QQQE

“As demonstrated above, at any given time they have a disproportionate fraction of their portfolios allocated to large temporarily overvalued stocks. Big single stock risk, and on any given day those same biggest positions are most likely to be overvalued ones.”

You have demonstrated nothing.

I think Jim’s comments make sense. In a cap weighted index, the biggest cap stocks dominate the index. Consider a toy universe where the largest 10 companies within an index all have the same true market value, but they can vary widely in market cap because of varying public moods over the years: at the peak of a market craze a particular one of the ten is up 50% in its stock price, while another is far out of fashion and is down 50%. In a cap weighted index now the popular, overvalued stock stands at the top weight in the index above all others, while the unpopular one, the one that is the best value has seen its weight in the index shrivel.

In an equal weight index, the over-valued one has been sold off as it rises and the under-valued one is bought.

As long as the fad driving the over-valuation continues, the cap weighted index does better, but when market values begin to revert to actual values, the equal weight does better and should do better over time.

I know that’s overly simplistic, but it makes sense to me.

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As long as the fad driving the over-valuation continues, the cap weighted index does better, but when market values begin to revert to actual values, the equal weight does better and should do better over time.

I think both cap-weighted and equal-weighted have problem. Cap-weighted has the above mentioned problem. On the other hand, I wouldn’t want to put in equal amount of money into Google and an unknown small-cap. Perhaps setting a maximum share threshold on any one company would be an improvement on the cap-weighted index.

I think Jim’s comments make sense…I know that’s overly simplistic, but it makes sense to me.

Demonstrating is providing numbers, statistics, an scientific evidence for a thesis.

What you and Jim are saying is your hunch. Because your favorite author has a hunch doesn’t mean that theory is valid.

In fact, I would argue, when the big cap names raise, they lift all boats. How can we separate the overvaluation of the market cap is not seeping into lower names?

Separately, take any of your favorite valuation measurement and use it, you will be surprised to see the big cap’s are generally lot cheaper, be is PE, Price to sales, ROE or ROA, risk adjusted return.

I wouldn’t want to put in equal amount of money into Google and an unknown small-cap.

Yeah, equal weighting might not be the best idea for a total stock market index, but the ones it’s found as an option for: the S&P500 and the Nasdaq 100, these are all mid-sized to large companies.

On the other hand, I wouldn’t want to put in equal amount of money into Google and an unknown small-cap.

Why not?
(not being argumentative, that’s a serious question–think about it)

First, remember that there is a price for everything.
The biggest company isn’t necessary the one that makes the best investment prospect.
Statistically it’s unlikely to be as good as the average one, both theoretically and empirically.

But also: if you know that Google is at an attractive valuation level, buy it.
But if so, you’re not the target audience for index funds, which is people who don’t know how to
value individual firms, nor to determine whether they are over- or under-valued.
For that audience, they do indeed want equal amounts of Google and an unknown smaller cap firm.
Or at least they should want that.

As an aside, it would probably be a stretch to call the smaller firms among the Nasdaq 100 “unknown small caps”.
I think the smallest by market cap is Docusign at around $13bn, trading around $370m/day.

Jim

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On the one hand Jim linked to research that cap weighted indicies lead to a risk of the largest holdings being overvalued.
On the other hand just a tiny number of stocks deliver the bulk of the gains in the stock market. See:
https://www.irishtimes.com/business/personal-finance/most-st…

That’s quite a well known study. And probably one of the most misleading studies ever done.
It’s particularly misleading (even to its authors) because the study is well constructed and presumably mathematically correct.
The problem is that the construction method contains a quirk that makes the obvious conclusion the wrong one.

To start with, bear in mind that the average company in the average year rises in value.
A “monkey with a dartboard” strategy that picks (say) 100 stocks, holds them for a year, and repeats, will do extremely well over time.
It is also a near certainty that it will beat a cap weight index over time. (roughly 99% chance, in one study)
Yet, having only 100 positions, it’s also pretty unlikely that portfolio will contain one of the tiny number of “long term winners” identified by the study.

So how to reconcile it:

Think about the lifetime of a public company.
A simple model would be something like this: the business lasts for a pretty unpredictable number of years.
Ignore the ones that are bought out, since those aren’t on average a problem for long run returns.
The remainder are generally profitable and have a positive real total return (on average) from the market for most of that life, however long it may last.
Then they fade and fail in a comparatively short time span, which is by comparison pretty constant.
The key bit here is “comparatively short”.
Let’s say the averagely prosperous lifespan is a random number 2-100 years, followed by 1-4 years of fade and death, as a mental model.

So what’s the subtle quirk in that study that leads people astray?
It held all positions for their entire lifetime…all the way through the fade and death step.
In our toy universe, it’s clear that most stocks will be a total loss during that end stage.
Yet we know that on any given day, most firms are not in that category at the moment.

A random selection of firms in a random finite time interval will have a strongly positive expected return,
because most picks, being chosen at random points in their lifetimes, will not be in their fade-and-die stage.
There is no need at all to be an owner of one of the few long term big winners.

