Marco Sammon joins Ben and Dan to unpack his latest paper, ‘Index Rebalancing and Stock Market Composition’, beginning with how Marco’s work (co-written by John Shim) compares to the Nobel Prize-winner Bill Sharpe’s paper, ‘Arithmetic of Active Management.’ We investigate the missing links in Sharpe’s logic before defining “the market” and ascertaining the main objectives of index funds. Then, we dive deeper into the mechanics of Marco’s paper, index and market tracking errors, why delayed rebalancing is more beneficial than instant rebalancing, and the role of technology in the modern tracking error obsession. We also assess the passive-active spectrum of index funds in portfolio management and learn how investors should choose their optimal excess return. To end, Marco shares practical applications for improving performance benchmarked against traditional indexes, and the Aftershow is all about bridging the gap between PWL Capital and you, our listeners.
Key Points From This Episode:
(0:00:00) Key takeaways from Marco Sammon’s latest paper and how it compares to Bill Sharpe’s ‘Arithmetic of Active Management.’
(0:08:10) Marco describes what’s missing from the ‘Arithmetic of Active Management’ logic.
(0:09:11) Defining ‘the market’, the main objective of an index fund, and how index funds track the market.
(0:15:57) The mechanics of Marco’s paper, ‘Index Rebalancing and Stock Market Composition.’
(0:18:38) Factor exposure, index and market tracking errors, and how often index funds trade.
(0:26:28) Rebalancing less frequently; why delayed does better than instant rebalancing.
(0:31:59) The tech run-up and lazy rebalancing, and the modern tracking error obsession.
(0:36:51) Assessing the passive-active spectrum of index funds in portfolio management.
(0:41:02) Exploring how investors should decide on their optimal excess return.
(0:45:14) How the rising index fund ownership of stocks impacts the implicit cost of indexing
(0:46:58) Practical ways to improve performance benchmarked against traditional indexes.
(0:52:30) The Aftershow: Canadian finances, more airtime for Cameron, and PWL – OneDigital.
Read The Transcript:
Ben Felix: This is the Rational Reminder podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We're hosted by me, Benjamin Felix, Chief Investment officer at PWL Capital, and Dan Bortolotti, Portfolio Manager at PWL Capital.
Dan Bortolotti: Happy to be back.
Ben Felix: Welcome to episode 355. Our episode formats are super confusing. This is one of those episodes where it's not technically a guest episode. It falls in the place of where we'd have an episode with just us hosts talking about a topic. But for the main topic, we have a guest. It's very confusing. But we still have the after-show. It is a great guest. We still have the after-show and we still do a little intro.
We have Marco Sammon back to talk about one single paper, which is why he was the main topic in an episode instead of being a full episode because we thought it wouldn't be enough content, but we ended up talking to him for about an hour, anyway. It's really interesting research that he's come up with on the nature of index fund rebalancing. And it shows some cracks around the edges of Bill Sharpe's famous ‘Arithmetic of Active Management’, which is something that may be surprising for a lot of listeners to hear, that there are cracks in that logic, which seems pretty bulletproof.
Marco has this new paper out with co-author John Shim and they look at how changes in market composition affect index fund or index, and by extension, index fund returns through the timing of index fund rebalancing. Think about things like new share issuance from existing companies. So an existing company issues new stock, they raise equity capital. Or a company lists for the first time in the public market, they do an IPO. Or a company buys back stock. Or a company gets delisted. Those are all changes to market composition. And the nature of index investing, which requires tracking an index, means that index funds have to trade around these events to minimize tracking error, which is their job. An index funds job is to track an index. And so to do that, when the market composition and therefore the index that is representing the market changes, index funds have to trade around that to match the index.
Now, the reason that I think this is really interesting is that Bill Sharpe's famous ‘Arithmetic of Active Management’ ignores trading explicitly. Sharpe talks about it in the paper, in a footnote at least, about how in his model there is no trading. And so Marco's paper is looking at the implications of when index funds do trade around changes of market composition and asks what are the implications for index and therefore index fund returns.
And in the title, they reference adverse selection costs. They're really looking at are there adverse selection costs to buying stock when firms want to issue it or when they go public and selling stock when firms want to buy back shares or when they get removed from the index. I read this paper and just was blown away at how insightful it was looking at something in a way that I think is pretty unique. I don't know, Dan, what do you think?
Dan Bortolotti: Yeah, I thought it was very surprising because I think indexes and index funds have this kind of reputation of funds that just buy the market full stop. They don't do anything. They just make one series of transactions and then that's it. And I think our discussion with Marco really revealed there's a lot more involved behind the scenes in managing an index fund than a lot of people believe.
Now, what goes on behind the scenes has nothing to do with stock selection and market timing and all of the things we associate with active management. It's just administrative, but there's a lot of it. And when we talk about index funds by the market, we chat with him about, "Well, what's the market?" And I think we have to agree that indexes are not the market. They are a proxy for the market. They're never going to be exactly representative of all the securities that are available to buy as an investor.
There's a little bit more decision making and a little bit more trading going on behind the scenes than I think a lot of people appreciate. And as he's pointed out, that trading at the margins can actually have an effect on the overall performance and it's not always a positive effect, right? And it doesn't show up in tracking error. This is, I think, the important thing. People might say, "Well, this S&P 500 index fund tracks the S&P 500 almost perfectly. So what are you talking about?" The point is that it's the indexes returns itself that are affected by the factors that Marco discusses in the paper. It's a very interesting conversation. I think people will come away from it thinking about these funds a little bit differently.
Ben Felix: That point about tracking error is so interesting for a couple of reasons. One, because you wouldn't see this, like you said. But when you compare an index fund to the index, it's going to track it because that's its job. But that doesn't mean that it's maximizing the investment returns for the market exposures that it has. The way that Marco tests this is he compares in the paper an index, representing an index fund that rebalances like a normal index would, like at the normal intervals that an index would, and then compares that to a counterfactual index that has a lag in weights to incorporate changes in market composition. And they test varying lags and they find that longer lags, waiting longer after changes in market composition to actually trade, to actually reflect those changes in the index, kind of monotonically increases the returns of the index.
They can compare them, these delayed, rebalancing counterfactual indexes to something like a normal index that an index fund would track and show the implied cost of immediately reflecting changes in market composition. They're not material numbers. I won't spoil it. I'll let Marco quantify that for us. But super interesting.
The other reason, though, that the point you made about tracking error is interesting is that that is a reason that people wouldn't necessarily do the stuff that Marco was talking about. Because we can say, "Hey, this is a really cool research. If you delay reflecting changes in market composition by a year, you're highly likely to outperform in the long run." People might look at that and say, "Oh, that's really cool. I want that." However, you're going to have tracking here.
There will be years or sub periods, maybe months, or quarters, or whatever, that this lagged rebalancing index actually underperforms major indexes like the Russell 3000 or the S&P 500. And a lot of people just can't handle tracking here. And we have a whole discussion about that in the episode. It's a really interesting thing to think about. It's like, "Hey, here's a little optimization. Oh, but there's a price. You might perform different from the index, from the major indexes over some periods of time."
Dan Bortolotti: And you have to be confident that the tracking error, in other words, your fund performance versus the index is going to be positive over the long term. How can we be positive of that? We can never be positive, but we can be highly confident. And as you said, there's a lot of pressure on advisors and specifically on institutional fund managers. You got to track that benchmark very, very tightly. And there's very little tolerance for straying from it. And so there are some practical restraints or constraints to implementing Marco's ideas in the real world. It's an interesting discussion. I think people will enjoy it.
