It’s a Lot Harder to Beat some Indexes Than we Think

Stock Indexes

In spite of only 1 in 5 active funds beating the S&P 500, plenty of investors still want to take their chances. There are better indexes than this, which active funds can’t touch.

The S&P 500 is the benchmark for investing, and both individual investors and funds look to beat the returns of this index over time. The idea behind this index is to look to be well diversified and therefore be more representative of the overall market, and they do a pretty good job at that.

Even though President Trump refers to the Dow as the stock market, and the Dow has always tried to represent the large cap market, there is only 30 stocks in it, and it therefore is less representative. A single stock can influence the Dow quite a bit, and since people use these indexes to try to get a pulse on the overall market, this has the Dow not representing it as well as the broader S&P 500 does.

The Nasdaq Composite Index actually tracks a lot more stocks than the S&P 500 does, but is overrepresented in the tech sector, which is why people care less about it. We want an index that we can say represents stocks in general, and you need a broad base for that.

The S&P 500 easily wins the game of representing, but does that mean that it also should win as far as being desirable to invest in? These are two different matters entirely. We need to ask ourselves why we’d want to take this from just a benchmark as to how the market is doing and want to actually invest in this representation of the market versus investing in other things.

It may seem to be a benefit to have a more balanced sector weighting, especially given that people generally want to invest longer term and may believe that the performance of particular sectors may change over time, with different ones being in the lead, and investing more broadly therefore hedges your bets.

Whether or not this ends up being the case going forward, we cannot just blindly select a strategy like this without weighing the costs of it. If certain sectors are doing poorly now, we have to question how it benefits us to be in them, where they only serve to put our returns down now.

The most important thing to realize here is that we do not have to select a certain strategy now and be done with it, as if there is a better way now and that way ends up no longer being the better way some years from now, we do have the ability to change horses.

We always want to seek to place our decisions in the near term as much as possible, where we prefer things that are working now over things that aren’t but might someday, as this is the only proper way to pursue what we are looking for, to drive our investment results.

Someday will come, but when it does, we will have a much clearer picture of it then. We really never know what the future holds, but hedging against something because we believe it may not continue to be great can only be properly dealt with if we actually wait until circumstances do change.

If underperforming sectors continue to underperform, and we’re holding positions in them, we just cost ourselves. If we invest in a well-represented index, we take on all this baggage and this costs us plenty, although you’ll never know unless you look.

It’s not that the average return over the last 5 years of the S&P has been anything to sneeze at, as investors have earned an average return of about 12% by investing in this index. This is the bar that funds struggle to keep up with, and most have not returned this much. Some have, but the best of them have only beaten this index by 1-3% per year, and you can’t count on the same ones doing this over the next 5 years just because they did it over the previous 5.

This simply isn’t even a big enough advantage to have us wanting to take on the added risk of their consistency, but there is an even better reason not to want to do this, as there are mightier opponents out there that simply remove any reason to play roulette this way with our portfolios.

We Shouldn’t Just Stop Looking When the Overall Market Wins

Investors can spend quite a bit of time seeking out these funds that have beaten the “market” lately and then cross their fingers in the hope that this outperformance will continue. Sometimes it does, and they may smile and pat themselves on the back for beating the market, although they really need to be concerned about whether they would not have been better off doing something else.

For whatever reason, just about everyone is so focused on the S&P 500, and the funds sure don’t mention better performing indexes because this would set the bar that they have to beat much more out of reach. All those people who invest in S&P 500 index funds aren’t thinking about this much either, and if we really want to be using major stock indexes as benchmarks or investment goals, we at least need to be aware that there is a major one that has well beaten both the S&P 500 and the funds.

Instead of just beating the S&P 500 by 1-3% like the top mutual funds have done over the last 5 years, the Nasdaq Composite has beaten it by a full 7%. This adds up to a total additional return of 35% over the last 5 years over the S&P 500, which is what you really call beating it.

The average mutual fund returns less than the S&P 500, which means that at the very least you need to be selective, but even if you had a time machine and could go back 5 years and buy the ones that performed the best, you’d still be 4% a year short of what the Nasdaq did over this time.

If most mutual funds do not beat the S&P 500 and all of them are well behind the Nasdaq, this should give investors who prefer actively managed funds much more pause for thought than the only 1 in 5 that beats the S&P does. This has been the biggest driver toward S&P 500 index funds, and the performance of the Nasdaq should drive us further away from both active funds and passively managed funds based upon the broader index.

More people moving toward the Nasdaq would also serve to propel this index further, where the stocks in the index would get even more love from investors and this would cause it to increase its lead if anything. We don’t need anything more to make this a faster running train though, because it already is, and as long as it is, it is simply a better train to be on.

We need not worry about this being the case in 2025 or 2030, as if this index ends up lagging, we can deal with that if and when it happens. We can even use this as a benchmark to tell us when to get out of stocks period, as when the Nasdaq lags, that means a bear market, and if your index is losing more, and the other one is losing less but still losing, it’s just better not to be in something else that is still losing when you could just be out during these times.

We could be pretty comfortable with saying that if the S&P 500 outperforms the Nasdaq, it is not time to be in stocks at all and you could just go flat when this happens and see money under your mattress outperform the broader index. Knowing this, we may wonder when it may ever be best to invest in the broad market over the Nasdaq, given that the Nasdaq wins so easily in bull markets and no one wins in bear markets.

