Active Indexing Strategy

As mentioned in my Investment Philosophy, I strongly believe that the only way to outperform the market consistently is to be contrarian, taking up either credit risk, illiquidity risk, concentration risk, leverage risk and/or impatience risk (the risk of being impatient and doing too much trading as a result), and that the more types of aforementioned risk you can take with your investment strategy, the higher possibility and potential of outperforming market returns.

Active Indexing allows for taking up impatience risk since index funds by nature theoretically could be held until perpetuity and still generate good returns.

The reason why you should do Active Indexing rather than Passive Indexing is simply because I’m uncomfortable with the notion of blindly buying overvalued index funds as advocated by passive indexing portfolio strategies. It is absolutely important to not lose money due to buying into overvaluation.

The way to recognize when index funds are undervalued enough to buy is when their P/E * P/B combined is less than 1/2 earnings yield of AAA grade bonds, as this gives me a significant enough amount of margin of safety.

Earnings yield is how much an investment will earn you every year. For bonds it is the yield to maturity, for stocks it is 100 divided by P/E * P/B. Eg. If P/E was 15 and P/B was 1.5, then the earnings yield would be 100 / 22.5 = 4.44%.

The decision to sell the index fund shares is when the P/E * P/B combined hits or exceeds earnings yield of AAA grade bonds as it makes more sense to hold AAA grade bonds instead of stocks since I can get an equivalent return with much less risk.

What index fund to buy is not too important as long as it is low cost, has information about P/E and P/B of underlying fund, and isn’t a synthetic index fund (a fund that tracks an index through derivatives instead of actually replicating the index by owning the stocks). I personally recommend any index funds from Vanguard since they are the lowest cost index fund provider, they provide information about P/E and P/B of underlying fund, and don’t provide synthetic index funds.

If there’s idle cash due to no available index funds are undervalued, you should only buy AAA grade bonds if interest rates of short term, mid term and long term US treasury bonds are flat. The reasons are outlined in “When Does Buying Bonds Make Sense?“.

[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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