So, the main case for QQQE being a better asset is simply that it rises in value more quickly.
ah! The value word. You cannot argue against it because it is what one assigns to it. Separately, I did a quick comparison of QQQE vs QQQ since inception till 2020 their performance was in lock step and since 2020 and QQQ outperformed QQQE.
So how are you coming to this conclusion besides mythical value. Anything tangible?
So how are you coming to this conclusion besides mythical value. Anything tangible?
Yes.
I have data back to 1997, not 2020, with and without dividends for both.
The equal weight version has done better.
The gap is quite small, largely because of the huge recent performance of the giants.
QQQ has done better by 4.6%/yr in the last five years of the recent supercap rally.
In the prior 18.3 years the equal weight version did better by about 1.3%/year.
But my previous comment is the appropriate one:
QQQE is not impossible to predict. Not perfectly of course, but a usefully good guess. It trends pretty well, and has low risk.
QQQ is best thought of as the return of QQQE, minus a very small constant, plus or minus a random number depending on the luck of the biggest few firms.
With a high multiple of the risk.
If you want low company-specific risk and you to know what kind of return youâre likely to get, use QQQE.
You can get a decent handle of likely valuation level and likely growth.
If you just want the luck of the draw while flying blind, which might be better or might be worse but is likely to be a bit worse, you can buy QQQ.
As a random example, everybodyâs favourite firm Tesla is about 4% of QQQ versus 1% of QQQE, and is trading at about 100 times earnings.
Amazon is almost 8% at a P/E of 56.
Maybe those firms will do very well and grow into their valuation levels based on recent business results. Maybe they wonât. Opinions differ.
But QQQ makes very concentrated bets, with the corresponding concentrated risk.
On average, over time, thatâs not a great idea. Neither for predictability nor empirically for returns.
Jim
I have data back to 1997
I was able to get data from 2012, and that is showing QQQ outperformance very slightly hence I called lock-step.
If you want low company-specific risk and you to know what kind of return youâre likely to get, use QQQE.
OK. I see, assuming company specific risk is random and evenly distributed across the 100, Apple getting hit has a bigger impact on the Index performance vs splunk or OKTA. The random events, should also factor positive surprises right? Wonât the positive surprises will have bigger impact on QQQ vs QQQE? Statistically, it should be a wash right?
But QQQ makes very concentrated bets, with the corresponding concentrated risk. On average, over time, thatâs not a great idea. Neither for predictability nor empirically for returns.
OK got it. Just saying⌠I thought you are in favor of concentrated bets. I thought I am bundle of contradictions, but⌠LOL.
The random events, should also factor positive surprises right? Wonât the positive surprises will have bigger impact on QQQ vs QQQE?
Statistically, it should be a wash right?
No, as it turns out. Perhaps surprisingly.
The odds of a company being overvalued are not randomâŚvery large caps are far more likely to have that situation.
Thatâs because overvaluation drives up market cap.
Take the numbers 1 through 100. (companies of a range of sizes ranked by the size of their actual true values rather than market valuations).
For each one, adjust its number by a random amount in the range -20% to +20% of its current level. (transient over- or under-valuation).
Now sort the revised numbers. (cap weighting).
What are the chances that the ones that sort to the âbiggestâ end the list are ones that just had a number added rather than subtracted?
Pretty high.
Now sum all the numbers. (the portfolio)
What percent of the total is allocated to those that just had their numbers increased (temporarily overvalued), versus decreased (temporarily undervalued)?
Considerably more than half.
I thought you are in favor of concentrated bets. I thought I am bundle of contradictions, butâŚ
Well, nice troll by straw man, but of course there is a big difference between a concentrated
bet on something you analyze in depth and a concentrated bet on something random you arenât even aware of.
The latter is the situation with most index investors.
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.
Thatâs why cap weight indexes do so badly compared to almost any other weighting you might choose.
https://jpm.pm-research.com/content/39/4/91
Jim
I canât make sense of two ideas that are seemingly at odds with one another.
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-stâŚ
This would seem to favor a cap weighted index.
Is it possible for both of these things to be true at the same time?
Todd
The odds of a company being overvalued are not randomâŚvery large caps are far more likely to have that situation. Thatâs because overvaluation drives up market cap.
Faulty logic at best. Even today, where you consider everything is still overvalued, you have a mega cap like Facebook, which is clearly not overvalued or Google. For a long time Apple was not overvalued. This is a very poor conclusion without any basis.
On the other hand many small companies that are not making any profits, but only potential, are perennially overvalued. Many grow into their overvaluation, many die. But overvaluation driving market cap therefore big companies are overvalued is a circular logic with no basis.
companies of a range of sizes ranked by the size of their actual true values rather than market valuations
What is true value??? Just an imaginary number, that fits your narrative? When you are comparing the performance of the Index, which is the measurement of market price movement and then suddenly saying let us not use market valuation is⌠what kind of a logic is that?
