Hedged Cash In Active Indexing Should Reflect Market Cap

There is a flaw with my current Active Indexing system, where I hedge based on how many ETFs Vanguard Hong Kong offers.

There are two huge problems with this:

  • Vanguard Hong Kong doesn’t offer a US ETF, which means I’m neglecting 50% of the world’s market cap
  • Equal hedge per ETF assumes that all ETFs are equal

The fact is, all ETFs aren’t equal, since some stock markets have a much bigger influence on financial spillover effects than other stock markets, such as US stock markets’ financial spillover effects onto Asia and Latin America during the 2007-2009 financial crisis.

This sounds like market timing, something John Bogle, founder of Vanguard Group, is strongly against, saying that “After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know of anybody who knows anybody who has done it successfully and consistently.

But to understand why there’s a need to adopt to macro market conditions, there’s a need to understand about how investors make money off of stocks, namely dividends, company earnings and earnings multiples.

Index funds by nature aren’t very sexy when taking dividends and company earnings into consideration, since most of the time based on dividends and company earnings they can’t be huge bargains due to mass diversification. The realistic way that index funds really bring fortune to investors is through earnings multiples (a.k.a. P/E), where the stock prices of index funds are driven more by sentiment rather than company fundamentals.

Therefore if any investment becomes over-valued, it should be sold to prevent permanent loss of capital and to minimize reduced returns over the long run for holding onto over-valued investments for too long.

And since I have to take sentiment and over-valuation into consideration, I should take the global stock market as a whole into consideration. When North American makes up to 55.30% of the world’s stock market (as of Nov 30th 2014), and it is over-valued based on P/E * P/B versus the earnings yield of AAA grade bonds, then in theory I should hedge 55.30% of my portfolio against such over-valuation.

This might sound drastic, but everything in life is opportunity cost. When I hold cash, I’m essentially making a point that I can use better investment opportunities down the road to compensate for my zero returns for now by guaranteeing the safety of my principal. Considering the fact that QE has pushed interest rates so low, “the opportunity cost of holding liquidity is among the lowest ever, when compared to dividend yields averaging just over 2%.

As such I’m going to change the composition of my current portfolio and edit my Active Indexing strategy plan of action to reflect this.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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