Ben Felix: In some ways, it's like the factor investing idea where you can say, "Hey, this factor investing thing has higher expected returns, but you're going to have some tracking error. I think the tracking error in this delayed rebalancing case is lower, but it's the same kind of idea that looks like it might give you higher expected returns in the long run, but you've got to live with tracking error in the interim.
We interviewed Marco about this paper a little over a week ago at the time that we're recording, which is a little over two weeks ago at the time that the episode is released. But with that, I think we'll go to this fascinating conversation with Marco Sammon.
Ben Felix: Marco Sammon, welcome back to the Rational Reminder podcast.
Marco Sammon: It is so great to be back. Last episode was a really good time, so I'm looking forward to have another conversation.
Ben Felix: So are we. Yeah, you had this new paper come out and I read it and I was like, "Okay, we have to have Marco back on to talk about this."
Marco Sammon: Let's go.
Ben Felix: What is missing from the ‘Arithmetic of Active Management’ logic?
Marco Sammon: So, to catch everyone up who may not be familiar, Bill Sharpe, who won the Nobel Prize a very long time ago, has this very famous paper called the ‘Arithmetic of Active Management.’ The idea is simple. Let's imagine the whole equity market as a whole with respect to itself, the alpha zero of the whole market. Now, if passive is just tracking the market, then the alpha of passive has to be zero. But if the whole market has a zero alpha and passive is a zero alpha, that means when we add up collectively an evaluated average basis, active has zero alpha.
And this is one of the critiques of active management, like on a valuated average basis, active can't beat the market. But there's two important assumptions here, and I hope we get back to the second one. The first one is that passive actually holds the market, and passive may not hold the market. And the second thing is, it assumes a static investment universe. It assumes that the set of investment opportunities is fixed, and this is also not true. And so, these two things are where the ‘Arithmetic of Active Management’ might break down.
Ben Felix: Let's back up for a second. What is the market? Because I think we kind of take that term for granted.
Marco Sammon: That is a great question, and that exactly gets to what this paper is about. So I think you could imagine a really extreme version of the market, which is, at every point in time, you're going to hold on a valuated average basis every publicly available security. Now, this is actually infeasible, because if you're running an index fund and you, for example, wanted to replicate this, it would mean that when an IPO happens, you need an allocation in the IPO. When an SEO happens, you need an allocation in the SEO. When a buyback happens, you need to be able to sell into the buyback.
Of course, the market could be every ordinary common share traded on major exchanges at every point in time. Now, no index fund can do that, so they say, "Well, we're going to add new stocks with a delay." CRSP funds who run Vanguard, they add an IPO four days later. S&P, they're going to wait a year for four quarters of gap earnings. Russell waits between a quarter and a year. The definition of the market actually depends on what is feasible versus some kind of theoretical ideal.
Ben Felix: What's the main objective of an index fund?
Marco Sammon: I think the way the index fund game has been played, and correct me if you think I'm wrong, is an index fund's goal is to track a particular index. Russell comes out and says, "This is the Russell 1000." The Russell thousand managers say, “I'm going to minimize tracking error defined as the standard deviation of the difference between my fund's returns and the index's returns. I'm going to minimize that.”
Now, how do they typically do that? Well, you could hold all the stocks in the right proportion. When a stock gets added, you buy it in the close and the day it's added. When a stock gets dropped, you sell it in the close and the day it's dropped. And that's how you're going to minimize tracking error. But this, I think deviates from our original idea. The CAPM describes that it's optimal. These really old theories, modern portfolio theories, they prescribe for a lot of people or everyone, it's optimal to hold some combination of the risk-free asset in the market portfolio. That's what's optimal in the CAPM world.
And so I think the genesis of index funds, if you read the Nobel Prize announcement from when Gene Fama won the Nobel Prize, they argue that when markets are efficient, this is what is the motivation by index funds. The goal is to track the market, but the market's not feasible. So we've made the goal to track a particular index. That's one way to think about it.
Ben Felix: The main objective of an index fund is to minimize tracking error to an index.
Marco Sammon: Exactly.
Ben Felix: Okay. How well do index funds track the market?
Marco Sammon: First of all, I think a different question is how well do index funds track indices? Index funds really, really well track indices. I mean, this is actually quite impressive. You think about VTI, it's a huge fund, over a trillion dollars. There are over 3,500 individual stocks in that fund. VTI has to trade 3,500 stocks. Their tracking year is less than five basis points. That is honestly trading 3,500 stocks to match an index. It is impressive.
Now, however they track the market? They track the market a little bit less well, and this goes back to something we should talk about what does it mean to be active and what does it mean to be passive? Every index fund has a different set of rebalancing rules to prescribe what they have to do. VTI actually is an R sample that we looked at. The index fund that is the closest tracking the market, which makes sense. They hold 3,500 stocks on a value-weighted average basis, but they deviate a little bit by about 70 basis points to standard deviation a year. Where does that come from? Well, it comes from the fact that they can't participate in these primary market transactions. It comes from the fact that they have certain stocks that they don't invest in. They apply float adjustment. So very closely held stocks.
And it comes from the fact that even if we think about buybacks, firms might not announce, “On this day, we bought back these many shares.” Vanguard might only learn that with a delay. And that's not Vanguard's fault. That's just the way it works. And so I think Vanguard is close, but they still have a calculation annualized 70 basis points of tracking error. And then something like Russell, which rebalances once a year. I know they're moving to semi-annually. But Russell, which rebalances once a year, they have a little more tracking error with respect to this ideal market. Yes, they kind of track the market, but they all kind of have different rules that make them deviate in certain ways.
Dan Bortolotti: Mark, I wonder if you think we've become a bit too complacent in thinking that well-known indexes are the market. In the media, all the time we hear about the S&P 500. Or more egregiously, the Dow Jones, which is a very crude proxy for the market. And I'm wondering if you feel that the fewer rules that a cap-weighted index has. Instead of the S&P 500 that tracks 500, not even the largest 500, but there's some selection involved, versus say a total market fund VTI, which just tries to hold everything that is reasonably possible. Are those total market indexes less susceptible to the problems that your paper identifies?
Marco Sammon: Okay, there's a few things. We haven't even talked about the problems that I've identified yet. But I do think the Dow is a great example. I love it when someone calls me and says, "Marco, the Dow is down 400 points." And I ask myself, "What is a point on the Dow?" Yes, everyone thinks this is the market. And by the way, to go back to the CAPM, the CAPM really should be using the aggregate wealth portfolio. And the private equity market is not the whole wealth portfolio. And to give you a particular example, this is not a critique of private equity. This is what private equity does. Suppose private equity identifies that Ben's company is cheap and they buy it out. Now the index funds don't get to hold that company anymore and the private equity companies benefit from having it cheap. Suppose five years later, the private equity company re-IPOs it after having increased the multiple. Now index funds are going to buy it at higher valuation.
I just want to say that I do think the prescription of the CAPM is to hold the market. The public equity market is one thing. And then of course, the narrow we make the index even less representative it is. But even just to highlight, the public equity market, even VTI, is not what the prescription of the CAPM or modern portfolio theory says is the market.
Ben Felix: Yeah, that's a good point. It's okay to critique private equity though, if you want to.
Marco Sammon: You know, I like stories. I remember my first day in graduate school, they sat us down in this big room, and they had the dean come in. And I was a kid. I didn't know anything. The dean comes in there and the dean is like, "You will one day have great authority on one tiny thing, and you should not use your authority to apply on things you know nothing about." I am not an expert on private equity. I have never written a paper on private equity. I want to focus on index funds. That's what I've spent the past four years studying, not private equity.
Ben Felix: Makes sense. We did ask Eugene Fama about that when he was on this podcast. We asked him this question, "Should private equity be included in the market portfolio?" He said something like, "It's not obvious. We don't have very good data, one. Not obvious that after fees that you're actually getting, the benefit that the CAPM would suggest that you should be getting."
