Beating the S+P 500 Index:
Here's How
By Selwyn Gerber CPA
Published: February 2011 10:29
For most stock investors, the Dow Jones Industrial Average returns for the past decade have left them feeling about the same as they did following their first root canal. It was a wild roller coaster ride of ups and downs, ending not much higher than it began. On January 14, 2000, the news media were in a frenzy, reporting that the Dow closed at an "all-time high" of 11,723 and then after severe volatility went on to reach its true record high of 14,164 on October 9 2007. After the subprime collapse, the Dow hit its nadir of 6,547 on March 9, 2009, a drop of 54%. This plunge effectively erased gains made since the late 90's.
Once again, the venerable Dow stands above 12,000 today, still 20% below it's all time peak and is where it was in 1999. Almost in stealth mode however, the Standard and Poors MidCap 600 index is just 5% from its all time high reached in July 2007, and the S&P 600® appreciated by 77% over the past decade. In long term studies conducted by market-watcher Ibbotson Associates, large stocks tended to compound at 9.8% annually vs 11.9% for small companies. Over time, that 20% difference is highly significant.
Nobel Prize-winning economists teach us that asset allocation is a primary determinant of portfolio performance rather than stock-picking and market-timing. In fact, over any 10-year period, an estimated 80% of mutual fund managers fail to beat their benchmark indexes.
"Asset allocation is a primary determinant of portfolio returns. 80% of managers fail to beat the indexes over any 10 year period."
INHERENT PROBLEMS WITH MOST INDEXES
During the first quarter-century of index investing, the S&P 500® offered breathtaking returns, multiplying a dollar invested in 1975 to nearly $17 by 2000, after taking inflation into account. In the decade that followed, it turned one dollar into just 71 cents. "Cap-weighting" - the standard method of valuing the S&P 500® Index - looked so good for so long precisely because so much money flowed into it, thereby boosting returns.
The most popular stock indexes are market capitalization-weighted ("MCW"), so that the higher the market value of a company (the total shares issued multiplied by the price of one share), the greater its impact on the index. Within the S&P 500® Index, 50% of the valuation is attributed to the largest 50 companies - causing the Index to always be overlyweighted in favor of the in-vogue and overpriced, and underweighted to the detriment of the underpriced and undervalued.
BEYOND CAPITALIZATION WEIGHTINGS
Many index investors believe it’s not possible to beat the stock market, or don’t wish to try, and they link their fortunes to the S↦P 500®, Russell 1000, or some other benchmark believed to represent the entire market. However, no index fund truly holds a slice of the entire market. All are biased in membership and weighting - that is, all indexes pick stocks.
The most popular index type, by far, weights companies by the sum value of their shares, called market capitalization. Cap-weighting favors expensive companies, critics argue, and creates a drag on returns. In fact MCW indexes are definitionally overweighted to the in-favor and overpriced companies.
An alternative is to weight companies equally. The lesser known S&P Equal Weighted Index is a good example of an index that does just that. This method uses quarterly rebalancing so that shares that rise in value are sold off to retain the allocation proportions and those proceeds are then deployed into those shares that have fallen in price. The process has a built-in contrarian element - selling what is hot and replacing it with what is not. Those who owned the S+P 500 Index a decade ago suffered disproportionately from the tech-collapse that ensued, because the most pricey shares were in the technology sector while the equal weighted indexes were steadily selling off their holdings into the frothy market and investing in the basic "bricks and mortar" type companies that had been largely overlooked by the raging bulls.
Still another approach involves weighting companies by accounting measures that signify economic size. The concept, known as "Enhanced Indexing," uses a blend of objective benchmarks (other than market valuation) including sales, earnings, cash flow, and dividends to measure true economic footprint. ETFs, properly chosen and combined, are perhaps the ideal portfolio elements - a low cost, tax efficient way to access diversified baskets of equities that meet rigid criteria. Regular rebalancing to the target allocation strikes the ideal balance between passive and active management. This approach has proved to be the best way for most minvestors who are patient , can endure volatility and have a long term horizon. Holding quality diversified equities is much like watching a man walking up the stairs with a yo yo in his hand. Savvy investors watch the feet and not the yo yo.
Analysis of the results of these enhanced index funds show a steady long term margin of 2-3% or more annually over the traditional indexes. Indeed, the promoters boast compound returns of more than 6% per year over the past 11 years, trouncing the popular indexes by a very wide margin.
Promoters of these enhanced and fundamental index funds claim a margin of 2-3% or more annually over the traditional indexes. Indeed, mthe promoters boast compound returns of more than 6% per year over the past 11 years, trouncing the popular indexes by a wide margin.
Why do ETFs seem to outshine their actively-managed counterparts? It is a direct result of the absence of management. Numerous academic studies, and even "dart-thrown" portfolios crafted by writers at The Wall Street Journal, have clearly, and repeatedly, demonstrated that stock-picking and market-timing efforts fail to provide consistent, winning results.
Index mutual funds are, without a doubt, an excellent investment vehicle. But ETFs offer superior advantages in many ways, making what has always been a good idea even better. ETFs offer lower costs and greater tax-efficiency by eliminating the sometimes sizable phantom income taxes that are created by mutual funds. EFT investors rarely see gains passed through on Form 1099 that are distributed to owners of taxable mutual fund accounts each year.
A final advantage of ETFs is that investors may avail themselves of the many funds available and develop precisely the right asset allocation strategy for their financial circumstances and objectives. There are far more ETF options available compared to index mutual funds in order mto match the multiple financial demands that individual investors face.
Using the "Enhanced ETF" strategy, it is possible to design a portfolio to achieve a value or growth tilt, emphasize small-, mid-, or largecap investments, and even attain a desired amount of global stock market exposure. This process ensures exactly the right balance of risk and reward to match one’s needs. In other words, a passive investor can create a well-balanced portfolio of ETFs that is expected to provide superior gains with minimal income tax liability. "Fundamentally-Valued" ETFs, which broadly resemble mutual funds - are not "actively-managed" and have almost none of the management fees or income tax exposure generated by mutual fund managers in their relentless pursuit of the crest of the wave.
THE BOTTOM LINE: The levels of portfolio design increase in sophistication as follows: (1) Even basic indexing beats active management; (2) Enhanced indexing tends to beat basic indexing - and then (3) Asset allocation takes those elements and blends them into an overall portfolio that is responsive the needs for safety, income and growth. ETFs are, perhaps, the ideal vehicle for accessing a diversified group of equities that are objectively selected to meet specified criteria. Combining these skillfully to produce a blend that is appropriately allocated and then periodically reviewing that allocation (especially with regular rebalancing) has been proven to work for most investors in the long run. Always remember that investing in quality equities is much like watching a man walking up the stairs with a yo yo in his hand - be sure to watch the feet and not the yo yo.