Smarter Approaches to Index Investing


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Did you know that only 24% of all active mutual fund managers have outperformed their respective benchmarks over the past decade? Traditional index funds are popular, but recent research shows that alternative indexing methods can lead to systematic outperformance.

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  • This is a missing chapter from an unfinished book that I started sometime ago, called “Pandora’s Portfolio: Beating the Market By Breaking the Rules”. One of the rules of investing is that it is really, really hard to outperform the market over the long-haul.
  • It is really difficult to beat an index fund. In a study of 7,600 mutual funds that invest in stocks, 75% of them lagged their respective indexes over the past 10 years. Why is that? Mutual fund managers often DO outperform their benchmarks before fees. This works out to about 0.5% of outperformance per year. But, after deducting management fees, they often LAG by about 0.46% per year.So, today, I’m going to show you how you could not only beat 75% of all mutual funds, but beat a well-known index as well.Assets in the top 2 S&P 500 index ETFs (SPY and the iShares S&P 500 Index Fund (IVV), exceed $100 billion, or about 12% of total ETF assets. In total, there are now over $5 trillion in assets tracking the S&P 500 benchmark.
  • What is the S&P 500? It represents the value of 500 of the largest publicly-traded companies in America. But it is important to realize that not all of these companies are represented equally. If you’ve ever cooked, you’ve know that getting the right proportion of ingredients is important. The Recipe of the S&P 500 index is based on something called Market Capitalization. The S&P 500 is what analysts would refer to as a “capitalization-weighted” index. That is just another way of saying that big companies get more representation in the S&P 500 than small companies do. Bigger companies each get a bigger slice of the investment pie – not only for the S&P 500, but also for the index funds that track the S&P 500. Exxon and Apple are almost tied for the largest position in the S&P 500. Each has a market capitalization (or total market value) of approximately $400 billion. Big Lots is one of the smallest, and has a market cap of just $2b. So, the S&P 500 index owns 200x more Exxon than Big lots. That’s why Exxon gets more love from S&P.
  • There are some big problems with this approach, however. Every capitalization-weighted index (including the S&P 500) is prone to get suckered into every stock-market bubble that comes along. If that involves tech stocks – the S&P 500 index is going to have a lot of tech. If there is a bubble in financial stocks – guess what? you better like financial stocks because you are going to have a lot of those in your portfolio.  Essentially, if you buy a cap-weighted index such as the S&P 500, you are going to perpetually be running with the bulls. Which is great – so long as you don’t get winded. Technology stocks comprised 39% of the S&P 500 by market cap as of March of 2000. By mid-2003 that percentage declined to just 14%.
  • As editor of the Financial Analysts Journal and portfolio manager at the PIMCO, Robert Arnott was already a heavy–hitter in the investment management community before he published his findings on fundamental-weighted indexing in 2005. The paper received quick criticism from giants such as Burton Malkiel (professor at Princeton University and author of A Random Walk Down Wall Street) and John Bogle (legendary founder of the Vanguard group and proponent of index investing).  Arnott suggested that by using an index of companies weighted based upon a combination of four basic accounting metrics -- book value, sales, gross dividends and cash flow, it might be possible to beat the standard S&P 500 index by over to two percentage points annually. As he explains, “it’s hitting a nerve because it addresses a concern people have had not just for years, but for decades.”  Imitation might be the sincerest form of flattery, and alternatively weighted strategies have become significant players in the ETF industry. Most of the leaders in the industry, including Barclays, PowerShares, WisdomTree, and Claymore now have some form of fundamentally weighted index available.Why it works:  According to Arnott, “in a less than efficient market, we know that some stocks will be priced above or below their true fair value. Those priced above true value will have an erroneously higher capitalization, and therefore, index weighting.”  For the purpose of simplicity, Arnott rebalanced the index at the beginning of each year. What’s the Difference? Gross of expenses, $1,000 invested over a 42 year- period would have grown to $67,000 using the S&P 500, or $139,000 using Arnott’s Fundamentally-Weighted Index, or $161,000 using a Revenue-weighted index. 
  • Revenues are hard to fake. Simpler accounting sometimes leads to better returns…
  • Bigger is not always better – and small to mid-sized company stocks typically outperform blue chip competitors over longer periods of time.  Standard and Poors has created an equal-weighted version of the well-known S&P 500 index. The index has the same holdings as the standard S&P 500, but each company in the index is given a fixed weighting of 0.2% of the total index value. This seemingly small difference creates a noticeable impact on returns – at least over the past few years.  Strategy:  Invest equal dollar amounts in all of the stocks within the S&P 500 index. I.e., each holding in the S&P 500 should represent 1/500th of total assets invested in the strategy. Rebalance quarterly.  This eliminates the large-cap bias of the S&P 500, by giving smaller companies the same degree of representation as market giants such as GE, Exxon Mobil, and Microsoft. The simplest way of implementing this strategy is to purchase shares of the Guggenheim S&P Equal Weight ETF (ticker: RSP). So far, Guggenheim has done a good job of rebalancing the ETF without generating taxable capital gains distributions. This makes this a suitable “core” strategy for taxable accounts.
  • Why it Works: The average market cap of the Guggenheim Equal Weight ETF is $8 billion versus $45 billion for the standard S&P 500 index. As such, this strategy feels more like an index of mid-sized companies than the standard S&P 500. Over the long-term, mid-sized companies will tend to outperform the mega-caps, with slightly higher annual volatility.  Mid-sized companies often grow their earnings at a faster rate than their oversized counterparts.  The quarterly rebalancing component of the strategy also plays a useful role. If a stock drops precipitously, more is added to the fund during the following quarter. Stocks that post big gains are trimmed. This process effectively causes the fund to “sell high and buy low” in a de facto kind of sense. Furthermore, the ETF structure enables the fund to exchange those shares on an institutional level without necessarily triggering realized gains and losses.
  • Is there a caveat here? Yes there is – higher volatility.Based on five years’ worth of data, the RevenueSharesMidCap fund catches about 134% of the S&P 500’s upside movement and 123% of it’s downside. So, while there is sometimes a price for higher performance – this trade-off might be worthwhile.
  • Smarter Approaches to Index Investing

    1. 1. Smarter Approaches to IndexInvestingJune 27, 2013
    2. 2. Source:
    3. 3. Source: MSN Money
    4. 4. Source: Bespoke Investment Group
    5. 5. Source: Financial Analystss Journal March/April 2005
    6. 6. Source: MSN Money
    7. 7. Source: MSN Money
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