Marco Sammon: We'll come back to fees in a second, but everything we're talking about so far, if you want to talk about what Sharpe's arithmetic is missing, everything I said so far is gross of fees. And if the value-weighted average active alpha is zero gross of fees, net of fee it has to be negative. Fama has a famous paper, 2010 in the Journal of Finance, exactly about that.
Ben Felix: Let's start to get into the mechanics of what your paper looks at. What specifically do index funds do in order to track indexes?
Marco Sammon: There's two broad reasons that index funds need to trade. One of them we're going to call scaling trades and one of them we're going to call rebalancing trades. Scaling trades are like you get an inflow or you get an outflow, or you get a dividend, or you have to pay a dividend, or we have some company that delisted and we get some delisting proceeds. We can call them cash events. This is when the index fund suddenly has extra cash. I know I'm abstracting from ETF arbitrage, but let's pretend for now it's an index mutual fund.
What do they do when they get the cash? They scale all the positions up proportionally. What do they do when they get an outflow? They scale all down all the positions proportionally. This also applies when there is imbalance between additions and deletions. When Tesla was added to the S&P 500, its weight was a lot bigger than the weight of the investment management which was dropped. So if you look at the data, SPY had to scale down every single position by 1.6% to make room for Tesla. But these things do not change the composition of the portfolio. All they do is make it bigger or smaller. And it shouldn't affect the returns because they're not really changing the composition.
The important thing that index funds do is they trade a response to composition of the market. And let's use VTI as an example, and then we can also talk about SPY in a second. VTI is going to buy almost every IPO. Anything above the small-cap threshold within four days, they're going to buy. When a private equity company buys out a company, they're going to have to tender those shares and get the cash.
Here's another thing though that a lot of people are less aware of. When a company issues equity, whether it's through compensation, secondary equity offering, exercise of warrants, convertible debt, that increases index-eligible shares. The index funds have to hold a constant percentage of the index-eligible shares of every member, so they're going to have to buy companies that issue equity. Similarly, when a company buys back equity, that's going to reduce their index-eligible shares. What are index funds going to have to do? They're going to have to sell those companies.
And so we can imagine if we start with some initial portfolio or index fund and we have some end portfolio, we can get there with three pieces. There's one piece that scaled the portfolio up and down in response to flows. There's one piece that deals with additions and deletions. And there's one piece that rebalances among stocks that did relatively more issuance or relatively more buybacks. And that's how we can think about basically every quarter or every year depending on the index, how they get there.
Now you say, "Marco, what is the supply to the S&P 500?" The way that I think about it, and this is maybe a little too index-fund nerdy, is the S&P 500 applies a float adjustment. They set the index-eligible shares of every non-member to zero. And then when they add a stock, that how now has a positive investable weight factor. And when they drop a stock, it goes to zero. And the same exact logic applies to every value-weighted index.
Ben Felix: Okay. If we look at the other two trading portfolios, what do those look like in terms of something like factor exposure?
Marco Sammon: The first thing is we have to go back, and this goes back to literature on this, what type of companies are issuing equity? Well, companies that issue equity are companies that have usually relatively high valuation. There's an old literature that firms like to time the market. These are going to be companies that are not very profitable. If you look at a profitability factor, they're going to load really negative on that. And if you look at a value factor, they're going to load negatively on that. They're going to look more like growth firms.
Similarly, when we look at stocks that are added to portfolios, they're going to load positively on momentum. These are stocks that have gone up a lot recently. They're going to load positively on aggressive investment. These are kind of momentumy stocks. And so I think what you're previewing is, we actually did this decomposition for every single index fund in the CRSP mutual fund database. And we look at the returns to the scaling portfolio, the average return and the factor alpha are just zero. Like you said, the scaling portfolio was not super interesting.
What is maybe a little more interesting is the unconditional return of that intensive margin rebalancing portfolio that buys companies that issued equity and sells companies that bought back equity has a big negative return and there's still an annualized alpha of about minus 3% per year of that rebalancing portfolio. There's also a negative alpha although not significant for the extensive margin. The buying and adding and dropping, that also has a negative alpha, but that's not super significant.
And then the last question is, how does this matter? We've showed you that the trades that index funds make don't look good. And this is, by the way, not new. People, the issuance anomaly like Sheridan Titman 20 years ago wrote a lot of papers on the issuance anomaly. What we think is interesting, John and I, in our work, is we have quantified a way that the issuance anomaly affects the way index funds affects their returns. And we think it could be 20 to 80 basis points a year.
The intensive modern rebalancing portfolio is about 8%. You get the alpha estimate, you're going to get 20 to 80 basis points a year. And this is a lot larger than fees. If Vanguard is charging three basis points a year, five basis points a year, and you're missing 20 to 80 basis points a year by trading in a way against informed people, firms know what their stock is worth. Firms are going to try to take advantage and do market timing, you're taking the exact other side of that with these mechanical loops.
Ben Felix: You've got factor loadings that indicate lower expected returns for these types of stocks. But then in the case of one of the portfolios, you also have a pretty significant alpha after adjusting for factor exposures.
Marco Sammon: Yeah. I do want to add one more piece of this is we've tried a lot of different things with those specifications. And this goes back to our original discussion of what is the market. And we can have two broad ideas of tracking error. One is index tracking error. How well do you replicate your index? One is market tracking error. How much do you look like the market?
Now, suppose we have a stock that's going to be added to Ben's index and it goes up 100% ahead of time. There's a bunch of really smart Dan has a fund that goes out and predicts what stocks Ben's going to add to his index. They go out and buy those ahead of time. They push the price up. Now, Ben goes out and he buys in the closing auction those stocks. His tracking error is zero with respect to his own index because he added the stocks at the price that they're added to the index.
However, remember what we said, like Sharpe's arithmetic assumes a static investment universe. Someone earned that hundred percent run-up ahead of time preparing those shares. And I think what John and I are saying, if you had market tracking error, which includes all the stocks at all points in time, that would include the returns you missed when everyone front ran your index. And that is not accounted for in current index calculations.
Ben Felix: Is that something your paper is looking at? Or is that a separate effect?
Marco Sammon: We do have this idea of market tracking error. And this is not in the version that's online yet. That's coming. John and I are working on it. There's two points you could say here is one – and this goes back to our original debate. What does it mean to be active? And what does it mean to be passive? Of course, if you know that there's an issuance anomaly, you can deviate from what you think trading every second and have a different set of index rules. But when you do that, you start to look less and less like the market.
John and I's prescription is that if a firm sells equity when the price is high, why don't you wait to rebalance? Wait six months. Wait a year. Wait for the market to correct the mispricing that the firm is exploiting and then rebalance. When you wait a year, you're taking more market tracking error. You're not holding a stock or you're not holding the composition of the market as it is. But you also may be increasing your returns by not getting adversely selected by firms.
And so in the new version of the paper, we're going to have this idea of a market information ratio, which is going to trade off the additional return you get from, say, buying at a certain time with how much you deviate from the market. And the market information ratio will account for front-running and trading costs. And we have a whole model of trying to estimate the expected price impact. It should all go in there. But we're pushing for a different way to evaluate index funds. If index funds get really front-run given the rules they follow, that is forgiven in standard tracking error in the way it's calculated now, which we think maybe we want to push against.
Dan Bortolotti: Mark, can you give us an idea of how often index funds typically trade? I mean, obviously the answer is going to be different for different funds, but it does seem to me that traditional index funds trade very, very infrequently. If you look up their trading expense ratios, they're frequently rounded to zero. And so if there are these kind of frictional rebalancing costs, how can they be showing up to the extent of 20 to 80 basis points when there are really so few trades?
