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Value Investor Greenblatt: Here’s How to Beat the Benchmark

You may have thought he dispelled all of his investing secrets, but there's more to reveal from Joel Greenblatt's recent visit here at Breakout. The author of The Big Secret for the Small Investor has some valuable insight on which benchmark indexes you should pay attention to, which could lose you money, and why ETFs tracking the right indexes are a "good passive strategy."

Greenblatt lays out a food chain of investing, with active fund managers at the bottom of the pyramid. He is very critical of active managers and prefers investors go it alone by tracking certain indexes and buying ETFs that do the same. Most investors follow the traditional indexes, like the S&P 500. Despite beating most active managers (putting them up higher in the food chain), he says "they're still very flawed." That's because they are market-cap weighted, meaning they put more weight into the largest companies whose size adjusts automatically as stock price fluctuates.

The problem with market-cap weighted indexes is "if a stock is overpriced, you own too much of it. If a stock is underpriced, you own too little of it." And this alone can cost an investor 2% a year, according to Greenblatt. So, we move up the investing food chain to avoid that loss and seek out profit.

Another Big Secret Revealed …

In order to beat market-cap weighted indexes (which beat active managers), consider equally weighted indexes like the Rydex S&P Equal Weight ETF (RSP). This type of fund holds the same percentage of each stock. Or, Greenblatt says to consider fundamentally weighted indexes, in which stocks are weighted based on their economic size and footprint, not their price. Greenblatt likes the PowerShares FTSE RAFI US 1000 (PRF).

Finally, according to Greenblatt, at the top of the investing chain are value-weighted indexes, which consist of stocks with cheap valuation and high quality. Greenblatt likes the Vanguard Value ETF (VTV) and of course the mutual fund that he was involved in creating, the Formula Investing US Value 1000 fund (FVVAX).

So to re"cap" (pun intended): Market-cap weighted indexes beat active managers. Equally weighted indexes and fundamentally weighted indexes beat market-cap weighted indexes. And the big winner according to Greenblatt: Value-weighted indexes can beat all of the above.

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