It’s peach season here. Perhaps you have noticed that individual peaches ripen and rot at very different rates.
Imagine buying a basket of peaches, most good and a few rotten.
One person buys those for consumption within three days. Most will be fine, and very enjoyable.
Another person holds the original peaches forever, and observes that they all eventually go rotten.
He concludes that all peaches are a waste of time and can never offer enjoyment.

A separate observation:
That study is also an interesting philosophical mirror.
Most industry participants who chose to comment on it used it to bolster their own pre-existing biases.
The Bogleheads used it as proof that it’s necessary to own everything because otherwise it’s very unlikely you’ll be an owner of one of the few firms that will make you money.
The stock pickers used it as proof that it’s necessary to show judgment, because the only way to succeed is to own the few obvious winners.
I just concluded it was a study constructed in a way that can’t give a useful conclusion.

Jim

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Demonstrating is providing numbers, statistics, and scientific evidence for a thesis.

What you and Jim are saying is your hunch.

It’s not just a hunch, it’s based on long-standing research that small stocks and value stocks tend to outperform over the long term. As the journal article Jim linked to upthread mentions, surprising ‘strategies’ for picking stocks, like throwing darts at the stock listings in the newspaper (lol, when is the last time anyone here looked at the stock listings in an actual newspaper?!?), will often outperform a cap-weighted index because the strategy provides a small-cap and value tilt to the selections compared to the cap weighted index.

In fact, I would argue, when the big cap names raise, they lift all boats. How can we separate the overvaluation of the market cap is not seeping into lower names?

Your question seems a bit unclear. There are obviously correlations across the various sectors of the stock market and a rising tide lifts all boats, but not equally. Different sectors come into and fall out of fashion. Among the biggest companies, which will naturally have the largest market capitalization, some will be more in fashion than others, more overvalued than others, and so will tend to have the largest market caps and weight in the index than others. This won’t be a hard and fast rule: there may be times when large cap stocks have been out of favor for years and the top companies by market cap will be mostly a good value, but that’s probably fairly uncommon.

Separately, take any of your favorite valuation measurement and use it, you will be surprised to see the big cap’s are generally lot cheaper, be is PE, Price to sales, ROE or ROA, risk adjusted return.

A quick check on this proves you wrong: per Vanguard’s info, average PE of the S&P 500 is 20.2, while average PE of the Vanguard Small Cap Index is 13.6.

PE of the top 5 stocks within the S&P500: AAPL: 23, MSFT: 28, GOOG/GOOGL: 21, AMZN: 56, TSLA: 100. Every one of them is higher PE than the average for the index.

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But also: if you know that Google is at an attractive valuation level, buy it.
But if so, you’re not the target audience for index funds, which is people who don’t know how to
value individual firms, nor to determine whether they are over- or under-valued.
For that audience, they do indeed want equal amounts of Google and an unknown smaller cap firm.

Agree that from blind statistical point of view, there is no reason to buy one more than the other. However there is a side effect, if such index become popular, it will also artificially push up the value of smaller firms as demand out-weights supply.

equal weighting might not be the best idea for a total stock market index

This is true from a simple practicality standpoint. Theoretically it would make a very good investment, with a heavy micro-cap tilt, but managing it would be a nightmare. Cap weight was the choice by Bogle for the original Vanguard S&P 500 index fund because it involves minimal trading and management expenses. Buying/selling microcaps on the regular would run into problems if the fund gained any real size.

A quick check on this proves you wrong: per Vanguard’s info, average PE of the S&P 500 is 20.2, while average PE of the Vanguard Small Cap Index is 13.6.

PE of the top 5 stocks within the S&P500: AAPL: 23, MSFT: 28, GOOG/GOOGL: 21, AMZN: 56, TSLA: 100. Every one of them is higher PE than the average for the index.

Is this true in Nasdaq, not S&P500? I thought these stocks are in Nasdaq

On the other hand, I wouldn’t want to put in equal amount of money into Google and an unknown small-cap. Perhaps setting a maximum share threshold on any one company would be an improvement on the cap-weighted index.

Or, buy the equal weighted index, and let it act like an index fund which tracks the Nasdaq 100 in an unskewed manner, then buy shares of the stocks you have conviction on.

IP

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"A quick check on this proves you wrong: per Vanguard’s info, average PE of the S&P 500 is 20.2, while average PE of the Vanguard Small Cap Index is 13.6.

PE of the top 5 stocks within the S&P500: AAPL: 23, MSFT: 28, GOOG/GOOGL: 21, AMZN: 56, TSLA: 100. Every one of them is higher PE than the average for the index."

Is this true in Nasdaq, not S&P500? I thought these stocks are in Nasdaq

S&P500 takes stocks from both Nasdaq and the NYSE, it’s exchange agnostic.

A quick look at QQQ’s info, I find Invesco says the PE of the index is 37. I couldn’t find the same figure for QQQE.

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Or, buy the equal weighted index, and let it act like an index fund which tracks the Nasdaq 100 in an unskewed manner, then buy shares of the stocks you have conviction on.

That’s a good idea. I would put 50% buying QQQE, another 50% buying the top 10 picks except Tesla of QQQ

Agree that from blind statistical point of view, there is no reason to buy one more than the other.
However there is a side effect, if such index become popular, it will also artificially push up the value of smaller firms as demand out-weights supply.