Marco Sammon: I want to push back on the idea that there are so few trades. First of all, an important thing is, at the end of the quarter, when a fund like VTI rebalances, it actually has to trade all 3,500 stocks. Why? Because even if you didn't issue any equity or buy back any equity, everyone else did something, and that money needs to be funded from somewhere. Even if you did nothing, and Ben's company bought back a little bit, I'm going to have to now reinvest with the money I get from selling some event stock.
We found that on average, over the last 20 years, a value-weighted index fund on a gross basis – this is not the SEC's definition of turnover, which is like a net. On a gross basis, it's 8% to 10% a year of a portfolio like VTI is turning over. So that's the first part is that, actually, index funds trade a lot. That doesn't account for when they buy a big IPO, they have to scale everything down to fund a big IPO. That doesn't account for ad hoc events by S&P where they have a merger and they need to add a new stock to stay at 500. And so I actually think that they trade more than we think.
The second thing is, and this is related to my paper with Alex Chinko that I talked about last time I was here, is that if you trade in the closing auction, it's kind of weird. Our traditional measures of trading costs, and price impact, and effective spread, or bid-ask spread, or realized spread, these things don't really apply in the closing auction. There's a price. You submit your market on close by, your market on close sell, you get executed at a certain price. That's exactly the price the stock has added to the index.
You could say, "Well, my trading costs were zero. I put in a market on close order. I got the close price I have zero trading costs." That's one possibility. I don't want to say what index funds are doing, but that's one possibility. But my paper with Chris, we have a paper on IPOs. For the average IPO being added to the VTI, it increases 40% from the IPO price to when Chris buys it. There are a lot of intermediaries who buy those stocks knowing they are going to flip it four days later. We believe that should be reflected as a trading cost. That is an execution cost.
You could imagine, "Oh. Well, one, maybe no one prepares the shares, and Vanguard puts in a huge order, and then we walk all the way up the book on the day of." Or everyone buys the shares ahead of time, we walk up the book that way, and then it happens, and there's no price impact. But I'm going to push back against the idea that, one, they don't trade that much, and two, I think we're mismeasuring the trading cost of index funds by just looking at the trades they make in the closing auction.
Ben Felix: If we did less frequent rebalancing, how significant do you think the effects would be?
Marco Sammon: John and I again find that the less frequently you rebalance in response to compositional changes, meaning adding IPOs, buying issuers and selling buybacks, returns are pretty much monotonously increasing. They start to level out around two or three years. But we actually did a crazy exercise where we said what if you run an index fund starting in 1980 and you never rebalanced? You're not going to have Apple, you're not going to have Amazon, you're not going to have any of these big names, you're not going to account for anything. That thing's cumulative return is nearly the same as the fund that rebalances much more frequently.
You mentioned Gene Fama before. Gene Fama used to always say, “No stock is so important that you need to hold it.” No individual stock is so important that you should have to immediately trade to rebalance your portfolio to hold that stock. John went to Booth and was Fama's student. So I think that was one of the guiding principles that like Gene has been saying for a long time, no individual stock is so special that you need to hold it right away.
And so returns are increasing. It does level off around say a thousand days or a few years, but it does level off but returns are increasing. And so like we said, you move, say, from quarterly to annual. You can improve your returns like 20 basis points. And if you go two years, three years, maybe you can go up to 80 basis points.
Now an important caveat is when do you earn higher than the market and when do you earn lower than the market? We've talked to a lot of index fund managers and they say, "Marco, if I end up underperformed by five basis points, I'm out of a job." In certain years, like 1999, where the – I hate this word, but like a growth episode where everyone gets really excited about tech stocks. Tech stocks are issuing equity, IPOing at sky-high valuations, and then they continue to rise, our sleepy rebalancing strategy is going to miss that. We're going to underperform by 20 basis points, 25 basis points in 1999. It's going to look really bad for our strategy.
But then in 2000, 2001 and 2002, we're going to outperform by 40 basis points, 60 basis points, 80 basis points, because we did not buy pets.com, company that has zero revenue, infinite multiple. And so you have to be careful that, yes, we can improve average returns. But this is a strategy for a very long run investor who on any year or two-year basis, when there's a growth episode, whatever you want to call it, it's not going to get skittish and sell out of the strategy. Because in the long run, we believe it does deliver higher returns.
Ben Felix: I didn't think about this paper when I was reading yours, and I don't think your paper mentions it, but Jeremy Siegal has a 2006 paper in the Financial Analyst Journal. Have you seen this one?
Marco Sammon: No. What's it about?
Ben Felix: They do what you just said. They compare the returns of the original S&P 500 firms from 1957 through 2003 to the actual index and find that the original firms outperform. I'll send it to you.
Marco Sammon: You have to send it to me. That's awesome. But my guess is those last six years are really going to help his case because the stocks added from '98, '99 do really bad.
Ben Felix: Yeah. I think that's true. I think they have a chart in the paper showing. I haven't read it in a while. I'll send it to you.
Marco Sammon: That's fascinating. We have to cite that paper and link to it more closely. But that's exactly consistent with everything I've been telling you so far.
Ben Felix: The answer to this question might be obvious because you kind of explained the mechanism earlier, but what is driving this excess return from delayed rebalancing?
Marco Sammon: You're asking why do we believe that the delayed rebalancing does better than the instant rebalancing?
Ben Felix: Right.
Marco Sammon: There's actually two components of it. One, I think I explained that I'll revisit quickly, and then there's one that I haven't explained yet. The one that I explained is the idea of you avoid getting adversely selected by firms. And maybe that's not the exact right word. Suppose, for some reason, say, GameStop's a good example. Some people who are not firms get really excited about GameStop and push up GameStop's price. Maybe GameStop's managers are not super privately informed, but they go, "Wow, our stock price went up a lot. Maybe now is a good time for us to issue equity." And then what do index fund do? They're going to buy GameStop.
And so I hate to pick this as an example, because, again, you could miss Apple, and our strategy still works. It's not just all Apple, but Apple has done pretty well. They've been buying back shares from whenever Einhorn started that campaign for iPrefs. They didn't do that, but they ended up doing a lot of buybacks, and they've done really well, and you're reducing your holdings of Apple every quarter.
And also, like we said, you're buying unprofitable firms. You're also taking factor risk which also has negative returns. You're buying growthy firms, you're buying unprofitable firms, you're buying stocks that have went up a lot recently. You avoid these negative factor premium, if you want to call it that. And in addition, you avoid this mania's adverse selection problem.
The second thing that we believe is important about rebalancing less frequently, and this is not in the version of the paper we have right now, is how we believe trading costs work. A lot of trading cost models, like ITG has a trading cost model like this. Erik Stafford, my colleague, has a paper called 'The Price of Immediacy'. And in all these kind of models, trading costs have some kind of curvature. There's some square root function usually as a percentage of ADV.
Now, what does that mean? When you trade a little bit, you're walking up that square root function very fast. When you trade a lot, you start hitting that point where the curvature on a flatter point, the slope is relatively shallower. If you're an index fund and you have to trade all the time to make room for an IPO, you have to trade 3,500 stocks. You're going to be on that really steep point of the trading cost curve more frequently. By waiting and by putting in your trades at scale, you can take advantage of some of these benefits of being further up and on a flatter section of the marginal cost curve of trading and reduce your trading costs as we have measured them, which hopefully, to some degree, account a little bit for the front running and some of the other elements we've been talking about.
Ben Felix: You mentioned the tech run-up being pretty rough time for this lazy rebalancing because you're missing out on the gross stuff. This makes me think of Zahi Ben-David's paper on thematic ETFs. You're basically buying something that looks like the thematic ETF portfolio.
