Investing Philosophy Part 2: Which Index Funds?

In it for the long haul? This chart tells the story.

UPDATE: I have gone against this reasoning and gone with VTI. Read this for a breakdown and charts and stuff!

Back in February, I laid out the reasoning behind my stock/bond allocation and rebalancing strategies. Basically, I waded through a lot of literature and decided that for my goals and (hoped for) discipline, an 80/20 stock/bond split and rebalancing quarterly made the most mathematical sense. I know, I know, it's a little dry, but those are fundamental questions you need to answer if you want to get the investing side of your financial triangle in order.

Around the same time, I was also reading Andrew Hallam's newest book, The Global Expatriates Guide To Investing and in his chapter about Index Fund Investing With a Twist, he talked about something I wasn't familiar with, Fundamental Index Funds.

Up until that point, I had only purchased diversified, low cost index funds, specifically, Vanguard Total World Stock Index Fund (VT). And I was very pleased with how it had been doing. But apparently, Fundamental Index funds could juice my returns around 1-2% over their lifetime. And as I'm a long term, index fund investor, over a couple decades, 1-2% could add up to hundreds of thousands of dollars.

So what are these magical financial products? They are designed as index funds that try to avoid the "hype" that some companies get which increases their stock price without having a real connection to the companies earnings. They stay more closely tied to a company's "Fundamentals" so that companies with stronger balance sheets will have larger chunks of the index fund. This is in contrast to traditional "Market Cap" index funds, like those that Vanguard has traditionally offered (although now they are offering some of these as well, but this only started a couple months ago) which just focus on how much size the company has, its Market Cap, where a lot of its size comes from its stock price.

If you want more data, and to really dig into the weeds, these two articles "Is it worth making the shift to fundamental indexes?" By Andrew Hallam and "Fundamental Versus Cap-Weighted Index Funds" by John Dahle, do a great job explaining it in more detail.

I decided to make the shift, after I did some research, even though the picture got a bit more complicated. The Fundamental Index fund I found was PowerShares FTSE RAFI US 1000 Portfolio (PRF) and when I compared it to my beloved VT, I paused a bit, but eventually pulled the trigger. Let me explain why using charts.

Year To Date for PRF (in purple) and VT (in Black)

For the keen eyed among you, you'll realize that for this year, VT is beating PRF! Sure, it's been a bit of a weird year, starting with a sharp climb, then dropping fast, then up and down, with it pretty firmly down right now. And if you just kept it there, obviously picking PRF over VT is a bad choice as it lost more money.

But here's the thing. Index Fund investing is a LONG-TERM system. So I needed to look at this comparison long term. At 3 years of comparison, it looks different.

PRF is now doing better than VT, up around 18% compared to around 15% for VT. And if you zoom out even further, to 10 years, the comparison is even easier to make.

At a range of 10 years, PRF is over double the increase, around 125% vs up 50% for VT. That is a HUGE increase in return. Now of course, prior performance does not predict future returns. But the math seems to work, over the long haul. And as I don't have any plans to retire for another 15 years or so, I need something that performs the best for that 15 year period. PRF just seems like the right solution for me.

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Update (May 7, 2018): Two people, including the amazing Andrew Hallam, have brought to my attention that my comparison between VT and PRF isn't as accurate as it could be. VT is an index of the global stock market, whereas PRF is only US stocks. When you compare PRF to an index focused on US stocks, like VTI, the results are much closer. But here are 2 reasons I'm not rewriting the post. 1. The conclusion that over a 10 year period PRF has better returns doesn't change. The amount of difference is lessened considerably, as shown in the following chart. 2. There is no world-wide Fundamental Index that is parallel to VT that I could find. VT is what I owned, so I was looking for as diversified a Fundamental Index fund as I could find which outperformed VT. That's why I compared these two specific funds.

VTI vs PRF over 10 years.

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