Valuation-Informed Indexing vs. Passive Investing - Which is Better?

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Well folks, it's been on my research topics list since January of this year, but during the past several days, I've finally been able to perform the detailed comparative analysis the topic deserves.

What topic is this, you're probably asking? The topic is Valuation-Informed Indexing (or Valuation-Informed Index Fund Investing - however you want to call it). This topic/investing strategy was first introduced to me by Rob Bennett when he guest posted on the subject over at Free From Broke?and has been the topic of numerous online and offline discussions in the personal finance world.

Reading Rob's post really got me interested in this form of investing, because it is sort of an attempt to put a more actively managed role on my current investing strategy of passive investing, but without all of the emotion that normally causes the performance of active investors to suffer. More specifically, I wanted to find out two things after first hearing about Valuation-Informed Indexing. These are described below:

• Determine the exact method it uses to find out how unbiased and repeatable it is.

• Perform a long term (approximately 20 years) performance comparison between Valuation-Informed Indexing and passive investing to determine which makes you more money.?
• In this analysis, I would also want to compare risk levels (standard deviations) and attempt to optimize the Valuation-Informed Indexing method.??

So, armed with nothing but a Toshiba laptop, a "why-not" attitude, and a smile, I set off in trying to find some answers to the?aforementioned?goals.

Note from Jacob: I really get a lot of enjoyment out of these types of post that require putting together a spreadsheet, inputing some interest rate formulas, and analyzing large amounts of historical data. Maybe it is the scientist in me that enjoys this!

What is Valuation-Informed Indexing (VII) and How is it Different from Passive Investing?

Truthfully, it was fairly difficult to figure out the exact method that defines Valuation-Informed Index Investing and makes it different from passive investing. This is most likely due to the fact that it doesn't yet have a wide following, as opposed to passive investing where there are shelves full of books written on the subject!


However, through study of 1) Rob Bennett's website about Valuation-Informed Indexing?(in particular, his "How To" guide) and 2) Professor Wade Pfau's preliminary research, I was able to piece together enough information to define the VII method and construct a study.


In a general sense, Valuation-Informed Indexing involves changing your asset allocation targets in response to fluctuations in market prices. What does this mean exactly? It means that you should have a higher equity asset allocation when the market is lower and a lower equity asset allocation when the market is high.

Now, this all sounds well and good. But, the real question is "How do we actually go about doing this in a way that doesn't introduce investor sentiment and ineffective market timing tactics?" VII has an answer to this too!


A summary of the Valuation-Informed Indexing methodology is summarized below:

• First, decide on your base asset allocation. For example, in my study, I used 60% equity / 40% fixed income securities.
• Second, use PE10 data (Current price of S&P500 divided by average inflation-adjusted earnings over the past 10 years) published by Professor Robert Shiller at Yale to change your asset allocation targets based on market fluctuations.
• When the PE10 goes above 20, switch to 30% equity / 70% fixed income.
• When the PE10 goes below 12, switch to 90% equity / 10% fixed income.
• When PE10 is between 12 and 20, use your base asset allocation (60% equity / 40% fixed income, for example).

Application of this strategy is supposed to deliver superior returns at much less risk (standard deviation of returns) than a fixed asset allocation with regular rebalancing (in other words, passive investing).

Existing Findings

The only other numerical studies comparing passive investing to Valuation-Informed Indexing were conducted by Professor Wade Pfau. His preliminary findings can be found here, and the definitive, complete report, can be found at this link.

Wade's findings reveal that VII provides more wealth for 102 of the 110 rolling 30-year periods from 1870 to 1980. However, in recent years, it appears that the?out performance?of VII over passive investing is becoming less and less.


As someone in my mid-20's, the time period I was most curious about was the most recent twenty year period. Additionally, I wanted to test this period because in order for me to be convinced to give up passive investing in favor of Valuation-Informed Investing, I would need to see demonstration of its superiority in a time frame that is more?relevant?to me.

Lastly, over any 20 year period, it would reason to believe that random, short term fluctuations in the market should be hidden by the correct, overall, long term behavior.

Study Methodology

So, now that I?ve explained a little bit about what Valuation-Informed Indexing is in general and what existing research has been done on the subject, we can now get in to the specific investigation that I conducted.
The details of how I set up my analysis are summarized below:???????Investment Total ? For simplicity, we will assume that our investment only consists of a one-time initial purchase of $10,000. Transaction fees, fund expense ratios, and taxes will not be considered in the scope of this analysis.

???????? Time Period ? January, 1990 to May, 2011.

???????? Portfolios ? There will be two competing types of portfolios ? 1) a Valuation-Informed Indexing portfolio, and 2) a passive investing portfolio. Various parameters within each of the models will be changed in order to analyze performance. o?? Both of these resources have a handy ?export in Excel format? feature to facilitate quick analysis in spreadsheet format.

???????? Rebalancing ? Rebalancing for the passive investing and VII portfolios will be done monthly (the same as what I do currently). This is different than Pfau?s analysis, which assumed annual rebalancing.