Marco Sammon: Exactly. And so just to catch people who haven't seen Zahi's paper, the idea is people make indices on all types of things. And sometimes indices don't even have an ETF yet. They're just an index of Ben and Dan's favourite value stocks. When those indices have gone up a lot, people are like, "Oh, wow. Now is the time I better launch an ETF on that index." They do exactly that. And of course, they're buying high, then the performance reverts, and then these newly launched ETFs are disastrous. It's exactly have that flavor. But the important thing here in going back to Sharpe's arithmetic, because I think that's a good null hypothesis for the whole thing, it comes from the investment universe changing.
When companies issue equity or companies get IPO'd, it changes the universe of stocks. And that's one place that the margin of Sharpe's arithmetic can break down. Zahi's paper is about something a little bit different. That's within the existing set of universes. This is a new ETF. And our point, it's just a little bit different on changing the composition of the market.
Ben Felix: How much tracking error are we introducing by delaying rebalancing?
Marco Sammon: I wish I had my slides in front of me. Maybe next time I'm on, I'll have little slides. As you're going to delay rebalancing, you're going to have more and more tracking error. But because no stock is super special, like with everything else we’ve talked about, it is going to level out at some point. There's some point where the tracking error is not going to increase that much more. And so if you rebalance, say, once a year, you might have 80 to 100 basis points of tracking error at a daily level annualized relative to our ideal version of the market.
Now, I think that a lot of people are going to say, "Wow, Marco, my tracking error budget is five basis points a year. This is something I can't stomach. We can't do that." But John and I believe, "What if we just defined a new index? What if we defined Marco and John's sleepy rebalancing index?" You could run an index fund with zero tracking error with respect to the index as we have defined it. And I think it's a good question. Yes, we're going to incur more and more market tracking error by delaying more slowly. But if that's the goal of what the fund is doing, we think it's okay.
And then I want to ask you guys here, because this is something that John and I were really wondering. Why do you think the index fund world has become so obsessed with tracking error? This is the way we compensate managers. This is how people get and lose their jobs. I've talked to a lot of people who say all I care about is minimizing tracking error. Is there a huge agency problem? Are people really worried that people are going to run the index fund badly and we need to really tie their hands just giving them a tracking error budget? Why is this the equilibrium we're in?
Dan Bortolotti: That's a really interesting question. I would say that certainly most individual investors are not going to be sensitive to it. But as advisors who work with clients and expound on the virtues of index funds, we do want to hold the funds accountable and look for those low tracking errors. I can think of a specific example that happened a few years ago with an iShares fund that was supposed to be a total market US equity fund. They tried to get a little creative. And I honestly don't know what they were thinking, but they could have simply bought all those stocks in the index like everybody else does. Whatever they did caused a very significant tracking error. It was something like 50, 60 basis points, or it might have even been more than that.
And as advisors who were using that fund, we actually went to the fund provider and said, "What are you guys doing? You have a responsibility to deliver the index return. And it's not your job to get creative and try to improve on it and, by doing so, have it backfire." I do think there is some accountability and there is some expectation. That's why I find it so interesting that you're saying it becomes self-referential at some point. We build the index and then we implement the index and we pat ourselves on the back for tracking the index perfectly. But you've pointed out the very important distinction between tracking the index and tracking the market that the index is supposed to be a proxy for, and those are not the same thing.
Ben Felix: But it matters. In the example Dan just talked about, we do annual fund due diligence for all the ETFs and mutual funds that we use in our business, and we put a big warning on that fund that we are watching this very carefully. We may not continue to use it if they don't solve these problems. It's a real issue. And I would also think about some of the investment committee work that I do. Indexes are just reference point. And so even if an investment committee decided that we're going to do this lazy rebalancing thing, if you have a year of negative tracking error to the index, which you're still going to benchmark to, even if that's not what your fund is benchmarked to, it's a problem. It's a real problem. Should we keep doing this? I don't know. It underperformed this year.
Marco Sammon: I think what you're saying is if I'm going to use this as a building block in my broader strategy, I want to know that this is the building block I think I'm getting, especially if you're hedging some risk. I'm going to buy Facebook and short the tech ETF. I want my Facebook risk. And if all of a sudden my hedge isn't hedging what I thought it was, I would be really mad. I would tell those people, "Okay, this is not right."
But then I guess this gets now to the second question which I wanted to talk to you about, is this idea of this spectrum of whether this is active or passive. And I'm curious, when I say the word passive or someone says the word index, how do you think about that with your business? And then I'll tell you what I think about that.
Ben Felix: Yeah. It's something that we've struggled with the language on for a long time. Dan and I have slightly different approaches to portfolio management. Dan is generally using total market index funds. I'm generally using funds from Dimensional Fund Advisors, which tilt towards small capital value stocks a little bit, but are pretty close to an index fund. So we just say it's a spectrum and that Dimensional is closer to index funds, but it's not an index fund. But yeah, it's not an easy thing to communicate.
Dan Bortolotti: Yeah. I was just going to say that we were chatting, Ben and I, a little bit before about this idea that I think somewhere along the line, those of us who advocate index funds can sometimes slip into this notion that indexing is an ideology. In other words, cap-weighted indexes are perfect. They are the natural order. We must follow them exactly. And any deviation from that is not passive. It's a silly idea. And that's why I like the ideas in your paper so much is, look, the index is supposed to be a reflection of the market, but it's always going to be imperfect.
If we add a few extra rules that actually counterintuitively reflect better what the market is, rather than just simply reflect this man-made index, then there's a lot of potential for improvement here. I think the challenge, and this goes back to the question about tracking error, is how do you benchmark it? If my S&P 500 index fund, I can compare it to the S&P 500 index. But your sort of sleepily rebalanced fund, what do we benchmark it against? And if we can't benchmark it, how can we be accountable?
Marco Sammon: First of all, I like to give us a fun example is you're right, there's a spectrum of fully passive. Meaning we hold the market every second there is. And, fully active. Bill Ackman holds six stocks, and he's really convinced about those six stocks. The Vanguard total market is really close to that ideal of the totally passive fund. Now, we're saying we should rebalance less. Russell has until recent, until next year, I think, annual rebalancing. Does anyone go, "Oh my God, Russell is so active. They rebalance once a year. This is a huge deviation from the market." Of course. Actually, among all the major index families. This is not a critique of Russell because Russell actually also does better. In line with our findings, the Russell 3000 does better because it waits, but Russell deviates from the market by delaying rebalancing. Also, they trade all at once, so they walk up the trading cost curve in a smarter way. I've never heard anyone in the world ever say that Russell is really active for making that decision, and they're like, "Your thing is really active. You're delaying rebalancing." I'm like, "Well, other people are doing it," and no one says it.
The first thing I want to say is that we hold all the same stocks as VTI, we just rebalance them with a little bit of a delay, accepting for IPOs. The second thing is there's been a huge growth and we haven't talked about this yet. This is related to Zahi's paper of these thematic ETFs. My favourite example is COWZ. It's the hundred most profitable stocks in the Russell 1000 and it's weighted by cashflow yield.
Not only is it not the whole market, it's not value-weighted. Ended up putting a weight cap on it that I think you can't have more than a weight of 5% in the index because there were certain stocks that had a free cash flow yield. Dividend ETFs have the same problem when you wait by dividend yield. And so I think that in recent years, there's been an explosion of index products. Meaning they follow a set of publicly available rules that do not look at all like the market.
And I guess what John and I are saying is, we have a set of publicly available rules. We could say you rebalance after a buyback by weight up to 252 trading days. It is a set of public rules, but it looks kind of like the market. I want I want to push back. And now I've gotten so into this, I forgot my third point. I'm sure it'll come back later when you guys ask me a few more questions.
