Index funds and value investing sit in two distinctly different investment groups.
On one hand, you have value investing; the principle that stocks should only be acquired if they are trading below intrinsic value.
On the other hand, you have index investing, which does not pay any attention to valuation and buys no matter what the level or fundamental value of the market.
So traditionally, these two styles have very little in common. However, I believe there is a strong case for combining both index investing and value investing.
Combining active and passive
I have written before about how value investors can use exchange-traded funds (ETFs) to gain access to whole sectors or even markets that would not usually be available to them, such as Eastern European markets or a bet on the entire U.S. master limited partnership sector. This approach combines the benefits of active value investing with low-cost, passive instruments in a way that allows value investors to access investments they would not usually be able to without spending a tremendous amount of time and effort on the opportunity.
But is there a case for combining a low-cost index tracker for the S&P 500 or Russell 2000 into your value portfolio?
I believe there is.
I am a big fan of using buckets to manage my investments. These buckets are separated into risk categories and the assets in each are based on the risk profile assigned. Value investing is the most substantial part of the portfolio because, if done correctly there is almost no risk investing in discounted securities with strong balance sheets.
Nonetheless, I am fully aware that while there should be no risk associated with value investing, any funds tied up in investments will be tied up for at least five years, so I need to have some extra cash on the side.
This is where using the S&P 500 tracker helps my strategy.
Looking at historic trading data, it is clear the S&P 500 has produced an average annualized return of around 10% over the past century. This performance is not guaranteed, but compared to value investing, which can be highly volatile, gains are almost predictable.
That is why I included the S&P 500 in my portfolio: to add a layer of predictability and stability. In bad years for value investing, the S&P 500 provides a returns cushion. In good years, it should only add to returns. Over the long term, my returns might suffer as there is less money being devoted to value, but gains will be smoother. I have also dedicated a portion of my portfolio to bonds for further smoothing of returns.
Tricking myself
I am not advocating an index strategy; it is anything but. In total, the S&P 500 and bonds account for around 10% to 15% of my portfolio as I am still a devout value believer. There is another reason for this approach, which is psychology.
From past experience, I have found that when value is underperforming, I can be tempted to churn my holdings -- a trait that is hardly helpful to my long-term performance.
However, by having the S&P 500 and bonds, I feel I am not missing out and, therefore, am less likely to make a mistake that is detrimental to my wealth.
This approach might not work for everyone, but it is not supposed to. I have found it works for me and I am only managing my wealth, so I have built a strategy that works for me. Charlie Munger (Trades, Portfolio) has said, “Someone will always be getting richer faster than you. This is not a tragedy.”
He is advocating you use a strategy that works for you. Investing in your comfort zone, in a way that works for you, is critical if you want to be a successful investor. The use of an index fund is helping me accomplish that.
Disclosure: The author owns the S&P 500 via index funds.
