Rule #6 Don’t Get Mad, Get Even!

We’ve all heard the statistic that over the long-term, S&P 500 index funds beat 80% of  large cap managers.  Followers of efficient market theory believe that it is almost impossible to beat the market on an ongoing basis.  They believe that the price of a stock represents the collective wisdom of all public and private knowledge regarding a company’s future prospects.  Resistance is futile, so you might as well join the masses of index fund investors and leave your sense of independence and free thinking at the door.

So does this mean that the S&P 500 index is the best choice for investors?  Probably not.

The S&P 500 is what analysts would refer to as a capitalization-weighted index.  In geek-speak, it is just another way of saying that big companies get more representation in the S&P 500 than small companies do.  The top 55 stocks of the S&P 500 represent close to 50% of the value of the index.   Meanwhile, the smallest 225 companies in the S&P 500 represent just 10% of the overall value of the index.

There are some big problems with this approach.  Capitalization-weighted indices get suckered into almost every stock-market bubble that comes along.  For example, technology stocks comprised 39% of the S&P 500 by market cap as of March of 2000.  By the end of 2002 that percentage declined to just 18%.  Meanwhile, financial stocks had a disproportionally large representation in early 2008 – just when you didn’t want to load up on financials.

If you buy a cap-weighted index such as the S&P 500, you will be running with the bulls.  This is fine – so long as you don’t get winded.

Sam Stovall, in his book The Seven Rules of Wall Street, advocates equal-weighted indices.   This  means that each stock in would have equal representationregardless of size.  The result is that you have an index with more exposure to small and mid-sized companies.

So what does this mean for returns?  From 1990-2007 the equal-weight methodology beat the standard cap-weighted approach by 1.3% per year, and outperformed in 56% of calendar years.  It also did so with slightly less volatility.  No surprises here – small and mid-cap stocks tend to outperform blue chips over the long-term.  (Rydex has an equal-weight S&P 500 ETF worth considering – ticker is RSP.)

This looks good, right? Better returns, somewhat consistent outperformance, slightly lower risk…

Rydex also has a number of equal-weight sector funds.  Using these instead of standard index ETFs in any sector rotation strategy can add an incremental 1 to 1½ % return per year.

This introduces the concept of factor stacking.  Instead of using just one thing that works, try to combine multiple strategies together in a way that tilts the odds even further in your favor.

There are alternative ways to re-weight the S&P 500 index.  One of my favorite techniques is fundamental weighting. The simplest approach is to weight holdings in the index based upon their annual revenues.  A company with $10 billion in revenues has twice the weight of companies with just $5 billion in revenues.  If you have some time, read the seminal paper by Robert Arnott, editor of the Financial Analysts Journal.

Using just a simple revenue-weighted version of the S&P 500 index beats the standard version by 2.5% annually, with similar volatility.  This is even better than Stovall’s equal cap-weighted approach.

This strategy is available in ETF format through RevenueShares.   These are available for large, mid, and small cap indices.  By blending the Large and Mid Cap RevenueShares ETFs, you could  conceivably add in incremental 3% per year worth of annual returns over a basic S&P 500 index fund.

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2 Responses to Rule #6 Don’t Get Mad, Get Even!

  1. How about fundamentally weighting an index based on operating margins? How about some measure of the capex dependence of the business? Net income instead of just gross revenue. That might be a better way to automatically hone in on business that are more robustly positioned for the new economy, possibly lowering the volatilty experience.

    I’m thinking of tech companies with really nice operating margins as well as physically based companies whose cashflow is more basic. Of course, the Qs and high-dividend blue chip stocks are already well “overbought” relative to the S&P, so it’s not like you’d be early to the party.

    • Jim Lee says:

      Those are pretty reasonable questions. Cash flow is a comparatively “clean” accounting statistic. When used for developing a weighted index, Arnott got similar results to a revenue-weighted index.

      Earnings (and therefore net income) are often a little easier to fudge with a little creative accounting.

      Operating margins are worth considering. Fat margins often attract competition, so the next step is looking at the width and depth of a company’s economic moat. Personally, I like to use decomposed ROE statistics so that I can look at multiple factors behind profitability.

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