Well, nice troll by straw man
Are you saying you didnât disparage Index investing? or you are in favor of concentrated bets? You recommended 80 year old to make a single stock bet of Berkshire, nothing can be concentrated bet.
AnywaysâŚ
big difference between a concentrated bet on something you analyze in depth and a concentrated bet on something random you arenât even aware of.
How much anyone truly knows about Berkshire? I have seen infinite discussions about price to book discussions, how it trended in the past, etc. Great, hindsight analysis, done to death. But how does it really make anyone smart about Berkshire subsidiary operations? My ability to forecast a REIT growth is far superior than your understanding of Berkshire. For all the fault of Saul and his boardâs, they analyze their business far more in depth, obsessively. What is this board and you are obsessed about? price to book multiple. And obsession on past performance. Period.
Never a single discussion on any business. I am not saying you need to or it is feasible for a conglomerate like Berkshire, but if you claim that you have in-depth understanding of gazillion Berkshire subsidiaries and analyzed them to arrive Berkshire valuation and feel confident, Power to you. To be brutally honest, you are just lying to yourself.
Investing in Berkshire is closest to investing in Index. Both in the case of Berkshire and Index the composition of companies/ industries that goes into are determined by someone passively. Simple example, you railed about how inferior US banks and Bank of America in particular, and how much WFC is a better bank than others, guess what??? WFC is not part of Berkshire holdings and BAC is a pretty big position. Actually I got that one correct. So much for your understanding of Berkshire or Buffett.
My friend on Buffettâs teaching you got his letters and not the spirit of his teaching. If you have you would have embraced Index investing.
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. Actually you do a decent back test with numbers, why donât you do that? pick any âvaluationâ metric and do that. The randomness is just random. When a big market cap takes a hit we see, in smaller ones it is just a tree falling in forest. The randomness, and the impact on the market cap are same and it has nothing to do with overvaluation.
What you perceive as âovervaluationâ at least on big business are often ârationalâ reaction by a large set of market participants. It is the âcheap stocksâ that are actually far riskier, stocks on their way to bankruptcies often pretty cheap on many metrics.
Value investing is not applying mechanically some multiple on some GAAP numbers. Valuing is far more than that.
âAs 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.â
You have demonstrated nothing.
I think Jimâs 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 thatâs overly simplistic, but it makes sense to me.
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 wouldnât 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 Jimâs comments make senseâŚI know thatâs 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 doesnât 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 capâs are generally lot cheaper, be is PE, Price to sales, ROE or ROA, risk adjusted return.
I wouldnât 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 itâs 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 wouldnât want to put in equal amount of money into Google and an unknown small-cap.
Why not?
(not being argumentative, thatâs a serious questionâthink about it)
First, remember that there is a price for everything.
The biggest company isnât necessary the one that makes the best investment prospect.
Statistically itâs 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, youâre not the target audience for index funds, which is people who donât 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 âunknown small capsâ.
I think the smallest by market cap is Docusign at around $13bn, trading around $370m/day.
Jim
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-stâŚ
Thatâs quite a well known study. And probably one of the most misleading studies ever done.
Itâs 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 âmonkey with a dartboardâ 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, itâs also pretty unlikely that portfolio will contain one of the tiny number of âlong term winnersâ 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 arenât 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 âcomparatively shortâ.
Letâs 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 whatâs the subtle quirk in that study that leads people astray?
It held all positions for their entire lifetimeâŚall the way through the fade and death step.
In our toy universe, itâs 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.
Itâs 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 itâs necessary to own everything because otherwise itâs very unlikely youâll be an owner of one of the few firms that will make you money.
The stock pickers used it as proof that itâs 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 canât give a useful conclusion.
Jim
Demonstrating is providing numbers, statistics, and scientific evidence for a thesis.
What you and Jim are saying is your hunch.
Itâs not just a hunch, itâs 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 âstrategiesâ 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 wonât 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 thatâs probably fairly uncommon.
Separately, take any of your favorite valuation measurement and use it, you will be surprised to see the big capâs 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 Vanguardâs 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.
But also: if you know that Google is at an attractive valuation level, buy it.
But if so, youâre not the target audience for index funds, which is people who donât 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 Vanguardâs 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 wouldnât 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
"A quick check on this proves you wrong: per Vanguardâs 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, itâs exchange agnostic.
A quick look at QQQâs info, I find Invesco says the PE of the index is 37. I couldnât find the same figure for QQQE.
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.
Thatâs 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 donât have that problem. Letâs leave them to it.
They have the money to fill that gap, and we donât, whether we like equal weight or not.
Jim