???????? Asset allocation changes ? The passive investing portfolio will remain at the same asset allocation targets for the duration of the study. However, the asset allocation targets for the Valuation-Informed Indexing portfolio will be adjusted based on the PE10 trigger levels discussed previously.The complete results/details of my comparison between VII and passive investing can be found at the following Google Docs Spreadsheet ? Valuation-Informed Investing vs. Passive Investing. Rows 1696 and 1697 contain the total return and standard deviation (risk level) for each portfolio.

The table below shows a summary of the portfolio returns and standard deviations of the analysis. Three passive investing portfolios were compared to three different Valuation-Informed Indexing portfolios/strategies. It?s interesting to note that from 1990-2011, the PE10 never fell to the lower trigger point level of 12.

As can be seen in the table, passive investing with monthly rebalancing resulted in total returns over the ~20 year time period of 239%, 267%, and 220%, for 60/40, 75/25, and 50/50, asset allocation splits, respectively.

For comparison, three different Valuation-Informed Indexing strategies/portfolios were employed, as described below:Valuation-Informed Indexing Portfolio 1

• When the PE10 goes above 20, switch to 30% equity / 70% fixed income.
• When the PE10 goes below 12, switch to 90% equity / 10% fixed income.
• When PE10 is between 12 and 20, use your base asset allocation (60% equity / 40% fixed income, for example).

Using this strategy, a total return over the time period analyzed was 185% (much less than the 60/40 asset allocation passive investing portfolio).
Valuation-Informed Indexing Portfolio 2Because the total return obtained from Portfolio 1 failed to outperform the passive investing portfolios, I decided to attempt to refine the strategy (because I really do feel that there is potential for this form of investing! We just have to find it!).Next, I proceeded to take the average PE10 from 1990-May 2011, and saw that the average PE10 was a whopping 25.68. Since this PE10 seems to be higher than we?ve seen historically, I figured that maybe by increasing the upper trigger to 25, a higher return would be seen.Making this change, the strategy for Portfolio 2 becomes as follows:

• When the PE10 goes above 25, switch to 30% equity / 70% fixed income.
• When the PE10 goes below 12, switch to 90% equity / 10% fixed income.
• When PE10 is between 12 and 20, use your base asset allocation (60% equity / 40% fixed income, for example).

Using this strategy resulted in a total return over the time period of 195% - higher than Portfolio 1, but still much lower than the passive portfolios.

Valuation-Informed Indexing Portfolio 3 ?In a final effort to increase my returns using VII, I next tried to increase my equity exposure during ?high PE10? times to 50% equity/50% fixed income (instead of 30/70 in Portfolio 1 and 2).Making this adaptation, the strategy for Portfolio 3 becomes as follows:

• When the PE10 goes above 20, switch to 50% equity / 50% fixed income.
• When the PE10 goes below 12, switch to 90% equity / 10% fixed income.
• When PE10 is between 12 and 20, use your base asset allocation (60% equity / 40% fixed income, for example).

Using this strategy resulted in a total return over the time period of 221% - higher than Portfolio 1 and 2, but still much lower than the passive portfolios, with the exception of the 50/50 asset allocation one.

Conclusion ? Passive investing outperforms Valuation-Informed Indexing in the past 20 years, but VII displays much less risk. This is consistent with the normal risk/return correlation. ??So, what can we conclude from all of these results and confusing numbers? In my opinion, we can take away several key things. 1)???? While Valuation-Informed Index Investing may have outperformed passive investing in most previous historical periods, evidence of it not performing as well in recent years is enough to keep me as a passive investor, at least until VII is refined. a.????? It?s interesting to note that by using the VII methodology, an investor would have been 30% equity / 70% fixed income from January 1995 until September 2008. The investor would have taken on less risk (in the subsequent market crash of 2008-2009) by owning fewer equity shares during this ?high price? time. However, he or she also almost totally missed out on the 163% total return during the ~13 year time period. 2)???? Valuation-Informed Index Investing has great potential because it greatly reduces the risk to investor returns.a.????? Even though VII failed to outperform passive investing in my analysis, it also provided much less risk, as evidenced by the sharp decrease in standard deviation of the portfolio value over time.b.???? For example, VII Portfolio 1 provides a slightly lower return of 185% over the time period analyzed (compared to the passive investing portfolios). However, the portfolio also has 34%, 55%, and 21% less risk (standard deviation of portfolio value) compared to the 60/40, 75/25, and 50/50 passive portfolios, respectively.This ability of VII to deliver sufficient (but slightly lower) returns at less risk is what I think is the real power of Valuation-Informed Indexing. I feel that with some refinements, VII can become an effective investing strategy. However, I?m not quite ready to switch over just yet?Thanks for reading!
How about you all? Have you ever tried or heard of Valuation-Informed Index Investing? What are your thoughts about its efficacy? What improvements do you think need to be made??


Share your experiences by commenting below!

Source: http://www.mypersonalfinancejourney.com/2011/05/valuation-informed-indexing-vs-passive.html

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