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 January 2006 You Can't Beat the Wrong Benchmark
Investors learned firsthand just how dangerous risky, non-diversified portfolios could be. The approach that led to short-term gains wasn't a viable strategy for long-term appreciation. In fact, many who survived the selloff came to the realization that stock picking doesn't work; in the long-term, you can't beat the market. As a result, indexing has been the leading trend this decade. Index mutual funds and exchange traded funds (ETFs) have proliferated to meet the demand. For most investors -- professional as well as individuals -- this is a marked improvement from the 1990s' collection of risky hot stocks. By their very nature, index funds and ETFs automatically provide more diversification and less risk than the haphazard individual stock portfolios. Unfortunately, they still provide no assurance of superior performance. In fact, the only think you know for certain when using an index fund or ETF is that in general, it will always trail its benchmark index. It must because all funds and ETFs carry management fees and other expenses. Even if gross returns follow those of the appropriate index, net results will always fall short. Of course there are always new twists to index vehicles to improve performance. Some use derivatives as well as the holdings of the underlying index. Others use quantitative models to try to capture upside return while minimizing downside risk. Some are successful in the short-term, but long-term results are more uncertain. The risks carried by these alternatives often differ considerably from those of the index. The difficulty of beating the benchmark has led many investors to throw up their hands and simply purchase a handful of index funds. Many don't even rebalance them since there doesn't seem to be a point. It's all based on the belief that as long as they're in the market and closely tracking the indexes, there's little else that can be done. Actually, there is something else they can do, and it is possible to beat the benchmark over the long-term, even when using index funds and ETFs. There's no magic to it, just an understanding of the appropriate benchmark and how you, as an investor, can add value.
Three Decisions The first, often called the "policy" decision, concerns your overall investment objective. Are you conservative, aggressive, or are you looking for a more balanced portfolio? Most investors make this decision themselves. They'll pattern their investments around it or give it to their money manager to help him or her tailor the portfolio. The more specific you can be, the better. For example, suppose you want a balanced domestic equity portfolio. As such, it won't incorporate bonds, large percentages of cash investments, or foreign stocks. Instead, it might be a mix of U.S. growth, value, large, mid, and small cap stocks. At least it can be unless you add other restrictions (e.g. no growth or small cap stocks). Most investors don't just stop with a general description of their objectives but take the additional step of quantifying it. In our example, you may favor a mix of 60% large caps, 30% mid caps, and 10% small caps. These proportions might not be required under all conditions but simply represent the average allocation. The actual mix at any given time is a different decision. The policy decision is a strategic choice which has a great bearing on expected returns but doesn't really offer the opportunity to add relative value. That's up to the other two decisions. The second concerns the type of securities that will be used within the portfolio. This is the "vehicle" decision. For an equity investor, individual stocks afford the chance to beat the broader indexes. By the same token, they also introduce additional risk as well as the possibility of poorer performance, too. Actively managed mutual funds provide additional diversification to reduce risk along with the possibility of market-beating returns. On the downside, their fees and historically poor performance tend to increase the chance of underperformance. Index funds and ETFs cut costs, but at the expense of outperforming the appropriate index over the long-term. Once again by closely tracking their benchmark, management fees and transaction costs doom them to at least slight underperformance. If the investor chooses to use ETFs, he or she gives up the opportunity to beat the benchmark at this level. It's here that active money managers claim to add value, but history shows that many -- possibly most -- actually fail to do so. To continue with the earlier example, let's assume you decided to use ETFs as the sole investment vehicles in your portfolio. If your policy decision was to use large, mid, and small cap domestic equities, you'd only need three ETFs. Any rebalancing would be limited to three transactions at the most, helping to hold down investment expenses. Management fees would also be minimal. Because the ETFs closely resemble their benchmarks, risk should be almost identical to that of the respective indexes. The major drawback of this approach is that it won't help you beat the benchmark over the long-term. In fact, because there are fees -- no matter how small -- each ETF will actually trail its respective benchmark. As an indexer, your policy and vehicle decisions won't add value.
If you are going to "beat the market", it will have to be because of your third decision: The "allocation" decision. This is the choice of the specific mix of investments at any given time. This is the choice most frequently delegated to a professional money manager. The allocation decision is heavily influenced (even limited) by your policy decision. This happens in two ways. First, you policy decision sets the risk level for your portfolio and determines the allowable allocations. Again, consider the earlier example with target percentages of 60% large cap, 30% mid cap, and 10% small cap stocks. Obviously this won't fare too well when stocks are declining or even when small caps substantially outperform large caps. Your allocation decision can't overcome this. Secondly, your policy decision sets limits on how far your allocation decision can stray from the target percentages. You may want your allocation to always match the target. In that case, you'd periodically rebalance your portfolio when the various components stray from the target. This approach is often referred to as "strategic" or "static" asset allocation. To limit transaction costs, you might want to rebalance only when the actual ETF percentages drift more than a specified limit, say 5%, from the target range. Such a "trading rule" will help avoid trading on mere market noise while resulting in lower transaction costs. On the other hand, you might be willing to let your current allocation differ as long as it stays within a specified range of the target percentages. This strategy, usually called "tactical" or "dynamic" asset allocation, allows you to let your winners run in a trending market rather than forcing you to take profits and reinvest in underperforming sectors as you would with a static approach. As you would guess, these two asset allocation strategies have distinctly different return patterns. Static approaches work best in trendless markets while dynamic ones shine when there's a definite trend. (For more on the differences in asset allocation strategies, please see, Blend and Change.) Your policy decision controls this, but working within its parameters, your allocation decision will ultimately have a bearing, too. Will it be enough to allow an index investor to beat the market?
