The Fundamental Flaw of Stock Indexes

With little fanfare, veteran value investor and Columbia Professor Joel Greenblatt solved the biggest flaw plaguing index fund investors.

This flaw forces index funds to buy richly priced stocks, while selling the cheap ones.

So basically, every index fund is run contrary to the most basic investment principle: buy low, sell high. 

In short, most big indexes including the S&P 500 and Russell 1000 — are market-cap weighted. This means that the index owns a greater amount of stocks with larger market capitalizations.

So as a company’s stock price rises – and its market cap grows – the index buys more of that stock.  Meanwhile, companies with falling share prices get underweighted. 

This fundamental flaw essentially forces indexes to buy larger companies as their share prices rise, while selling companies when they get cheaper. 

And as a value investor, I want to buy cheap stocks. Not big stocks.

To solve the problem, Greenblatt turned the typical index fund on its head.

He created a new type of investment fund that he calls a value-weighted index. As the name suggests, this index selects stocks based on their value, rather than their market capitalization. 

The result is an improved index that buys more of the cheap stocks in the index, and sells those that are more expensive.

In late 2010, Greenblatt launched the Formula Investing Funds.  And his firm now offers no-load mutual funds that implement his value-weighted approach to index investing.  Instead of choosing investments based upon their size, the indexes select stocks based on their valuation relative to last year’s earnings.

The backdated studies of Greenblatt’s value-weighted index show considerable outperformance.  His index delivered a total return of 1,891% over 20 years versus 834% for the S&P 500.

The company’s largest fund is the Formula Investing U.S. Value Select (FNSAX).  It’s an actively managed fund that uses Greenblatt’s value-weighted approach to overweight the cheapest stocks. The fund owns 124 stocks, including large caps, mid caps and small caps.

The historical analysis from Greenblatt was interesting. But what really matters is how this performs in the real word.

Since launching in November 2010, the Formula Investing U.S. Value Select fund is up 62%.  Compare that with the 39% gain for the S&P 500 or 40% gain for the Russell 1000. 

Value Index Wins by 20%

Greenblatt’s Formula Investing mutual fund charges a 1.5% expense ratio.  But since inception, the superior performance of this fund has easily offset the added costs.

With just $400 million in assets, Formula Investing is a small mutual fund company.  The funds will have their third anniversary in just a couple weeks.  With a three-year performance record that’s superior to the indexes, their flagship fund could begin gathering a bit more attention. 

Even if you’re investing just a portion of your investment portfolio in index funds, you should consider a value-weighted index. Funds like those from Formula Investing offer reasonable costs and no load. Most importantly, they buy cheap stocks and sell expensive ones.

Are you familiar with a value-weighted index?  Do you own index funds that consider the valuation of the stocks in the portfolio?  I’d love to hear about your favorite mutual funds and ETFs that are taking a value approach.  My email is [email protected]

P.S. I have no affiliation or business relationship with Joel Greenblatt or Formula Investing Funds. I’m simply writing to make you aware of a better way to invest in a stock market index.

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