Is Index Investing Still Relevant In 2022?

A reader writes (abridged):

“I’ve been struggling with the idea of index investing recently.

With inflation rising globally, I can’t see how going with an S&P 500 / All-World ETF is still the right approach. 

There’s strong evidence that during inflationary periods, value stocks do better while growth stocks tend to underperform.

Given inflation doesn’t seem to be “transitory” anymore, I am tempted to tilt to value as opposed to growth. 

This is especially true when I consider the run-up in growth stocks over the past decade and the fact that they comprise a very significant chunk of the major indices out there.

In that context, rebalancing a big part of my portfolio towards value seems like the right approach.”

I can definitely relate to the sentiment above, and it’s well-supported by facts.

The Russell 2000 Value ETF has barely moved over the past 5 years.  It’s up 34% – and only thanks to a rally in late 2020 / early 2021 which now seems to be fizzling out.

As a matter of fact, the reason the email above struck a chord with me is that c. 15% of my equity portfolio is in fact in a value index:

Now, I made that allocation more than a decade ago and it had nothing to do with inflationary expectations (you can read about my dangerous liaison with value stocks here)

The reason I mention it is because I do have skin in the game here and I am just as amazed at the continued outperformance of growth stocks.

In the past 5 years, the Vanguard Growth ETF which includes some of the largest growth stocks out there is up an astounding 181% – and continues roaring ahead:

So yes, it is true that the growth stocks are the engine that has propelled the S&P 500 and other diversified indices forward – while value stocks served as a brake on returns.

But will that hold true in an inflationary environment?

All About That Cash

The fundamental logic here is simple – at the end of the day, investors are valuing companies based on their expected cash flow profile.  They forecast those cash flows out, discount them back to today, and boom – out comes a number.

In theory, that number is the intrinsic value of the stock.

In practice, everyone comes up with a different number – because all investors have their own view on the quantum of the actual cash flows, the timing of those cash flows, and the discount rate they use to present-value those cash flows.

This is where inflation comes in.  When inflation is low, the discount rate is low(er).  Thus, $100 worth of cash flows in 2030 is worth more today than it would be in an alternate, higher inflation world.

This benefits growth companies that typically reinvest all of their cash flows back into the business as opposed to paying them out as dividends.

As an example, Amazon is notorious for taking its torrent of cash and using it to build new businesses such as AWS.

Other companies still in growth mode might not even have the capacity to pay dividends.  As a matter of fact, they are cash-flow negative – and often use an IPO as a way to fund their operations.

Value stocks move the opposite way.  They typically have less exciting growth prospects and as a result, return more cash flows to investors.  Think tobacco and telecoms companies.

In a higher inflation period, investors prefer to have their money today rather than waiting a decade – so they bid up the value stocks.

So far, so good – so let’s turn our attention to the hard stuff now.

All Priced In

Here’s what makes all the “tilting” (aka active investing) decisions so damn hard:  all of the public information out there is already reflected in asset prices.

You and I clearly know that inflation is here – but so does everyone else who hasn’t been living under a rock for the past year.

Talented economists, fund managers, and yes – those naughty active retail investors have been reading the news, tracking the data, updating their analysis, and revising their portfolio allocation decisions.

Very often, they would have done it ahead of the data being widely available.  I mean, there’s a reason why value rallied so damn hard early this year – BEFORE the official inflation data started coming out in April.

The market saw it coming before anyone else did.

Thus, if as of today, your expectations of inflation are the same as the market’s, you will not make money buying up value stocks.

The only way you will generate alpha is if you have a strong conviction that inflation will end up higher than where millions of other investors think it will – and if you are willing to back up that conviction with cold, hard cash.

That’s challenge number one.

Challenge number two is figuring out what inflationary expectations are baked into today’s valuations.

Government bonds seem to be suggesting somewhere between 1 and 2%, depending on which country we are talking about.

The stock market, on the other hand, could be pricing in 5 – 7%, in line with the consumer inflation levels over the past few months.

To compound the issue, government bond yields might not be a credible source of inflationary expectations anymore.  Here’s a great chart from Ben Carlson that illustrates the divergence:

Source: A Wealth Of Common Sense

In a world where every basis point matters, the range between 1 and 7% seems a bit too wide for comfort – especially when you are about to put some proper money behind it.

Challenge number three is that the market usually always knows something you don’t.

Back in March 2020, the market “knew” that Covid will not be the end of the world.

As a matter of fact, it also knew that Covid will accelerate the digitization of our society, with all the efficiency gains that come with it (helped by hefty government stimulus, of course).

Cue in a sharp but short-lived crash followed by an astounding recovery (reflexivity also played a role here but let’s leave that out for simplicity).

I will be the first to admit that I wasn’t nearly as foresightful – but taking my cues from the market turned out to be a pretty good decision in retrospect.

Right now, the market seems to be telling us that while we will have some inflation, growth stocks will likely be okay.

That may well change based on new data coming in.  But unless you know something the market doesn’t and are willing to act on it before anyone else finds out, it’s probably a good idea to stick with a nicely diversified, low-cost index tracker.

I know that it’s tough to sit on your hands and do nothing when it comes to investing.

However, it’s worth reminding yourself that investing is unlike any other activity in the world.

In any other endeavor, making tens of thousands per hour usually involves some combination of high skill activity combined with high leverage.

But in investing, $10,000/hour work is doing nothing.  And it’s often much, much harder than it sounds.

As always, thank you for reading – and happy investing!