capital, surely their price is a reflection of this and their shares are forbiddingly expensive? Well, historical experience shows that it is not necessarily the case. As long as you do not pay a ridiculously high multiple for the business and the company keeps earning high returns, you should be fine over the long term .

Charlie Munger was saying the same when he stated:

Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.

This point is absolutely essential. If it is not clear for you, let’s look at the following example:

  • Business A earns for 40 years 20% on its capital, and keep reinvesting its capital at these returns
  • Business B earns a more modest 10% on its capital
  • Investor A buys business A with an unlucky timing: he buys at a high-ish multiple (let’s say price to book value = 4 ) and sells 40 years later at a much lower multiple of 2
  • Inversely, investor B has a much better timing: he buys business B at a low mutliple (P/B= 2 ) and sells 40 years later at P/B=4

Which investor would you prefer to be? We consider for simplification purposes that there is no dividend nor buybacks nor any raise of additional capital. Let’s also say that both businesses’ shares are trading at the beginning at a price of $100.

Well, the below table should prove Munger’s point:

Year Share Price, Company A Share Price, Company B Capital, Company A Capital, Company B
0 100 100 25 50
1 30.00 55.00
2 36.00 60.50
3 43.20 66.55
4 51.84 73.21
5 62.21 80.53
6 74.65 88.58
7 89.58 97.44
8 107.50 107.18
9 128.99 117.90
10 154.79 129.69
11 185.75 142.66
12 222.90 156.92
13 267.48 172.61
14 320.98 189.87
15 385.18 208.86
16 462.21 229.75
17 554.65 252.72
18 665.58 278.00
19 798.70 305.80
20 958.44 336.37
21 1,150.13 370.01
22 1,380.15 407.01
23 1,656.18 447.72
24 1,987.42 492.49
25 2,384.91 541.74
26 2,861.89 595.91
27 3,434.26 655.50
28 4,121.12 721.05
29 4,945.34 793.15
30 5,934.41 872.47
31 7,121.29 959.72
32 8,545.55 1,055.69
33 10,254.66 1,161.26
34 12,305.59 1,277.38
35 14,766.71 1,405.12
36 17,720.05 1,545.63
37 21,264.06 1,700.20
38 25,516.87 1,870.22
39 30,620.24 2,057.24
40 73,488.58 9,051.85 36,744.29 2,262.96

At the end, Investor A will get an annual growth rate of 17.9% with an unlucky timing, while investor B, with a superb timing, will only earn 11.9% per year. The conclusion should be clear: if you are a long-term investor, as long as you buy a good business at a multiple that is not too ridiculous, you will enjoy satisfying returns. And if you are not a long-term investor, I wonder what the hell you are doing investing in equities.

Application to indexing

Enough for the theory. How could we apply these points to passive, low-cost index funds or ETFs?

One thing that often stroke me in the past is that usually passive investors want to invest into possibly every company under the sun, by means of an index that is a broad as possible. For instance, the VT ETF follows the FTSE Global All Cap Index, which covers approximately 8’000 companies over the globe. Same thing with the MSCI World Index, which covers 1’603 companies in the developed countries. Both have been returning around 7% per annum over the long term.

In my view, such an approach is guaranteed to cover a lot of good businesses, but will also invest in heaps and heaps of mediocre and degrading companies.

I get the point of diversification: we would like to spread our money over enough companies so that the failure of one particular firm is not threatening our portfolio. But if we invest in so many mediocre companies, is it not detrimental as well to our portfolio?

It is a bit like the wolf saying to the three little pigs: “Sure, you can have the brick house, but how about those two very nice straw and stick houses?”

I would like to improve this endeavor, not by adding as many stocks as possible, but by using the via negativa concept of Nassim Taleb: to improve something, ask not what to add, but what to withdraw.

What I would like to withdraw from these global indices is clear: the mountains of mediocre businesses that do not earn enough returns on the capital they employ. Couldn’t we find a new index such that:

  • There are more than enough companies making the index so that we benefit from diversification.
  • The companies making the index are all weighting on the quality side, which means:
    • A high return on capital
    • Some room for growth at attractive returns
    • No excessive financial leverage

Well, it turns out that such an index exists: it is the MSCI World Quality Index.

This index is made of 297 constituents from 23 developed countries, which provides more than enough diversification for a passive investor. Furthermore, according to the prospectus, The index aims to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.

