In Defense of "Slice and Dice"

Jeff Troutner, TAM Asset Management, Inc.

A common debate on the IndexFunds.com Discussion Board is whether investors should simply invest in an index fund mirroring the total stock market (TSM) or divide their portfolio among large growth, large value, small growth, and small value stocks in a more even balance, say, 25% each. This latter strategy is known affectionately as "slice and dice."

Those advocating a slice and dice approach are more often than not professional investment advisors like myself who have studied research by Eugene Fama and Ken French that shows a return premium for small company and value stocks. This premium is attributed to extra risk associated with these asset classes and, as you would guess, combining them in a balanced portfolio does result in higher returns with slightly higher annual volatility over time.

Those arguing against slice and dice point to the simplicity, tax efficiency, and "theoretical purity" of a TSM approach. I can't argue with any of those points. Investors can buy the total market with one, low cost index fund such as the Vanguard Total Market Index fund. The fund is very tax-efficient since very little trading occurs to keep the fund in line with its underlying index, the Wilshire 5000. And being a staunch "efficient market" guy, I have to admit that it's pretty hard to beat the market over the long -term.

But, as Bill Bernstein alluded to in his Merchants of Greenwich article, relying solely on academic theories at the expense of common sense seems to be a sure route to disappointment for investors. Despite all of the good things about the TSM index funds, investors should not ignore the fact that today these funds are dominated by large growth stocks selling at historically high prices. If the bloom fades for these stocks--most of which are technology related--the high returns of TSM funds could fade as well.

Advocates of TSM funds argue that if money moves out of large growth stocks, it will simply find its way to the "undervalued" small company and value stocks--both large and small--and this will drive the index higher. In other words, we'll simply see a shift in leadership. Nice theory, but what if investors lose so much confidence in stocks generally after watching the "safe" stocks fall from their lofty perches that they pull money out of the market completely and park it in cash or buy bonds? We might still witness a rebirth in small and value companies since it will require less investment to move their prices, but in a TSM fund these gains will be diluted.
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