Ben Felix: The COWZ point makes me think of Adriana Robertson's paper on passive in name only. Are you familiar with that one?
Marco Sammon: I don't know it, but I think from the title, I understand the flavor.
Ben Felix: She talks about indexes that are created by the fund managers themselves. And so it's really just an actively managed fund, but they call it an index fund because they're tracking index, even though they have made index.
Marco Sammon: Yeah. If you think about like DFA or whatever, if they try to do smart things when small stocks, they can get them at a discount. Where do we draw the line between a public rule, taking a little bit of tracking error to trade a little smarter? It's really hard.
Ben Felix: How do you think investors should decide? I mentioned the investment committee example, or that's a hard thing because you've got a bunch of people with varying levels of knowledge, and you've got to benchmark against something, to Dan's point, about accountability. How do you think investors should decide on their optimal excess return from lazy rebalancing to tracking error trade-off?
Marco Sammon: That's a great question. There's some introspection, which is, how long am I going to have this investment? I actually think that for retail investors, when they underperform their buddies by 20% or 30% and they're going to go, "Wow, what's going on?" this is a very different value proposition than I'm running a pension fund that needs to provide cash flows 50 years in the future. And one bad year this year for three amazing years next year is a trade-off I'm willing to make. This first step is how long are you willing to stay in this?
Now, John and I's strategy outperforms almost every year for the past 40 years except for the '99, '98. And I think after COVID, a bunch of companies issued equity. And then when the rebound happened, it underperformed a little bit. Of course, that equity ended up not being amazing. Can you stomach one or two years of underperformance? And then we kind of have somewhere around two years. If you use our concept of market tracking error and market information ratio, our market information ratio is – this is not in the paper yet. It's going to go up very soon, I hope. Around two years is where you maximize the market information ratio.
Now, of course, the last thing we haven't talked about is how big is this strategy? How many people are doing this strategy? One good thing about our strategy is it's kind of immune in many ways to gaming by firms by introducing a fixed delay. So if you rebalance quarterly, if the company issues equity on the second-to-last day of the quarter, they might buy it two days late. Even if you rebalance once every five years, if you have a fixed period of rebalancing, firms could just wait and then issue right before when they know they're going to have an elastic buyer.
Our methodology imposes a fixed delay on all compositional changes. So that type of gaming, I think we're pretty immune from. The type of gaming we're less immune from is the front running. And so even if you're going to wait two years to rebalance, people who are sophisticated and can predict that. Remember this is all public rules. They could still front run you and that would show up as trading costs. And the bigger you got, the bigger your trading costs would be, and that might not even be linear. And so I don't have a great answer for it yet. But I do think, right now, we have a partial equilibrium view of you're one person running this strategy for something that is not systematically important in the passive industry ecosystem. As that changes, the rules we need might change. And so I can't speak to that yet. But somewhere around with our partial equilibrium calculations, two years is close to optimum.
Ben Felix: This probably isn't proper equilibrium thinking, but not everyone's going to do this because of the tracking error. I don't know how you do an equilibrium model of that, but it's just not going to happen. A lot of people are still going to prefer index funds because they can't stomach any tracking error.
Marco Sammon: They can't stomach any tracking error relative to the really famous benchmarks like the S&P 500 or the Vanguard Total Market. I totally agree. And so I think that I'm just trying to hedge a little bit and say there are some products that have become very huge. VTI now is buying 7% of the float of every IPO. That is a massive demand shock that is coming. You've had Val on here, and Ralph on here, and many people. We are having massive inelastic demand shock. And so I'm just saying that I want to be careful that if people move towards not even our model, but any model of rebalancing differently, whether it's sleepy rebalancing or instantaneously rebalancing, or here's one other thing, a weird feature. And I wanted to stick this in here because I think this is so cool. I forgot the movie it's from. If you don't skate where the puck is, you skate where the puck is going, right? This is like an old adage in hockey.
When an index one gets inflows, they scale everything up. Think about VTI, they scale everything up. And then at the end of the quarter, they end up selling Apple, which bought back. Now they're trading Apple twice. They're scaling up Apple when they get the inflows, and then they're scaling it down at the end of the quarter for rebalancing. Why not, if you're getting inflows, just put those into the things you know you're going to have to buy in the next regular rebalance, as opposed to putting them in things you literally already know you are going to have to sell on the next rebalance? Trading twice doesn't make sense. We could really go very far on the scope for enhanced indexing in this sense.
Ben Felix: I've just got one more question, and I think Dan has one last one too. What effect do you think the increasing share of index fund ownership of stocks has on the implicit cost of indexing as it's currently implemented?
Marco Sammon: This is actually a perfect segue from our last discussion, which is, do you think indexing is getting bigger and bigger in those inelastic demand shocks? Which, given the way many index funds are run now, happen all at once on one day and are predictable in many senses, you could imagine that this could increase the front running. But there is one interesting data point that I want to push back on here. So many of you might have seen that there was a Bloomberg article a few months ago saying Millennium lost $900 million in their contract index liquidity group.
This goes back to Jeremy Stein has a paper from the late 80s, I think, about the idea of an unanchored strategy. And I think this is one reason answering your question is so hard. What do I mean by unanchored strategy? Suppose you, Dan, and I all know that some fund is going to buy a million shares from Tesla a month from now. All of us start accumulating shares ahead of time with the idea of selling it to the fund.
I tell you guys, you shouldn't accumulate any shares. I've already got all the shares. We're going to tank the price. We can't commit to this. This is like Cournot competition. Now, if everyone bought too many shares because we cannot coordinate, we cannot commit. We all buy too many shares. We all sell them in the closing auction. The price goes way down and then all of our trades get blown out of the water.
In this sense, it is an unanchored strategy because none of us can commit ahead of time to limiting the quantity that we front-run indices. I think that even though these groups have had many good years, there was an article in Bloomberg like two years ago saying groups at major banks were making hundreds of millions printing money. And then you have a year like this year where they're losing hundreds of millions. I think that this coordination problem and this unanchored strategy problem makes this really almost impossible to predict.
Dan Bortolotti: Mark, I'm just wondering if there's any kind of genuinely practical application here, at least in the medium term. One of the trends we've seen in the index fund world is more and more funds are looking to alternative index providers, mainly to avoid the high licensing fees of the big guys like S&P, and the CI, and so on. These secondary index providers are looking to provide an alternative that has some advantages and not just, "Hey, I'm going to pick 500 large-cap US companies and make this kind of faux S&P 500." I'm wondering if you have heard of any index providers who are looking at this kind of research and saying, "Hey, we're going to start with these traditional cap-weighted indexes, but we're going to add this sleepy rebalancing strategy or some form of it. And we're actually going to suggest to you that this can improve performance benchmarked against the traditional indexes.
Marco Sammon: It's interesting, without sharing too much information, because we've talked to a lot of people about this. When we got covered in Matt Levine's article, a lot of people reached out to us. We talked about this last time in the podcast. Whenever you have a good idea, everyone says, "Oh, I knew it already. Actually, this is my idea."
What's interesting is some very large institutional managers. These are not fund providers. These are people who think sovereign wealth funds, think pension funds, they reached out to us, the people from their enhanced indexing groups and said, "Yeah, we knew this. We never do this." And actually, they try to participate a little bit in the front running. They buy a little bit ahead of the ad. They hold on to the drops for a little bit and get some of the bounce back.
I think that enhanced indexing groups at very large institutional managers who have the trading expertise and who have a long-term focus in consumer tracking error, they are already doing this, even if it's not a retail-oriented product yet. But I do think that you're making a good point.
