Peter's Perspective
21st November 2014 by Tama Churchouse

Outperformance & Lower Risk

Peter is currently in Europe on assignment – this edition of Peter’s Perspective is brought to you by Tama Churchouse.

There are approximately US$5.14 TRILLION dollars benchmarked against the S&P 500.

Hedge funds, portfolio managers… they’re all judged against this index (fairly or not).

The largest ETF in the world in terms of assets under management (AUM) is the one that tracks the S&P 500 Index. The SPDR S&P 500 ETF (SPY US) has $200bn AUM. It’s nearly 3x larger than the second biggest ETF.

What if there was a way to buy the S&P 500 AND outperform it?

What if there was a way to buy the S&P 500 AND reduce your downside risk?

And what if you could do this yourself, and do it easily?

You see, the index works like this. Every three months S&P looks at U.S. companies with a minimum market cap of US$5.3 billion. At least 50% of the outstanding company shares must be available for trading. And they must be highly tradable common stocks with active and deep markets.

The index then weights the constituents by their float-adjusted market cap. Simply put, this means the bigger the company, the more weighting in the index.

Right now the top 10 by weighting include Exxon Mobil, Microsoft, Johnson & Johnson, GE, and Proctor & Gamble. These are all great companies, but they’re mature and thus typically exhibit more modest growth.

An easy way to give us more exposure to smaller companies with higher growth potential is to take an equal weighted approach.

The S&P 500 Equal Weight Index takes the same constituents as the regular cap-weighted index and simply allocates 0.2% to each of them.

The chart below shows the dramatic impact of this simple change of index composition.

Over nearly 25 years, the regular S&P 500 returned 966%.

The equal weighted index returned 1691%.

S&P 500 vs S&P 500 Equal-Weighted (Nov 1990-Nov 2014. Indexed to 100)

And the ‘cost’ of this out performance was just a tiny bit more volatility.

The equal weighted S&P 500 has outperformed the regular S&P 500 in every single bull market cycle since 1990.

Including the current one.

The table below shows the total returns for each of the 3 bull cycles over the past 25 years.

Bull Market 1, from November 1990-May 2001, S&P 500 gained 422%, S&P 500 Equal Weighted gained 490%, Equal Weighted Outperformed by 68%. Bull Market 2 from October 2002-October 2007, S&P 500 gained 121%, S&P 500 Equal Weighted gained 177%, Equal Weighted Outperformed by 57%. Bull Market 3 from March 2009-November 2014, S&P 500 gained 242%, S&P 500 Equal Weighted gained 335%, Equal Weighted Outperformed by 93%. Bear Market 1 from May 2001-October 2002, S&P 500 fell 40%, S&P 500 Equal Weighted fell 39%, Equal Weighted Outperformed by 1%. Bear Market 2 from October 2007 to March 2009, S&P500 fell 55%, S&P500 Equal Weighted fell 59%, Equal Weighted Outperformed by -3%.

But during the two bear markets of 2001/02 (Tech bubble) and 2007/09 (Global Financial Crisis), the equal-weighted index gave up the same or more of its gains as the regular S&P 500.

This leads us to our next question. How can we limit the downside?

There’s another index we can use. It’s the S&P 500 Low Volatility Index. This index simply picks the 100 least volatile stocks from the S&P 500 universe. It measures the prior one year of volatility for each stock and picks the 100 lowest.

The chart below shows how this lower volatility index has also outperformed the regular S&P 500 over 25 years. The key with this index is that it doesn’t match the upside of the S&P 500, rather it is significantly more defensive when markets turn.

S&P 500 vs S&P 500 Low Volatility (From Nov 1990-Nov2014, Indexed to 100).

The key to longer term gains isn’t just about your upside, it’s about minimising your downside.

The constituents of the low-vol index by their very nature are more defensive, hence we see a higher allocation towards Electricity, Insurance, and REITs for example.

It’s also why you’ll notice in the late 1990’s this low volatility index underperformed the broader S&P 500.

Why?

Because tech bubble stocks trading at Price-Earnings ratios north of 200x (like Cisco for example) had no place in a low volatility index!

Ultimately, you can get very highly correlated returns that outperform the S&P 500 and implementing this is relatively straightforward.

So, depending on your market outlook you have some options:

  1. If you believe that this bull market still has plenty of legs, then the Guggenheim S&P 500 Equal Weight ETF (RSP US) could continue to outperform the regular S&P 500.

    Despite having outperformed SPY US for 90 per cent of 2014, they are both currently exhibiting the same return after the after the October correction.

  2. If you’re more concerned about a ‘proper’ correction but you want to stay in the market and get better downside protection, then the PowerShares S&P 500 Low Volatility Portfolio (SPLV US) is an ETF to look at.

    This ETF also pays you around a 2.4 per cent yield vs. 1.83 percent for the regular S&P 500 ETF. So far in 2014 it’s outperformed SPY US by around 1.6 per cent.

But if you want to both maximize your upside and minimize your downside, just think about a 50/50 split between the equal weight (RSP) and low volatility (SPLV) ETFs.

  • A 50/50 split between the equal-weight and low-vol S&P 500 indices has outperformed the regular S&P 500 in the last two bull markets.
  • This split has also experienced smaller declines in the past two bear markets.
  • Over the past 25 years, it has a 95%+ correlation with the regular S&P 500.

S&P 500 vs 50/50 Equal Weighted + Low Volatility S&P 500.

So far in 2014 a 50/50 split between RSP (equal weight) and SPLV (low volatility) has outperformed SPY (the regular S&P 500 ETF) by 0.50%.

Not huge I know. But it’s also done that with smaller drawdowns AND lower volatility.

Higher returns. Less volatility. And 98.5 per cent correlated with the benchmark S&P 500 this year.

Just something to consider, particularly for your passive U.S. equity allocation…

Good investing,

Tama

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