Exactly what we are looking for! I would bet that such an index would provide a superior performance over the long term.

But theory is not worth much if it is not proven in practice. As Feynman used to say, It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong.

So how does it fare in practice? Very well, i have to say. MSCI provides data for the index since 1994 and since then (26 years, including two majors bear markets):

  • The MSCI World Quality Index has compounded at 11.3% per annum
  • The MSCI World Index has compounded at 7.53% per annum

The two indices have roughly the same dividend yields (1.73% for the MSCI World Quality Index and 2.06% for the MSCI World Index).

In other words, without counting dividends, $1’000 invested in 1994 in the MSCI World Quality Index would be worth $16’176 now, while $1’000 invested in the MSCI World Index would be worth only $6’603. This is not insignificant.

We should bear another point in mind: all of the companies making the MSCI World Quality Index are also included in the MSCI World Index. In other words, adding all the mediocre companies in the MSCI World Index creates a drag on performance of around -4%. Over the long-term, it makes a hell of a difference.

And this over-performance seems to be consistent. There might have been a few years where the MSCI World Index outperformed the MSCI World Quality Index (for instance 2016, 2012 and 2010). But there has never been a 10-years period where the MSCI World Quality Index has not beaten the MSCI World Index.

But wait a second! You might say, “Well, since this index provides consistently superior returns, then, according to the modern portfolio theory, an investor is bearing more risk while investing in it…”

I beg to differ. MSCI also provides its risk metrics for both indices, such as volatility, max drawdown, beta and Sharpe ratio, and all of them are in favour of the MSCI Quality Index. In other world, buying quality provides superior returns while bearing less risk than buying an all-world index. So much for the modern portfolio theory.

Conclusion

As I said at the beginning, I am not a passive investor as I like to hold good companies that will compound their capital at an attractive rate over the long term. But if I had to follow the passive, low-cost index funds route, I would surely invest in something akin to the MSCI World Quality Index. In the long term, quality always matter.

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Unfortunately, I have nothing worth adding to what you wrote, all make perfect sense for my small brain :), but I just wanted to say that the fact you are active on this forum is a huge advantage for it :D. Many thanks!

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The MSCI World Quality Index was launched on Dec 18, 2012. Data prior to the launch date is back-tested data (i.e. calculations of how the index might have performed over
that time period had the index existed).

So if I knew the Lotto numbers for the past years, I would be a millionaire. In the end we have only data from 8 years mega-bullrun 2012 -2020.

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Thank you Julianek, very educational for me.

So far I have only identified a single ETF covering that index: IWQU

Anyone knows of another (that is perhaps also not Acc)?

XDEQ? But also Acc

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The main idea of passive investing is that you don’t know any better than the market. Your approach would be pretty active to me.

In the long term, yes. But what about companies like Amazon or Tesla, which were (or are) unprofitable for a long time, simply because it takes a lot of time & capital to ramp up production (Tesla) or constantly invest in new industries and expand their activities (Amazon). An index will struggle to capture disruptors / growth companies, right?

Ben Felix would step in and say something like: each company is priced according to exposure to risk factors. You don’t know which company will shine. A degrading company is priced accordingly. If that’s not the case, then how come is the market so wrong?

Regarding factors, I have two points. What if high returns are a risk? Like, Apple has the iPhone, delivers strong returns, and is priced accordingly. What if suddenly people stop buying iPhones? (like what happened to Nokia)

The second point I have is this: the price is an outcome of market forces between short term, medium term and long term players. What if certain companies, that are highly likely to perform great in the long term, are underpriced because of poor current results. So they are overlooked by many investors who look for short term returns. We as mustachians should look for companies that will not cost a lot in 1 year, but in 20 years. I don’t know however, how to look for such an index.

Wow, that’s a bold claim, you’re really questioning the investing philosophy of many people. :wink: I welcome this, especially because it is well argumented and especially the chart looks impressive. Is this index a bit similar in its philosophy to Fundsmith? How can it be a passive index? Does it automatically make balancing decisions based on publicly available indicators?

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The MSCI Momentum factor takes care of this. You can think of it as a derivative of Quality. You still get all the strong compounders, because they satisfy the criteria of delivering higher returns (because of their quality) while at the same time you catch trends in companies which may not be so easy to fit in a box.

