Letting You In On a Big Secret

Joel Greenblatt has a sense of humour—I’ll grant him that. In The Big Secret for the Small Investor (Wiley, 2011), he pokes fun at the crass title of his previous book, You Can Be a Stock Market Genius, and goes so far as to renounce it: “It was meant to help the individual investor, too. It didn’t.” Now the author has new strategy to share with his readers.

Greenblatt spends the first few chapters building his case by explaining why identifying undervalued stocks is far more difficult than it sounds. Then he describes the challenges faced by active managers: if they are index huggers they almost never beat their benchmarks, and if they are more adventurous they risk periods of dramatic underperformance, which usually gets them fired. As a result, managers become so obsessed with short-term results that they can’t follow through with legitimate strategies—such as value investing—that might actually do well over the long term.

If you think you’re about to hear an argument for indexing, you’re right—sort of. Greenblatt doesn’t take the position of orthodox passive investors: that you should be content to achieve market returns at the lowest possible cost. Rather, he suggests that individual investors can beat the market—it’s just that they’re going about it the wrong way.

Greenblatt argues that traditional index funds are likely to beat most stock pickers, but you can do a lot better. He reviews the usual criticisms of cap-weighted indexes and touts fundamental weighting and equal weighting as superior alternatives. So far, nothing too surprising.

So what’s the big secret Greenblatt has been waiting to reveal? (Spoiler alert.) The secret is that investors can earn even better results with funds that track value-weighted indexes. Specifically, he recommends weighting stocks according to “cheapness,” as measured by trailing earnings yield, and “quality,” measured by trailing return on capital. He provides a table showing that the S&P 500 has returned 7.6% annually since 1990, while a value-weighted index would have returned 13.9%.

One secret remains

Getting to the end of Greenblatt’s book reminded me of the series finale of The Sopranos: you’re left wondering what just happened. After spending nine chapters making an argument for investing in value-weighted indexes, there’s no mention of how to actually do this. A brief appendix lists some fundamental and equal-weighted ETFs, as well as some value ETFs from Vanguard and iShares, but he’s quick to note these do not track the value-weighted indexes he’s been talking about. In fact, there don’t seem to be any products that follow Greenblatt’s strategy.

Then comes the last paragraph: “We have created a free website, valueweightedindex.com, to keep readers up to date on what I believe will be a growing area in the investment field.” Visit the site and you’ll eventually figure out that Greenblatt has created two mutual funds based on the ideas described in the book. In other words, the big secret for small investors is: “If you want to beat the market, buy my funds.”

I admit I felt duped—as though I had just read a 150-page marketing piece disguised as a book. I get that many financial authors have vested interests, but I have more respect for the ones who aren’t so sneaky about it.

This spud’s for you

I get a lot of email from people who have questions about the Couch Potato strategy, and I do my best to respond to all of them. It recently dawned on me that other readers would be interested in many of the questions and answers. So I’m happy to announce a new Q&A feature on the blog, which I’ll run a few times a month.

If you have a question about index investing—whether theory or practice—drop me a line and I will answer the best ones in future posts.

A few ground rules apply. I can’t dispense investment advice to individuals: since I’m not a licensed advisor, it’s irresponsible and potentially illegal. So please don’t ask me to review your portfolio, draw up a financial plan, or recommend individual securities. I’ll just refer you to a good advisor.

To get things rolling, I invite you to post a question below and I’ll enter you in a draw to win a copy of The Big Secret for the Small Investor. Even though I spoiled the ending, it’s still a worthwhile read for index investors with a value bent. Contest closes Monday, June 6, at midnight EST.

18 Responses to Letting You In On a Big Secret

  1. Steve June 3, 2011 at 8:21 am #

    Speaking of good advisors… are you able to recommend one in the Halifax area?

  2. Paul T June 3, 2011 at 8:28 am #

    I completely agree with you on this book. It does feel a little like a marketing ploy, and the real kicker (if you really believe in the theory, which I do) is that here in Canada we can’t even purchase those Mutual Funds.

    Greenblatt is a value investor at heart, and I (generally) like what he has to say. His other book, “The little book that beats the market” is a good read. It provides detailed instructions on how to find and rank value stocks. The Big Secret is more or less an extension to that that book, but he does all of the work for you (through a mutual fund).

  3. Canadian Couch Potato June 3, 2011 at 9:05 am #

    @Paul: Although I think Greenblatt greatly overstates the potential of value-based indexing (a 5% outperformance annually is never going to persist), most of the book is not too far off what Fama and French have shown. That’s why I think it’s a worthwhile book, as long as you know his bias before you start reading.

    @Steve: I think I can help: I will email you directly with some suggestions.