CRSP is a great example of this. Having a five-day rebalance, letting the rebalance be spread out a little bit, having a little bit of uncertainty so you can't be perfectly front-run. I do think that, in many ways, these index providers that we follow, like Dow Jones, or S&P, or Russell, these are things that date back 50-plus years. And so a lot of modern indexing may be a historical accident. These index providers who were started a long time ago with a price-weighted index because that's easy to compute back in the 1920s, that somehow has carried over 100 years. And we think that if a lot of indexing is historical accidents, why don't we just start from first principles? We want to follow the advice of the CAPM. We want to track the market, but we don't want to expose ourselves to well-known risk factors. So why don't we just design a set of rules that does that?
Dan Bortolotti: I don't think there's any question that Dow Jones is a historical relic. If somebody were to create such a benchmark today, it would be laughable. And the only reason it still exists and so popular is because, well, it doesn't help that Dow Jones is a large media company as well. But what are all of the ideas? What are the core principles that make indexing so powerful? Just stick to those and recognize that there are some other factors in constructing and managing an index fund that don't really add any value and probably subtract it. If we can reduce those frictions and just stick to the big ideas, the question is, how successful can it be implemented? And I guess that remains to be seen.
Marco Sammon: I think I couldn't say it better than you. That's exactly right. That we should stick to the principles. These are indices that have been around for 30 years, more. We can revisit these ideas and then rebuild them given what we know.
Dan Bortolotti: I think it's important always to remember that those original indexes were not designed to be investment strategies. They were designed to be benchmarks for active investment strategies. The S&P 500 predates S&P 500 index funds by at least 20 years.
Marco Sammon: That's a great point that these were originally designed to evaluate active managers.
Ben Felix: Not to pile on to the other people thought of this before you, but –
Marco Sammon: But you thought of it first.
Ben Felix: I didn't. But DFA, like you said earlier, they do think about a lot of this stuff. But most of their strategies are factor strategies that are tilted towards certain types of stocks, but they do have one ETF that they converted from a mutual fund. I can't remember when. It's fairly new. But it's total market ETF. It doesn't have any factor tilts. It just tries to replicate or capture the returns of the market. But it follows DFA's trading strategies, which includes delaying, buying IPOs by – I think it's a year. Other stuff like that. And they don't follow a fixed rebalancing strategy. It's all flexible trading to try and minimize transaction costs.
When I read your paper, I went and looked at how that fund has performed relative to VTI. And when I looked at it – I don't know if it's changed since then. But when I looked at it, it outperformed by about 50 basis points, which is kind of like right in line with what your model suggests.
Marco Sammon: I did not know that. I got to look this up after. We got to talk about this afterwards. Everyone says, "Oh, what if you actually –" this is kind of like Dan's question, "What if you actually run this strategy? What does it look like? How does it do?" That's a nice first step towards, "Okay, someone tried to run this, and they can do better to the tune of our exact estimates."
Ben Felix: Yeah, I thought that was pretty interesting. This has been a great conversation, Marco. I think this paper is super interesting. Like I said, as soon as I saw it, I knew we had to have you back on to talk about it. But I think you're getting at some stuff that, like Dan said earlier, indexing has become, in a lot of ways, ideological. There will be people in the Bogleheads community who are going to be absolutely furious about this episode. But I think it's really important. And I think what you've done here is really sensible.
Marco Sammon: Well, thank you. And I hope they can reach out to me and we can have a discussion. I hope no one's too mad about this. But thank you so much. This is awesome. I actually learned a lot from you guys. A lot of ideas that John and I hadn't thought of and that we're going to have to incorporate into the next draft, because this is super cool.
Ben Felix: Awesome.
Dan Bortolotti: Thanks, Marco. It's a pleasure.
Ben Felix: That was awesome, man.
Marco Sammon: Thank you.
Ben Felix: That was a great conversation with Marco, Dan. I know we both found it super interesting. Hopefully, the listeners did too.
Dan Bortolotti: Yeah. And he's such a compelling speaker, too. I mean, academics certainly vary in their ability to communicate their research in layperson's terms and articulately. But he's really high energy, very articulate, and really a pleasure to talk to.
Ben Felix: Yeah, he's a great guest. I'm sure that this won't be his last time on the podcast. All right. We got one review, and then I want to talk a little bit about Cameron appearing on another podcast. Do you want to do the review and I'll do the Cameron thing?
Dan Bortolotti: Yeah, sure. We'll just read the review here from iTunes. So it says, "I found the podcast because I moved to Canada in 2020 and I did not understand all of the tax nuances. I remember I searched with the keyword TFSA and I found a bunch of podcasts, and I listened to one of the podcasts and I immediately loved it because of the depth and the complexity. At times, it's challenging to understand and follow, but you know you're learning by pushing the boundaries of your knowledge. I also got into the habit of reading with the reading challenge and got some good book recommendations from the podcast. I think the podcast changed my life in a positive way by adding this high-intensity research, not only from finances, but also other areas that were related. They have a nice forum that I like to check when I have questions. I don't post, but I read. And maybe one day, I encourage you to make an episode about someone who just moved to Canada, how to understand the financial differences from non-North American countries such as FHSA, RSP, et cetera. Thanks for all the hard work. You guys are awesome."
Ben Felix: Very nice review.
Dan Bortolotti: It's a nice review. Yeah.
Ben Felix: Yeah. Interesting episode idea, too.
Dan Bortolotti: Yeah, it would be. I imagine that we have a lot of listeners who have come to Canada just in the last few years. And I've certainly dealt with clients like this who are very smart financially, but they just are from another country and they don't understand all of the specific account types and tax implications. And yeah, it might not be a bad introductory. And I guess that a lot of Canadians, too, would learn a lot from that discussion as well.
Ben Felix: Totally. I will give a shout out to Money Scope where Mark Soth and I do have an episode specifically on Canadian account types and how to think about each one, and what each one's meant for, and how to use them.
Dan Bortolotti: Yeah. And Dave Chilton on The Wealthy Barber Podcast has planned to do a series like that as well. And the one that he did on TFSAs, of course, featured Mark McGrath. You guys can go back and check that out if you want to learn more about TFSAs.
Ben Felix: Good call. I will also shout out the forum that he's talking about, of course, is the Rational Reminder Community. It lives at community.rationalreminder.ca. It's ridiculously active. I think we're just under right now 500,000-page views per month in the community, which is an insane amount of page views for any website. But it's very active, very good discussions always happening in there if people want to go and talk about things they heard in the podcast or talk about anything usually related to finance and investing, but some other stuff too, with people that are like-minded-ish. The type of person that listens to this podcast, there's lots of them in that community.
Okay. I wanted to mention Cameron, who, of course, is our long-time original co-host, is going to be making some more frequent appearances back on the podcast now that Mark has stepped away. He was recently a guest on Michael Kitces' podcast. Michael was a guest in episode in the 100s. I want to say 122, but I'm not 100% sure on that. But you can just search Michael Kitces Rational Reminder if you want to hear him. We had a great episode with him.
Michael Kitces has also had his own podcast, the Financial Adviser Success Podcast. That's been running for a very long time. It's kind of a go-to podcast for really nerdy financial advisors, nerdy in the sense of wanting to have a really, really good financial advisory practice. It's less so about specific stuff on investing or financial planning and more so about how to build a great financial advisor practice and how to serve your clients in the best way possible.
His podcast is focused on and he talks to advisors who have built great practices. Cameron was a guest on there recently. He kind of talks through PWL's growth story, PWL's story more generally, and also about the decision to join OneDigital and what our vision is for the future. I thought it was a great conversation. I know that Cameron's gotten great feedback from it, from other people about that podcast appearance overall.