Almost every strategy fails in one way or another if everyone does it.
The same complaint, perhaps more serious, applies to cap weight indexes when they become too popular.

Institutions with $100bn to invest have to be stick with near total concentration in the very largest firms.
Most of us don’t have that problem. Let’s leave them to it.
They have the money to fill that gap, and we don’t, whether we like equal weight or not.

Jim

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A quick look at QQQ’s info, I find Invesco says the PE of the index is 37. I couldn’t find the same figure for QQQE.

The P/E of QQQE is 24.52 as of Friday close.

Calculated as:
1 / (Average trailing four quarter earnings yield)
Never try to do math with P/E ratios : )

Median P/E among the 100 stocks is currently 26.32
The average across all days of that median-within-the-100 is a P/E of 25.6 since 2005.
The median among all days of that median-within-the-100 is a P/E of 26.9 since 2005.
So, to the extent that that’s a reasonable era to consider, it’s basically at an average valuation level.
(you get a very slightly different result by adding a cyclical adjustment to earnings, but they aren’t far off trend right now)

FWIW, median ROE among the 100 stocks is 23.2
Pretty impressive.

Jim

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The P/E of QQQE is 24.52 as of Friday close … Median P/E among the 100 stocks is currently 26.32. The average across all days of that median-within-the-100 is a P/E of 25.6 since 2005.

Thanks, Jim, great info. Slightly above average valuation currently, and in the throes of a steep bear market, currently down 28.5% from peak. Who knows what will happen, but it appears likely the bear will continue. Recent lows have not seen any kind of dramatic volume that looks like a major bottom.

I’ll keep an eye on this one and aim to buy when its valuation is significantly better than average.

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Demonstrating is providing numbers, statistics, and scientific evidence for a thesis.

The following is based on the backtester GTR1 and is from March 1, 1957 to present, with rebalance every 3 months using S&P 500 stocks

CAGR for S&P 500 weighted by market cap: 10.2%

http://gtr1.net/2013/?h63::sp500.a:et1:MktCap:tn500:MktCap:b…

CAGR for S&P 500 equally weighted: 12.12%

http://gtr1.net/2013/?h63::sp500.a:et1:MktCap:tn500:MktCap:b…

CARG for S&P 500 remove top 20 market cap and equally weight remaining 480: 12.21%

http://gtr1.net/2013/?h63::sp500.a:et1:MktCap:tn500:MktCap:b…

Regards

Craig

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CAGR for S&P 500 equally weighted: 12.12%
CAGR for S&P 500 weighted by market cap: 10.2%

First thought: what about implementation costs?

Actual ETF results from portfoliovisualizer.com May 2003 - May 2022:
RSP: 10.02%
SPY: 9.47%

Not as advantageous but still useful.
RSP a little more volatile.

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It’s not just a hunch, it’s based on long-standing research that small stocks and value stocks tend to outperform over the long term

Now you are confusing stock performance with valuation. Out performance happens because they grow faster, but they are still overvalued. Remember, the discussion, the thesis is mega caps’ are overvalued, hence you should do equal weightage.

The best example for you is, take a look at MSFT, WMT or SBUX or any number of firms, while they were growing they had much higher valuation and as they matured in their growth (their market cap raised) their valuation moderated.

I am not sure how exactly that article proves that mega caps were overvalued. Jim is great in deflection, using confusing but superficially convincing arguments that people eat out of his hands. I will never forget when he mentioned debt is not part of market cap and it is irrelevant and got 100 rec’s. He happily indulges in financial slight of hand. But I digress, still show me where in that article you come to the conclusion that mega caps’ are perennially overvalued.

Your question seems a bit unclear
Typically when growth outperforms therefore gets expensive, value doesn’t follow suit. OTOH when megacap value joins the party except few times growth gets further boost. Now, to begin with growth/ lower cap names are typically more expensive than the megacap (except the recent few years, primarily due to AMZN, GOOGL’s of the world and recently Apple and Softy joined the party). Historically the top of the index is not expensive but they carried higher weightage. When the mega caps raise they lift all boats further, but when small caps raise they make no impact on megacap’s.

A quick check on this proves you wrong: per Vanguard’s info, average PE of the S&P 500 is 20.2, while average PE of the Vanguard Small Cap Index is 13.6
Pretty lazy attempt. For one to switch from market-cap weighted index to equal-cap weighted index, you cannot take one point in time, but you have to have demonstrated outperformance, something like multi-decade. Go back and see historically you will see surprising results. I could be wrong, but I think if a firm is not making any profit that is not included in the PE calculation. Check it out.

I have data only from 2012 and clearly QQQE is not outperforming QQQ from that period. Jim, says he has data that goes to 1995, may be he can share it. He has access to some amazing database, I would happily take back my position if there is a data that shows equal cap outperforms mega cap. I haven’t see it yet.

“So, the main case for QQQE being a better asset is simply that it rises in value more quickly.”

How difficult would it be to put together a basket of the companies with the fastest rates of value growth?