  4. Eric June 3, 2011 at 12:12 pm #

    Fama-French studies have confirmed that value stocks have a much higher rate of return……..over the long-term. Your previous post has confirmed that value will not add extra return for period as long as 15 years (Global Couch Potato vs DFA).

    In Canada we have RBC O’Shaughnessy US value (mutual fund) which is one of the best is this category but Claymore CLU did better over the last 5 years.

  5. GreatGobo June 3, 2011 at 1:48 pm #

    I’ve asked this before, and I don’t think I got a great answer. Being a fairly novice investor, I also have some laddered GIC’s. Their value is higher than my Basic Couch Potato. I’d like to better understand how to incorporate GIC’s with a Couch Potato portfolio.

  6. Joe S June 4, 2011 at 1:32 pm #

    Q. Have you ever thought or done any calculations into the optimum time to purchase index funds/ETFs based on broad market indicators as opposed to straight DCA’ing on a regular basis? Essentially..timing the buy during market dips and some rules to get more ETF shares to hold over the long run. Would like to see some numbers timing in the short term (dips/corrections) and long term (bear markets), perhaps based on moving averages.

  7. Canadian Couch Potato June 4, 2011 at 1:37 pm #

    @Joe: Love that question and will hang on to it for a future post!

  8. Be'en June 5, 2011 at 8:14 pm #

    Rob Bennet advocates looking at P/E10 values of ETFs/Indexes to determine if an ETF is over/under valued. I was directed to a site which studied S&P 500 for various matrics. It’s P/E10 is currently at 24 — grossly overvalued and too risky to own. It would be good for value investors to have a source of information of current (and may be historic) P/E10 values of various ETFs in the Canadian market .

  9. uptoolate June 6, 2011 at 12:22 am #

    Thanks for the review. I felt a little let down after reading this one as well. Wish there was an easy way to get a Fama-French type approach in a low-cost ETF.

    Keep up the good work. Cheers.

  10. Paul G. June 6, 2011 at 3:39 am #

    For the FAQ, my question would be how best to set things up to minimize taxes – the answer being a simple summation of what I’ve read in various parts of your blog, but which could be repeated in a couple of sentences or a short table, to give people the gist of what’s needed to avoid paying more taxes than needed.

  11. Canadian Couch Potato June 6, 2011 at 8:02 am #

    @Paul G: Great question, thanks. I think it may even be time for a tax-friendly model portfolio…

  12. Stephen L. June 6, 2011 at 8:35 pm #

    For the FAQ, I was hoping you would be able to list the advantages and disadvantages of both mutual funds and ETFs. For my question, I was wondering which fund would be the most useful for someone with not a lot of money to invest? Also at what point would I consider transferring from one to the other? Is there a certain amount of money that you should have when you would make the transition?

  13. Canadian Couch Potato June 6, 2011 at 8:51 pm #

    @Stephen L: I address that question in the site’s FAQ:
    http://canadiancouchpotato.com/couch-potato-faq/

    In general, I think most people should not bother with ETFs unless they have about $50,000 to invest.

  14. GeoEng51 June 8, 2011 at 2:25 pm #

    I just finished reading Joel Greenblatt’s book, going to his recommended web page (valueweightedindex.com), then trying to figure out how I could purchase the recommended funds. Guess what – if you are a Canadian living in Canada – forget it!

    Well, the book was humourous, practical and laid out a reasonable strategy, nonetheless. It was worth the $20.

    So, what do you do when there are no options left? Go to Google, of course. I tried searching on “Canadian Value Weighted Index Funds” and came up with several hits on the Couch Potato Site, including your review of his book, which pretty much nailed it.

    So — my first time on the site, and I like what I see. I’ll peruse the site a lot more as time goes on. Thanks for the effort in creating it!

  15. Canadian Couch Potato June 8, 2011 at 2:54 pm #

    @GeoEng51: Thanks for stopping by. I agree, the book was a good read and contained mostly sensible advice. It’s just that it made too many grand promises and was too sneaky about its bias.

    Hope you’ll continue enjoying the blog.

  16. Paul Gerard June 12, 2011 at 9:28 am #

    I am a fan of Vanguard funds and morningstar ratings. What is wrong with buying 4 and 5 star funds and selling when they drop a star, and buy went they gain a star? The initial burst will have already happened and I will miss that but will not the direction stablize for the forseable future. It may seem like I am buying high and selling low, but I see it as ditching something that is sinking and buying something that is rising.

  17. Canadian Couch Potato June 12, 2011 at 9:34 am #

    @Paul: What you describe sounds like classic performance chasing. Morningstar ratings are a good measure of past perfromance, but they have no predictive value. If a fund gains a star, that is not a reason to believe that it will outperform in the future. A far better strategy is to choose low-cost funds with good records of tracking their indexes and to stick to a disciplined plan. Jumping from fund to fund is almost certain to be disappointing.

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