Monday, May 31, 2010

Lumpers vs. Splitters

Among investors who agree that using low-cost index funds is the winning investment strategy, there is an ongoing and unresolved debate. On one side the lumpers believe that since markets are very efficient, the best approach is to use a few total market index funds; e.g., a total US stock market fund, a total bond market fund, and perhaps a total international stock fund. On the other side, the splitters believe that the academic research justifies slicing and dicing the stock portion of your portfolio into more asset classes; e.g., large-cap, small-cap, value, growth, developed (foreign) markets, emerging markets, REITs, etc. Depending on which book you read or which web site you visit, you can find compelling evidence for each point of view. Let’s briefly explore the debate.

One of the pre-eminent lumpers is John Bogle, founder of Vanguard, and creator of the first retail index fund. In his short and very readable book The Little Book on Common Sense Investing, Bogle presents a compelling case for what he calls “the majesty of simplicity”; i.e., investing the stock portion of your portfolio in the entire stock market by using a low-cost total stock market index fund. Bogle uses historical evidence and common sense to demonstrate that by “casting your lot with business”, and simply buying a low-cost index fund that essentially invests in all the public businesses in the US, you are likely to outperform the vast majority of investors (including professionals) who try to beat the market through stock selection, market timing or betting on particular subsets of the stock market.

Splitters point to academic research that shows that a portfolio of multiple uncorrelated asset classes has usually generated higher returns for a given level of risk, or similar returns with lower risk (i.e., higher risk-adjusted returns), and sometimes even higher returns with lower risk. Academic research by Eugene Fama and Kenneth French has provided convincing evidence that exposure to risk factors based on company size (smaller = riskier) and value/growth (value = riskier) has resulted in higher returns over many periods in multiple countries.

Value and Small-Cap Stocks

The studies of Fama, French and many others have convinced splitters that they are likely to receive higher risk-adjusted returns by spreading their investments among several low-cost index funds that invest in the four size/style quadrants of the market: Large Growth, Large Value, Small Growth and Small Value. Many modify this somewhat and recommend using Large Blend instead of Large Growth and Small Blend instead of Small Growth, arguing that the blend funds already have a heavy growth emphasis. An S&P 500 index fund is a typical recommendation for the large blend allocation, and the Vanguard Small-Cap Index fund is an example of a small blend fund.

One of the lumpers’ counter-arguments to slicing and dicing is that it is betting that small-cap and value stocks will outperform the total stock market in the future, and that most of the excess returns for the small-cap and value asset classes were generated during a few relatively short periods in the past. Over a period of 80 years, significant outperformance of value and small stocks over one or two 10-15 year periods has made the performance over the entire 80 year period look much better. However, you must also consider the 10-20 year periods where small-cap or value stocks underperformed the total stock market (which is dominated by large-cap stocks). John Bogle and other lumpers warn us that it’s unlikely that a typical investor will stick with a strategy that doesn’t work as expected for 10 years or longer, and that abandoning the bets on small-cap or value stocks after an extended period of underperformance will reduce the investor’s long-term returns relative to simply investing in the total stock market.

Bogle uses examples from his own company, Vanguard, to demonstrate the hazards of betting on market sectors. While the Vanguard Growth Index and Value Index funds had cumulative returns of 224% and 320% respectively between 1993 and 2006, investors in these funds earned only about 13% and 170% respectively. Investors had such low returns relative to the funds themselves because they purchased the funds after periods of strong performance, and sold them after periods of weak performance; i.e., investors’ emotions led them to move in and out of the funds at the wrong times.

International Stocks

Many studies have demonstrated that some allocation to non-US (international) stocks has increased risk-adjusted returns. A minimum allocation of 20% and a maximum of 40% of the stock portion of your portfolio is a common recommendation (this is Vanguard’s recommendation), but some highly respected financial advisors recommend as much as 50% (e.g., Larry Swedroe and Paul Merriman).

