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Is Your Index Fund Leaving Money Behind?

In late January 2011, Smart Money ran an article asking whether index investors were missing a large part of the return their passive approach should deliver. That question sounds strange for a product built on owning the market at market weight. The claim came from a report in The Journal of Indexes, though, and it was strong enough to irritate Vanguard, one of the largest index fund firms in the country.

Dorsey, Wright followed with a February 4, 2011 newsletter that pushed the same argument further. Readers should keep one fact in view throughout: the firm runs relative strength strategies and has a stake in the answer. That bias does not automatically make the numbers wrong. It does mean every claim deserves a second look before investors rebalance a retirement account around it.

Why revisit a newsletter that is nearly two years old in January 2013? The debate has not faded. Investors who bought broad index funds after the 2008 collapse lived through a recovery that was uneven across sectors. Many began asking whether the weighting scheme had shaped their results.

Cap weighting became the default because it is cheap to run. It needs no forecasts, and it holds the market portfolio by construction. Challengers such as equal weighting and fundamental weighting grew up beside it. The Smart Money article cited an eleven-year window in which every alternative beat cap weighting, and relative strength was missing from that comparison altogether.

What Relative Strength Actually Measures

Relative strength compares a stock's price performance to a market average or to a universe of other stocks. It does not ask whether a stock went up. It asks whether the stock went up more than its peers, or fell less. That distinction drives everything else.

Consider a simple case. Suppose the market gains 10% in a year, and two stocks start at $50. Stock A climbs to $58, a 16% gain, while Stock B reaches $53, a 6% gain.

Stock A's ratio to the market improves by about 5.5% (1.16 divided by 1.10). Stock B's ratio to the market falls below 1. Stock A ranks ahead of B, and that ranking is the signal.

The same logic works in a downtrend. A stock that drops 12% while the market falls 25% has improved its relative standing, even though nobody would call it a winner. Relative strength rewards persistence more than conviction.

Relative strength does not promise that a leader will keep leading. Leadership rotates, and a high ranking can reverse within a few months. A relative strength portfolio therefore needs regular rebalancing, which creates turnover and trading costs.

The newsletter argues that relative strength is too simple to attract academic attention, and that a spreadsheet is enough to compute it. Simple does not mean careless, though. The method still depends on the look-back window, the stock universe, and how often the portfolio is rebalanced. Change any of those and the results change.