Incidentally, MSCI World Momentum and MSCI World Quality returns are quite similar in the long term with many constituents overlapping:
https://www.msci.com/documents/10199/904e031c-94e4-4dbc-a314-7c373446dffa
https://www.msci.com/documents/10199/344aa133-d8fa-4a15-b091-20a8fd024b65

I applaud Julianek for conveying this knowledge into a short and informative post.

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I’ve gotta say, I like the list of constituents of MSCI Momentum a bit more. So… do you invest in an ETF based on one of these indexes?

No, I do my momentum investing manually (actively). This is how I got to own companies such as NIO, PTON, FVRR etc. The passive momentum factor rebalances based on 6-month and 12-month returns which is relatively slow.

At the same time, disruptors are usually Small-Cap companies and by the time they get a chance to grow into Index-relevant weights and actually make a difference, the growth rates slow down.

I have to say, a passive MSCI Quality portfolio core and some active investments on the side would be a perfect combination for me.

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Thanks for the great post. Regarding the MSCI Quality, it is available at finpension via one fund. I asked VIAC if they have any plan to add it, which would be great.

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Regardless if we speak about MSCI Quality or MSCI Momentum or NASDAQ 100, what is the reason behind their ability to outperform the market? Is it sustainable? Past performance does not mean future returns. Yesterdays winners might become tomorrow’s losers.

But the crucial question is really, once again: why does the market price these assets below their value, so that even with a couple of passive indicators you can build an index with higher return, without higher risk exposure?

Look at the turnover % of both indexes, Quality has 22% and Momentum has 156%(!!) so as you mention how can this be termed “passive”… For an ETF to be based on these indexes they should have in theory a high TER. Looking at IWQU shows 0.30% TER which is not even high but yes still 4x more than your usual VT.

I wonder why Vangaurd does not have any Momentum/Quality ETF… maybe precisely because it can not be so “passively” managed…

Nevertheless these two indexes are very tempting :wink: and @Julianek’s research super interesting to read!

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Quality and Momentum are considered smart beta ETFs, not really passive indeed. Some people would also argue that SP500 is not passive, because a committee will select the stocks (like not including Tesla).
In a way, it’s easy to create a smart beta index and backtest it to beat the market. I’m not really convinced about backtests

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I stopped believing in all those factors. It’s just artificial. Like looking at 100 years of US stock history and coming to the conclusion: If you bought stocks which name started with A/F/M and left out the others, you would have increased your returns by 3%/year. It’s the AFM-risk premium and should also persist in the future, lol.

The reason we buy VT is because we know everything about the past and don’t know shit about the future (sorry about the expression).

My point is, Quality, Momentum or even NASDAQ 100 are chosen in a non-arbitrary way, which makes them kind of passive. There is a set of rules which determines which company gets included and at which weight. And they seem to constantly beat the market. Then why does the market put such a high price on stock of companies that are known to have trouble and nobody expects them to make a sudden rally?

According to the efficient market theory, when we see a risk premium from investing in quality stocks, we should asks ourselves, what is the extra risk that the investor is taking? To me, it’s weird, because it seems like the quality stocks only have upsides. If investing in quality yields better returns with no increased risk, the prices of these stocks should go up to make this premium disappear. Why does this not happen?

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Thank you for noticing this, i had totally missed it. Although it makes my point a bit weaker, I still think that it is remarkable that:

  • Buffett (arguably one of the greatest investors over the last 60 years) says in his letters since the 70s that the number one criteria to look for is return on capital
  • 40 years later, when we say “Wait a second, what would actually have happened if we had followed his advice”, we end up with a very fine result, even if backtested.

I’ll grant you that. I will rename the topic from “passive” to “index fund”. The approach i am trying to follow here is to ask:

  • The first step (totally passive) is to say that I do not know anything.
  • But then, is there a single decision that could dramatically improve results? Thinking from first principle, what drives wealth over the long term? I’d argue that a consistent high return on capital comes pretty close to that.

You only need a database of 10-K filings (or local equivalents) to be able to compute a return on capital, growth rate and financial leverage. The factsheet says that the index is rebalanced every six months based on these criteria.