And someone in the Rational Reminder community, I thought they had a really good comment that summarized why someone might want to listen to it. They said, "I was shocked that in 350 episodes, we never got this much insight into PWL. This podcast episode gave a family member confidence to reach out to PWL and me more confidence to one day apply to a job. Really happy we got this inside look into the company itself. I assume RR, Rational Reminder, doesn't want to come across like you're there to sell PWL. But man, if you've got it, flaunt it."
That is true. We've become a little bit more overt. We didn't do it today, although I guess I'm kind of doing it now. But we've come a little bit more overt about talking about PWL and the fact that we're taking clients and the fact that we're hiring and that kind of thing. But we were intentional about that a year ago, maybe. Prior to that, we were super, super sensitive about coming across as promotional in any way.
Since we started doing it, I've found that there's really no negative reaction. And overall, it's actually probably a positive reaction when we do talk about the business. This person's comment kind of affirms that.
Dan Bortolotti: Yeah. I think when you've got a long track record of creating good content and educating investors, people have come to trust that this is not a marketing exercise here. And I think in a lot of ways, the vast majority of our audience are people who will never be clients at PWL because they're enthusiastic DIY investors. And that's fine. That's great. That's what we're here to help.
But I found the Kitces episode amazing as well. I mean, I've been here a dozen years. Around the same time I think as you, Ben. And I learned so much about PWL that I had not known about. Things that happened before I got there, things that have happened after as well. So yeah, if you're looking for an introduction about PWL's culture, Cameron doesn't spend a lot of time in the podcast talking about investment strategy. And that's less, I think, unique. But about the company's culture and its approach, it's a really remarkable summary. A great episode.
Ben Felix: Yeah. Hopefully, people we'll check that out. My suspicion is that it's the recent market volatility. We have noticed a big optic in people who are DIY investors reaching out to inquire about becoming a client of PWL. And really the only variable that I can see, and it could just be noise, but it seems to have coincided with market volatility, which is an interesting thing that we've noticed.
Dan Bortolotti: I wonder if people become a little more sensitive to their behavioural biases during a downturn. It's easy to be a buy-and-hold investor during a long bull market. It's a little harder when you're tempted to make changes. We get more client emails as well and calls about should we be doing something different when there's market volatility than we do when markets will go basically in a straight line up for six months? Those are the quietest times. It does make sense. I think advisors can add a lot of value during periods of downturns like this just by keeping people on track.
Ben Felix: Yeah, totally. You and I worked on it together, Dan, an email that went out to clients, which listeners heard a version of because we've summarized some of those notes in our last AMA podcast episode at the beginning. But we got a ton of really good feedback from clients saying that they're glad that we're thinking about it. They're glad to have some clarity on what's happening and what we're doing. Communication in times like this is super important.
Dan Bortolotti: Yeah, that's really important, I think, for clients to know that we're not "doing nothing" because we're staying in the course. There are lots of things we can do behind the scenes. There's opportunities for tax loss selling. There's opportunities for proactive rebalancing and do during market downturns. But sometimes the most important thing is just to let clients know. We didn't know when this was going to happen, but we knew there was going to be market volatility along the way. It's baked into the plan. It's not a surprise. So often, the financial media makes every downturn seem like it's some sort of first time it's ever happened. And we have this fundamentally changes everything. And it's like, no, it's stressful, it's difficult, but it's nothing that we haven't endured countless times before.
Ben Felix: If it weren't so stressful for people, it would be comical, how it would be so easily perceived if you just looked at the media and even talked to certain people. It would be so easy to assume that this is the first time that we've ever had any uncertainty in the world.
Dan Bortolotti: That's right. There was an AMA that I'd seen on another media outlet at some point and people asked questions like, "I've had my portfolio for X number of years and now it's down 7%. What should I do?" Really? I don't mean to make fun of people's concerns. I'm just really surprised that your portfolio for sure has been down more than 7% lots of times. Have you forgotten all of them? And if you have, I suppose that's a good thing because it didn't burn it into your brain as some terrible experience. But it is really interesting why the response isn't just, "This is awful." It was much more volatile, I think, over the last couple of weeks than it is in a typical correction. And it was a bit scary for sure. But again, it's not a unique occurrence in the market to fall 10%. It really is something that I think no one ever gets used to. I think that's what it comes down to.
Ben Felix: Yeah. And we talked about this when we covered this idea in the AMA episode recently, but it's because the cause is always different. And that's why it affects the market, because it's, "Oh, this is a new thing that the market has to price." And that's why we see major volatility. This time was always different, but it's really always the same. And people act as if it's really different.
I will mention, I don't know when it comes out, but I did an interview with Amy Arnott and Christine Benz for Morningstar's the Long View podcast. They sent me a whole bunch of questions. We covered a lot of ground in about an hour. I'm assuming that comes out soon. I'll just mention it now in case it's out by the time this is out. But if it's not, then presumably it'll be out pretty soon.
All right. Anything else, Dan?
Dan Bortolotti: I think we're good.
Ben Felix: All right. Thanks, everyone, for listening.
Dan Bortolotti: See you soon.
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Papers From Today’s Episode:
‘The Arithmetic of Active Management’ — https://www.jstor.org/stable/4479386
‘Index Rebalancing and Stock Market Composition: Do Index Funds Incur Adverse Selection Costs?’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=5080459
‘Luck versus Skill in the Cross-Section of Mutual Fund Returns’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1356021
‘The Passive-Ownership Share Is Double What You Think It Is’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4188052
‘Long-Term Returns on the Original S&P 500 Companies’ — https://www.researchgate.net/publication/247884354_Long-Term_Returns_on_the_Original_SP_500_Companies
‘The Price of Immediacy’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1001762
‘Competition for Attention in the ETF Space’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3765063
‘Passive in Name Only: Delegated Management and “Index” Investing’ — https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3244991
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Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
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Benjamin Felix — https://pwlcapital.com/our-team/
Benjamin on X — https://x.com/benjaminwfelix
Benjamin on LinkedIn — https://www.linkedin.com/in/benjaminwfelix/
Dan Bortolotti on LinkedIn — https://www.linkedin.com/in/dan-bortolotti-8a482310/
Episode 322: Prof. Marco Sammon: How are Passive Investors Affecting the Stock Market? — https://rationalreminder.ca/podcast/322
Episode 200: Prof. Eugene Fama — https://rationalreminder.ca/podcast/200
Episode 268: Itzhak Ben-David: ETFs, Investor Behavior, and Hedge Fund Fees — https://rationalreminder.ca/podcast/268
Episode 112: Michael Kitces: Retirement Research and the Business of Financial Advice — https://rationalreminder.ca/podcast/112
Marco Sammon — https://marcosammon.com/
Marco Sammon on LinkedIn — https://www.linkedin.com/in/marco-sammon-b3b81456/
Marco Sammon on X — https://x.com/mcsammon19
Marco Sammon | Harvard Business School — https://www.hbs.edu/faculty/Pages/profile.aspx?facId=1326895
‘Millennium Loses $900 Million on Strategy Roiled by Market Chaos’ — https://www.bloomberg.com/news/articles/2025-03-08/millennium-loses-900-million-on-strategy-roiled-by-market-chaos Z
The Money Scope Podcast Episode 8: Canadian Investment Accounts — https://moneyscope.ca/2024/03/01/episode-8-canadian-investment-accounts/
Financial Advisor Success Podcast Episode 433: When You 10X Your Advisory Firm To Over $20M Of Revenue…And Want To 10X Again, With Cameron Passmore — https://www.kitces.com/blog/cameron-passmore-pwl-capital-10x-revenue-growth-advisory-firm/
OneDigital — https://www.onedigital.com/