Should most investors beat the market?

mdxyz

IronWolf wrote: »

Just over 10 years ago the S&P 500 equal weight index was launched, since then it has returned 10.2% a year compared to the normal S&P 500 (market cap weighted) of 7.1% a year [ source]. It also won over 20 years, however not on a "risk adjusted" basis.

I have run backtests on this kind of thing myself, and the evidence is compelling that equally weighted portfolios consistently beat their benchmark indices.

Considering that investor wisdom now seems to be steering towards 'invest in low cost index trackers' I think it is interesting, because research suggests that individual investors have an inherent advantage over indexes - they dont have to weight by market cap.

To test the theory a research company randomly selected 100 portfolios containing 30 stocks from a 1,000 stock universe. They repeated this processes every year from 1964 to 2010, and tracked the results. Amazingly, on average, 98 of the 100 portfolios beat the 1,000 stock capitalization weighted stock universe each year.

'Equal weight' indices overweight smaller companies, so they produce higher returns because they're higher risk. It's the well-known higher return to small cap, though the smallest companies in the S&P aren't exactly small. There isn't a free lunch here nor any surprise, but if you can tolerate the risk it might be worth investing in small cap, either with an 'equal weight' blue chip index, or just through a small cap fund.

bowlhead99

To borrow from the abstract of Ironwolf's article, which I haven't read in full:

The value and small tilts stem from the fact that these new weighting schemes sever the link between a company’s share price/capitalization and its weight in the portfolio. Generally, an investment thesis where price does not drive the weight in the portfolio will have a value tilt and an investment thesis where company size/capitalization does not drive portfolio weights will have a small-cap tilt.

As a result, these strategies produce outperformance against the cap-weighted benchmark due to the often unintended value and small cap tilts and independent of the investment philosophies that drive the product design.

That is common sense really. If the FTSE Allshare or S&P500 index picks its stocks by market cap, it has a huge weighting to the performance of large cap companies. If you as an investor construct a personal portfolio in 2003 (inception of the S&P500 "equal weight" index), which has a roughly equal amount of money in everything, you have a relative tilt to smaller companies compared to the other index.

Then when the market goes on a multi-year bull run from 2003 (which was post-dotcom bust, post 9/11, post Enron etc and the lowest market point for an age), your 'bias' to small companies with growth prospects and undervaluations rather than slow moving stable behemoths, will serve you well.

In itself, this doesn't prove you have found a better system. You have certainly found a very costly system, because on day 2 of your 3650 day journey, when Smallcap company A has gone up by 0.02% and Behemoth Z has stayed flat or only gone up by 0.01%, you have to sell some A and buy some Z and ditto for everything else in the portfolio if you want to maintain the 'equal weight' philosophy. Rinse and repeat on day 3, 4, 5 ..3650 and you have an expensive 10-year journey. As gadgetmind says, how do you maintain equal weight?

I guess in reality you would just look in on the portfolio every so often and rebalance the weights periodically as most investors like us will do to our own portfolio. If it was a professionally managed fund accepting new subscriptions daily and always claiming to be equal weight, that frequency might not cut it for new investors who joined when it was out of whack.

But going back to what is risk, what is volatility etc. The Rick Ferri article which said that the equal weight index was riskier than the marketcap weight index, ended with:

The laws of economics cannot be overturned. Investors earn a market return less cost. Everything else is marketing.

Effectively saying that you are only getting more of a return by taking more of a gamble; the investment opportunity of 'the market' is all the share capital available from all the companies. It also says:

The market in aggregate only produces a finite amount of profit or loss for all investors to share. Coming up with alternative weighting schemes has never produced an extra dime of profit from the market. It’s impossible to get two quarts of milk from a one quart bottle.

So, investors trying to deploy $30 trillion across the world, are offered $40bn of Tesco and $4bn of Ocado, and if they take all $4bn of Ocado but only a tenth of the Tesco, they are not getting an 'edge', but are taking a risk.

There are plenty of multi-billion UK equity funds that are not claiming to be trackers but would still have more in HSBC than Cairn Energy and Moss Bros because, ignoring sector preferences, they are trying to deploy capital across limited market opportunities and the bank is 100x the market cap of the oiler which is 10x the market cap of the retailer.

However, for us as individuals investing, who are not at all constrained by the size of these companies compared to our wallets, if we are looking at the opportunities out there we are very unlikely to market weight in a self select portfolio. If I put £1k into Moss Bros based on my feelings of prospective growth and reasonableness of its current price, I am not necessarily going to go and put £10k in Cairn, £1m in HSBC and £2.8m in Apple if I have similar feelings about their prospective growth and fairness of current price.

