Feb

14

Beating an Index, by Bill Rafter

February 14, 2007 |

Dr. Bruno had posed the idea of beating an index by deleting the worst performers. This is an area in which we have done considerable work. Please note that we do not consider this trend following. The assets are not charted, just ranked.

Let us imagine an investor who is savvy enough to identify what is strong about an economy and invest in sectors representative of those areas, while avoiding sectors representing the weaker areas of the economy. Note that we are not requiring our investor to be prescient. She does not need to see what will be strong tomorrow, just what is strong and weak now, measured by performance over a recent period.

What is a market sector? Standard & Poors does that work for us, and breaks down the overall market (that is, the S&P500) into 10 Sectors. They then further break it down into 24 Industry Groups, and further still into 60-plus Industries and 140-plus Sub-Industries. The number of the various groups and their constituents change from time to time as the economy evolves, but essentially the 500 stocks can be grouped in a variety of ways, depending on the degree of focus desired. Some of the groupings are so narrow that only one company represents that group.

Our investor starts out looking at the 10 Sectors and ranks them according to their performance (such as their quarterly rate of change). She then invests in those ranked first through fourth (25 percent in each), and maintains those holdings until the rankings change. How does she do? Not bad, it turns out.

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From 1990 through 2006, which encompasses several types of market conditions, the overall market managed an eight percent compound annual rate of return. Our savvy investor achieved 10.77%. A less savvy investor who had the bad fortune to pick the worst six groups would have earned 7.23%. Those results are below. (Note, for comparison purposes, all results excluded dividends.)

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How can our savvy investor do better? By simply sharpening focus, major improvements can be achieved. If instead of ranking the top four of 10 Sectors, our savvy investor invests in a similar number (say the top 4, 5, or 6) of the 24 Industry Groups, she achieves a 13.12% compounded annual rate of return over the same period. Note that the same stocks are represented in the 10 Sectors and the 24 Industry Groups. At no time did she have to be prescient.

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One thing you will notice from the graphs above is that the equity curves of our savvy and unlucky investors mimic the rises and declines of the market index itself. Being savvy makes money but it does not insulate one from overall bad markets because the Sectors and even the Industry Groups are not significantly diversified from the overall market.

Why not keep going further out and rank all stocks individually? That clearly results in superior returns, but the volume of trading is such that it can only be accomplished effectively in a fund structure - not by the individual. And even ranking thousands of stocks will not insulate an investor from an overall market decline, if she is only invested in equities. The answer of course is diversification.

It is possible to rank debt and alternative investment sectors alongside equities, in the hope of letting their performances dictate what the investor should own. However, the debt and commodities markets have different volatilities than the equities markets. Anyone ranking them must make adjustments for their inherent differences. That is, when ranking really diverse assets, one must rank them on a risk-adjusted basis for it to be a true comparison. But if we make those adjustments and rank treasury bonds (debt) against our 24 Industry Groups (equity) we can avoid some of the overall equity declines. We refer to this as a Strategic Overlay:

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Adding this Strategic Overlay increases the returns slightly, but more important, it diversifies the investor away from some periods of total equity market decline. We are not talking of a policy of running for cover every time the equities markets stall. In the long run, the investor must be in equities.

Invariably in ranking diverse assets such as equities, debt, and commodities, our investor will be faced with a decision that she should be completely out of equities. It is likely that will occur during a period of high volatility for equities, but one that has also experienced great returns. Thus our investor would be abandoning equities when her recent experience would suggest otherwise. And since timing can never be perfect, it is further likely that the equities she abandons will continue to outperform for some period. On an absolute basis, equities may rank best, but on a risk-adjusted basis, they may not. It is not uncommon for investors to ignore risk in such a situation, to their subsequent regret.

Ranking is not without its problems. For example, if you are selecting the top four groups of whatever category, there is a fair chance that at some time the assets ranked 4 and 5 will change places back and forth on a daily basis. This "flutter" can be easily solved by providing those who make the cut with a subsequent incumbency advantage. For a newcomer to replace a list member, it then must outrank the current assets on the selected list by the incumbency advantage. This is very similar to the manner in which thermostats work. We have found adding an incumbency advantage to be a profitable improvement without considering transactions costs. When one also considers the reduced transaction costs, the benefits increase even more.

Another important consideration is the "lookback" period. Above we used the example of our savvy investor ranking assets on the basis of their quarterly growth. Not surprising, the choice of lookback period can have an effect on profitability. Since markets tend to fall more abruptly than they rise, lookback periods that perform best during rising markets are markedly different from those that perform best during falling markets. Determining whether a market is rising or falling can be problematic, as it can only be done with certainty in retrospect. However, another key factor influencing the choice of lookback period is volatility, which can be determined concurrently. Thus an optimal lookback period can be automatically determined based on volatility.

There is certainly no question that a diligent investor can outperform the market. By outperforming the market we mean that she will achieve a greater average rate of return than the market, while limiting the maximum drawdown (or percentage equity decline) to less than that experienced by the market. But the average investor is generally not up to the diligence or persistence required.

In the research work illustrated above, all transactions were executed on the close of the day following a decision being made. Thus the strategy illustrated is certainly executable. Nothing required a forecast; all that was required was for the investor to recognize concurrently which assets have performed well over a recent period. It is not difficult, but requires daily monitoring.


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