“I don’t believe that I am the only person who cannot predict future prices.
No one consistently can predict anything, especially investors. Prices, not investors, predict the future.
Despite this, investors hope or believe that they can predict the future, or someone else can.
A lot of them look to you to predict what the next macroeconomic cycle will be.
We rely on the fact that other investors are convinced that they can predict the future,
and I believe that’s where our profits come from.”

– John W. Henry

“Steve, it’s Mark.” I struggled to recognize the voice. “Can you come down to see me?”

“Of course,” I answered. It had been several years since we last spoke. My friend was on the winning side of a battle with a bad polyp found on his vocal cords.

When Mark Finn speaks, you listen. Commanding, sharp, brilliant. He’s a maverick in the investment business. He’s also a mentor, incredibly humble and frankly one of the nicest human beings you could meet. He continued, “I need your help on something. I’ve got something big and I’m not sure how it should best be packaged. What I can tell you is I think this ‘son of a gun’ might someday win a Nobel Prize.” Mark had me at “I need your help.” Mark is a former chairman of the Commonwealth of Virginia Retirement Plan’s Investment Advisory Committee and current chairman and CEO of Vantage Consulting. He is the smartest investor I know, so I was really curious about what my friend found that might be Nobel Prize worthy.

A few weeks later, I joined Mark on his golf course in Virginia. A college standout, he remains a low single-digit player and still ultra-competitive. A normal four-hour round took us six. Uncrowded and absent pressure, we talked, hit the ball and talked more. Mark began, “What if you could own the exact same stocks that make up the S&P 500 Index and improve the return by perhaps 4% per year?” To better understand where he was taking me, he started first by talking about the benefits of equal-weight over cap-weight. Simply, think of it as owning the same 500 stocks but with, by rule, equal exposure to each. Over time, equal-weight has beaten cap-weight by nearly 2% per year. Better? Yes. Not all the time but better over a longer cycle.

Mark next went on to talk about fundamental weighting. An idea that my friend Rob Arnott pioneered and later lead to a wave of S&P 500 Index-beating product known as “Smart Beta.” The concept is to own the same exact stocks that make up S&P 500 Index, but in a weighting process that over-weights to the stocks with the strongest fundamentals. Sounds logical. This index process beats the cap-weighted S&P 500 by one to two percent per year yet like equal-weight not all the time. (As a quick aside: If you’ve been exposed to this type of ETF the last number of years, you’ve under-performed. The process has a “value” bias and value stocks have materially under-performed growth stocks the last five years.)

OK – to make some sense for where Mark was taking me. It’s important to understand the following:

You and I and most investors have long considered the S&P 500 and the Dow Jones Industrial Average indices to be “the market.” The Dow Jones Industrial Average (DJIA) is a stock market index created by Wall Street Journal editor Charles Dow on May 26, 1896. The “Composite Index,” as the S&P 500 was first called when it introduced its first stock index in 1923, began tracking a small number of stocks. Three years later in 1926, the Composite Index expanded to 90 stocks and then, in 1957, it expanded to its current 500.

So over the years, it is what we all view as “the market.” Over the last 10 years, we’ve witnessed a proliferation of products designed to beat those cap-weighted indices. And some do. There is an inherent problem built into the cap-weighted structure that causes an over-concentration of exposures to certain sectors and certain stocks at certain times based on the construction rules of an index put in place many years ago. Cap-weighting means the stocks with the highest market capitalization (take the number of shares outstanding times the share price) get a higher weighting in the index. Of course, that is something you well know.

One example of increased risk is the over-exposure to technology in 1999. It became 39% of your index exposure. Everyone chasing into tech stocks caused prices to rise causing their market capitalization to grow every larger. So, in the S&P 500 Index, you got more and more exposure to tech stocks. Over-weight the most expensive thing at the wrong time. Tech went on to lose over 75% the next two years. And it was financials in 2007 and a number of those stocks went on to lose over 80% in The Great Financial Crisis. Some goose-egged and went out of business, like Lehman Brothers and Bear Stearns. By structure, you are owing more of the most overvalued stocks. If you think about it, the cap-weighted structure forces you into the most overvalued sectors at market tops. I think many investors fail to get this even today. OK, back to the story.

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