This is the case as well with those who wish to chase mutual funds, and the same thing applies to actively managed ETFs as well as we start getting more and more of these in the market as the regulations open up more. If you are beating the Nasdaq, that’s a bad omen because this requires stocks to be bearish, especially with the love affair that so many fund managers have with underperformers, which is their undoing.

While we may object that the Nasdaq is riskier because it can move down more, we also need to realize that, as returns rise, risk tolerance rises in turn. If you are up 35% and you give back 10% more in a move, you are still ahead 25% on a net basis and are also poised to get this temporary loss of 10% back and then just add to your advantage from there, provided that we’re still in a bull market overall. If we are not, it is simply time to step away.

If we want to take this a step further, we can move from the tech heavy Nasdaq to a pure tech play such as the SPDR technology sector, the XLK, to allow us to do even better in bull markets. While the Nasdaq gained 38% last year, beating the S&P 500 by 9%, the XLK beat both by a big margin with its 49% return. It has averaged a 70% average return since 2009 so this is no flash in the pan by any means.

People may worry about the impact of corrections, and since we just saw one not long ago, this does give us a chance to see how much worse this tech fund performs in these settings. The fund gave back a maximum of 21% from early October to late December 2018, only 1% more than the S&P 500 did.

This 1% was made up for in a flash, and since then, the Nasdaq is up by 47%, easily outdistancing the 37% that the S&P 500 has managed, but taking a back seat to the 67% that the SPDR technology index has delivered. Beating the broad market by 10% is nice, beating it by 30% is just better.

Better Performance Means You Can Take on More Drawdown Risk

This extra 30% does play going forward as well, and this is why you can’t just look at comparing drawdowns, as this is a much more dynamic calculation. This might be the single most important principle that very few investors understand, as an outperforming fund like this will build a buffer that will have us playing with a lot more house money should things slide.

We can and definitely should be out of something like this before we give back this 30% extra or anything close. This does not mean losing 30%, it means losing 30% more than the broad market. This would require a huge bear market to be that much behind, something much more significant to techs than the 2008 crash, where the XLK went down 5% less than the S&P 500, not 30% more.

We did see this 30% kick in once, during the 2000 crash that simply hammered tech stocks, although that was a singular event that we probably will never see again. We can’t be investing based upon events this extremely unlikely though, and if you were in this index back in 2000 when it started to crash, if you didn’t recognize this as a bear, they don’t exist for you.

We need to remember that this 30% only represents the additional gains over just the last 13 months though, and when we consider that the XLK has outperformed the S&P 500 by a total of 246% since March 2009, we have a lot more to play with than this over the long run. Once we take this running advantage into account, it should be easy to see that the risk of not getting to a certain goal in the future is not increased, it becomes significantly lessened, the opposite of what people think.

This is what we have left on the table by just investing in the S&P 500 index, and likely have done even worse by going with active funds who just end up picking the wrong stocks year after year. Even with the best performing ones, just beating the big index by a little each year is nothing to crow about when you get beat this badly by the Nasdaq and get beat even worse by this sector fund.

Investing can be very complicated if you let it, although more complicated isn’t necessarily better and can be considerably worse. For all the complexity that actively managed funds use, most fail in even beating as simple a strategy as just buying an index, which investors are waking up to more and more.

If we’re willing to invest in indexes, we should be open to putting in a little thought and select the better ones, given how much we can help ourselves here. If the S&P 500 beats 4 out of 5 index funds, and another fund beats 5 out of 5 as well as the S&P, by embarrassing amounts, as long as we prefer better, this should be an easy call.

This strategy works because it actually is focused on the near term, and we know how hot tech stocks have been and continue to be. There are 10 major sectors in the stock market, where there will be some that perform better than others in the near term, and rather than being in them all and allowing the weaker sectors to bring down our returns, we might want to pick the better ones and discard the rest.

An even better idea, as it turns out, is to go with the best of the indexes and look to maximize this advantage. While we should never see investing as getting married, and if we are looking for a relationship, we’ll do better if we select based upon desirability and not just let our home be overrun with a bunch of random people, some which simply don’t behave that well, and be so happy to degrade our enjoyment of life.

Even a little screening can help though. The top 5 sectors from 2019 have already outperformed the bottom 5 by 2% in 2020 in just half a month. Going with the Nasdaq instead adds an additional 1.5%, and our tech sector SPDR instead adds another half a percent.

This is not rocket science and far from it. This is actually an amazingly simple way to invest. Someone else builds the rockets, and we just measure their speed and hop on a fast one. We definitely don’t want to be combing through the junkyard to try to find a homemade rocket an active fund manager built, as these are the worst ones in the yard overall.

If we want to take this principle one step further and are up to building our own rockets, this isn’t so tough either, as we just look to refine our gold to an even higher level, going with the best of the best. The little rocket that we built for you at the end of last year with our 5 stocks is beating the tech SPDR by 1.7% and the Nasdaq by 2.2%.

This is for bonus points though should we wish to use this principle to refine things even further, to the maximum in this case. However, given how comfortable people are with indexes and the fact that no skill is required, this makes them a far more popular option.

Taking index investing to the next level by actually looking at the indexes we could invest in and being selective only becomes an option if we are open to considering it. Given that investing itself is supposed to be about trying to select the best investments, this should not be such a big leap.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.