I like Ben Felix but sometimes he should not rely so heavily on modern portfolio theory. MPT works in some cases, and not at all in others. For instance, in this study, Baker and Haugen showed that low-risk stocks (as measured by volatility) consistently over-perform high risk stocks in every developed market.
Someone will try to find a new factor to explain the anomaly and make the French-Fama model consistent, but at some point it is better to ask if you cannot start again on a better basis.

I already touched on a few points here, but there are two kinds of explanation:

  • Cognitive biases, such as:
    • Hyperbolic discounting bias, where we value short term returns over long term ones
    • the fact that the human brain works in a logarithmic way and is incapable to grasp exponential growth
  • But mainly, i think there is a structural issue with how the industry and analysts evaluate stocks. Let me explain.

You might know that the number one valuation method to evaluate a business is the discounted cash flow analysis. Analysts try to forecast the cash flow for the next few years, after which they say that they don’t know what’s going to happen so they assign a GDP growth rate in perpetuity after 5 or 10 years. That is to say, they assume that after 5 or 10 years, the business is going to grow at the same rate than the economy, i.e not a lot. That means that each of the forecasted year will have its discounted cash flow, and after that they will add what we call the Terminal Value, i.e the value of all the cash flows after the period of projection.

The vast majority of analysts will use 5-year or 10-year DCF models to value a company and pay painstaking attention to the assumptions to drive their interim period cash flows. If you do yourself the exercise, you will notice something interesting. Here is the contribution of the terminal value to the appraised value of the firm given different interim growth rates in a 10-year DCF model:

Projection Period Growth Rate Terminal Value Contribution
5% 73%
10% 78%
15% 82%
20% 85%
25% 87%
30% 89%

In other words, what happens before the 10 years only weights for 11% to 27% of the company. What is 11%-27%? A margin of error. You can get the next 10 years of projections wrong- as long as you know what the company will look like 20 years from now.
This has a lot of implications:

  1. Again, people use 5-year or 10-year DCF models where they model in high growth rates and high rates of return. At the end of the “projection period”, they will plug in a perpetual 2% growth rate to the then “boring” company. What if a company can compound capital at a higher rate than its competitors for longer than that? A junior analyst will get laughed out of the room for creating a 20 or 30-year DCF, so again, unfortunate situation for the junior analyst but an opportunity for investors.
  2. If you follow financial news, you will notice that experts and Wall Street all focus on next quarter EPS expectation. This is all noise and is irrelevant. First, next quarter EPS weight close to nothing in the value of the business. Second, remember that instead of focusing on EPS, you should ask if the profitability of the business has not been impaired.
  3. Now that you know that most of the value of a business lies in what happens after 10 years, next time you see a -30% drawdown like we had in march, if you believe that the business has the balance sheet to survive, you should pounce on the occasion.

This is another topic, but this comes down to the qualitative analysis of the competitive environment of the business and its competitive advantage (i.e “moat”). Maybe at some point i will do another thread on the subject.

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Thank you for the post Julianek. This is very helpful as I am considering whether to invest my 2nd pillar currently being transferred to Value Pension vested benefit account in MSCI World Quality or MSCI world

Did you find anything in your research on how they did the backtest - did they go back and apply the quality algorithm fully to 1994 financial statements and then model which stocks it would have bought ? And update the portfolio for every year between 1994 and when the index was created

Yes, you’ve raised this argument once. But is it seriously so bad? I mean, individual investors can be short-sighted, they are mortal. But institutions exist for 100+ years. A fund should look 30 years into the future, because they should still exist and be in the game at that point. You’re saying that most of these companies don’t?

It just seems like such a simple thing to overlook. To think that you could invest into an ETF and get 2-3x returns in 20y horizon is just incredible. If you were a passive investor (in the understanding of betting on one horse and sticking to him), would you seriously go for MSCI Quality in favor of VT? Is this something you would advise to consider for me and other holders of VT? Do you have some links to other FIRE sources where they encourage this approach?

And finally, what’s your take on MSCI Momentum, mentioned by Glina? I like that it includes Tesla & Amazon, but at the same time I don’t think it’s a smart index if it only looks at the price graph, without looking at the fundamentals.

He also says that at least for his estate planning, he wants it in a pure passive fund:

“Well I can tell you I haven’t changed my will and it directs that my widow would have 90% of the funds in index funds,” Buffett said. “I think it’s better advice than people are generally getting from people that are paid a lot to give advice.”

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