John Bogle contends that since the very long-term returns of US and international markets are similar, the long-term investor doesn’t even have to invest in international stock funds to achieve adequate diversification. More recently, he has acknowledged that perhaps a 20% allocation to international funds is appropriate, although he himself has never invested in international funds.

My sense is that there is less disagreement about allocating at least 20% of your stock portfolio to international than there is about over weighting small-cap and value stocks. The bigger argument about international is with regard to the upper limit of your allocation to international stocks.

Other Asset Classes

REITs (real estate investment trusts) is another asset class commonly recommended by splitters, due to its low correlation to other stocks during many periods. Splitting your international allocation between developed and emerging markets is another common recommendation. Some splitters recommend diversifying among even more asset classes, such as commodities, small-cap international, international value, international REITs, and more.


The authors of the books in my recommended book list include both lumpers and splitters. If you’re serious about your investing education, it’s worthwhile to read books that present both points of view.

William Bernstein is one author that presents a balanced view, but he admits that his sympathies are with the splitters. I highly recommend his book The Investor’s Manifesto. His advice is that you are likely to do quite well with a simple portfolio consisting of a total US stock market fund, a total international stock fund, and a total bond market fund (see page 89 of the referenced book). He says of this portfolio, “Does this portfolio seem overly simplistic, even amateurish? Get over it. Over the next few decades, the overwhelming majority of all professional investors will not be able to beat it.” In the next few pages of the book, he proceeds to illustrate increasingly complex (sliced and diced) portfolios that he believes are likely (but not certain) to do better, but at the cost of increased portfolio management effort.

I agree with Bernstein’s starting point. You are likely to do better than the vast majority of investors with a Total US Stock fund, a Total International Stock fund, and one or two low-cost, high quality bond funds. If that’s all the complexity you want, or if you don’t want to take the risk of deviating from “the market”, or if you simply are not convinced by the splitters’ arguments, then know that you are in the company of many wise and experienced investors, and that there is solid financial theory that supports your position.

In considering whether or not to further diversify, I think more about the possibility of a poor outcome than the probability of beating the total US stock market return. The total US stock market is dominated by large-cap US stocks, even though it includes mid-cap and small-cap stocks (for example, over many periods, you can barely see the difference if you compare a chart of the Vanguard Total Stock Market Index fund to the S&P 500, a US large-cap index). I would rather be somewhat more diversified among international, small-cap and value stocks in case large US growth stocks have an extended period of poor performance. I am willing to accept the possibility that large US stocks could be the best performing asset class over the next 20 years, and that by diversifying among other stock asset classes, I’ll underperform relative to the S&P 500.

If you’re willing to handle more portfolio complexity, I think the risk of a poor long-term outcome (e.g., large-cap US stocks have an extended period of poor performance) is reduced by further diversifying into low-cost index funds that invest in REITs, small-cap value, large-cap value, and small-cap blend. You could use the Vanguard Total Stock Market Index fund as your core US stock holding, and then tilt your US stock allocation to one or more of the other US stock asset classes by allocating 10-15% of your US stock allocation to each of Vanguard’s index funds or ETFs that invest in these asset classes.

A good core international stock holding is Vanguard’s Total International Stock Index fund, which includes both developed and emerging markets. If you want to tilt toward small-cap in the international stock portion your portfolio, you could invest 10-15% of your international stock allocation in an index fund or ETF that invests in small-cap international stocks.

No one knows whether the lumpers or the splitters will do better over the next 20, 30 or 40 years. Many financial advisors and authors write and talk as if they are very confident that one or the other strategy is superior, but remember that there is academic theory and research to support both positions. I am not highly confident that tilting away from the market portfolio is a superior strategy, but that is the way I lean.


  1. Thank you, I have recently been searching for information about this topic for ages and yours is the best I have discovered so far.

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    - Henry

  3. This was a very clear presentation. Many thanks!

  4. Dave, glad it was useful. Thanks for the comment.