In that example I suppose it's pretty obvious that I am 'taking a punt' if I did equal weight them because it is far from a balanced portfolio anyway. But in considering riskiness, we have to say, what is risk? Traditionally in the investment world, people say this is volatility, deviation from the normal return.

The normal return is the return of everything out there (i.e. buying all of Tesco, all of Ocado, all of HSBC and Apple and Cairn etc). At a market level, this 'normal return' pretty much has to be done on market cap, on 'all of' each company and not £1000 of each company, as we know that the performance of Moss Bros is pretty much nothing to do with what people perceive to be the performance of the UK stockmarket while HSBC is less of a niche business and 'must' be a better barometer being 1000x larger and heavily traded, and we should have a greater link between it and our declared 'normal return'.

But if you were picking stocks to try and get what you consider to be fair exposure to all sectors, I would argue that the FTSE100 or S&P500 is not a great benchmark to compare yourself against. The FTSE100 graph, because of its cap-weighting, is going to tell you what return you could have got from financials, oilers/miners and big pharma. It is not going to tell you what you could have got from tech firms like Google and Facebook or Apple and Samsung and Microsoft nor car manufacturers like VW or Ford. So it is obviously not a global benchmark. And the sector mix is awful.

You have to go heavy into certain sectors to achieve the stated headline return. And as an investor who is not finding scarce opportunities for tens of trillions, why would you want to go heavy into those sectors? This is Thrugelmir's point, which I agree with.

Market weighting or not, in the real world -a worked example:

Say you look at your portfolio and you have £5k spare cash and are not exposed to supermarkets and you are thinking of major players like Tesco vs Sainsbury or Morrisons. For general UK retailers, Ocado is a bit too niche, Asda is a bit too non-UK because you have to buy Walmart and get massive US exposure and so on. So you get to those 3, and then you think, Tesco is getting increased overseas exposure these days and its sheer size and revenues have it on 4x the market cap of Sainsbury so let's just look at Sainsbury and Morrison as being somewhat comparable.

Likely, you will have a preference (rational or irrational) for one or the other. If you really couldn't decide, you might toss a coin and put the £5k into one or the other. Or you might put £2.5k in each. If you followed market weighting, you would put £3k in Sainsbury and £2k in Morrison. But I would bet that most people would not come up with the £3k:£2k mix and go heavier on Sainsbury purely on the grounds that its market cap was bigger (£6bn vs £4bn) and so 'less risky' because its performance would be closer to the 'market average return' of both of them on a technicality.

Example: if Morrison market cap goes up over the next year by 10% (£400m on £4000m) and Sainsbury by 2% (£120m on £6000m) then the Sainsbury return of 2% is closer to the mini- 'market' return of 5.2% (£520m on £10,000m) than the Morrison 10% was.

Well, "more risk, more reward" people will say. "You would have got a result quite different to the market, by picking the smaller risky stock". "The larger stable stock was closer to the market result, and a choice to go equal weight, or maybe even heavier on the small stock, is a risky choice". These all sound quite negative and are some of the comments you would hear, to refute the idea that you should share your assets equally across companies instead of weighting them to bigger companies.

But it is a self fulfilling prophecy. If the fortunes were reversed and Sainsbury did 10% (£600m) and Morrison did 2% (£80m) on their respective valuations, the total 'market' return would be 6.8% and again Sainsbury's result is closer to this at 10% than Morrison at 2. Now they tell you that the Morrison choice has underperformed because it is 'risky'. It is delivering a return more removed from the 'normal market return', so by that traditional definition, yes it is risky.

However, my contention would be that with a 2-company market like that - where nobody has any idea which company will do better going into the year, and we are only trying to deploy £5k into a market worth tens of billions so face no constraints in doing so - it is clear that it is NOT inherently 'riskier' in the common sense of the word to put your money with Morrison.

They are similar companies in a similar sector. The one which happens to be a bit smaller is not really any more likely to go bust, and not really any more likely to add 5% to their profits. As a new arrival to the UK, without evaluating their financials and reports and market commentary and visiting the stores and listening to the press and considering the share price to assets or price to earnings ratios, you would not know which one you preferred but you certainly wouldn't say that buying M was 'taking a punt' while S was 'the safe and stable choice'.

However, the market-cap weighted index says that S is the safe and stable choice because its returns are consistently closer to the market return. It is a fix, because the market returns are being calculated off S's performance with M's performance being somewhat disregarded. This does not mean that your goal should be to achieve the market return and this does not mean that you should buy S. It is perfectly valid to do what Gadgetmind does with his UK income portfolio and buy a set of quality companies in equal measure.