A Look at the Numbers Let's also suppose your policy decision is as stated above: 60% large caps, 30% mid caps, and 10% small caps. You want to use a dynamic approach with no limits on how far the individual components stray from the target as long as the target is the average mix over the long term. In keeping with the example, your vehicle decision is to use ETFs. In this case, S&P 500 Depositary Receipts (SPX) will be used for large caps, S&P 400 Depositary Receipts (MDY) will represent mid caps, and Russell 2000 i-Shares (IWM) will be the proxy for small caps. Let's also assume you're paying a $45 commission for each trade, a fairly representative rate.
You decide to review and rebalance your portfolio at the end of 12-month period. Because your policy decision allows dynamic asset allocation, you don't have to balance back to the target percentages. Let's add one other assumption to create the dynamic asset allocation: At the end of each 12-month period where small caps outperform large caps, 15% of the portfolio will be shifted to small caps, and vice-versa. Mid caps will always be rebalanced back to 30% of the portfolio. Because there are three years, the final allocation puts the portfolio in almost equal balance with 30% large cap, 30% mid cap, and 40% small cap. These are reasonable dynamic asset allocation moves given that small caps outperformed large caps throughout the period. Now let's see how you would have fared in the three year period extending from October 1, 2002 through September 30, 2005. Results are shown on Chart 1 and Chart 2 has the overall returns. Although our example assumes dynamic asset allocation, let's first consider static results with quarterly rebalancing (you'll see why in a minute). By the end of the three years, a 60/30/10 blend of the indexes would have grown your $10,000 investment to $14,974 while ETFs would have only increased it to $14,952. Truth be told, with only a $22 deficit over three years, the ETF portfolio did a pretty good job tracking the blended indexes. It did, nevertheless, still trail. This, of course, is the effect of the ETFs' management fees and trading costs. Over time, this drag can be expected to compound and increase. In calculating these returns, we used the "trading rule" suggested above: The ETF portfolio was reviewed at the end of each calendar quarter, but was only rebalanced when at least one of its components strayed more than 5% from the policy decision's target range. As it turned out, the portfolio was never rebalanced as this condition never occurred. While this may not seem significant, it actually is as we'll see in a moment. In contrast, the dynamic ETF model experienced three different sets of trades. The first occurred when the portfolio was created (you have to make your initial purchases, don't you?) and then twice more when it was rebalanced at the end of each of the first two years. Despite the trading costs, the dynamic ETF portfolio not only outperformed its static counterpart, it actually beat the static blended indexes. As you'll notice from Chart 1, the dynamic portfolios led the static ones at all points. This is the result of the trending market. As suggested above, dynamic asset allocation works better in trending markets and here the increasing emphasis on small caps played that trend. But the dynamic ETF portfolio still didn't beat the dynamic blended indexes. At $45 a trade, commissions totaled $405 (3 x $45 x 3) over the full three years. However, part of this cost was made up as the ETF portfolio only trailed the blended indexes by $163 at the end of the period ($15,170 vs. $15, 333, respectively). But think about that: If the ETF portfolio made up lost ground versus the blended indexes, it must have outperformed them for at least some period of time. But how could that happen if the ETFs have management fees weighing them down relative to the fee-free indexes? The timing of the trades has something to do with this. While the ETFs do a good job tracking their respective indexes, they aren't perfect. Tracking error occurs both ways -- both positive as well as negative. The timing of the trades -- while not timed to enhance performance relative to the equally weighted respective index -- can (and apparently did) have this effect. Over the long-term, however, these positive and negative effects of timing should be expected to cancel one another out. Given that, the dynamic ETFs' slight pick-up against the blended indexes would appear to be just a stroke of good luck in the short-term. Overall performance still trailed the benchmark so even dynamic allocation seems to add no real value for the long-term. While that seems to be the case, it's not, and that's because we're using the wrong benchmark.
Credit Where Credit's Due That's why it only seems natural when using a blended index to make changes to it to mirror any rebalancing that goes on in your portfolio. When the dynamic ETF portfolio moved 15% from large cap stocks to small cap stocks, similar weighting changes should occur in the benchmark's weightings, right? That's how you get a true "apples to apples" comparison, isn't it?
No. No, it's not. Think about it this way: Who's responsible for the benefits of rebalancing, you or the index? Your policy decision determined the appropriate blend of indexes, in our example 60% large cap, 30% mid cap, and 10% small cap. In choosing ETFs as your investment vehicle, you let the market determine the return of each individual component. But the dynamic rebalancing decision and even the static allocation trading rule is up to you. You're the one that makes these decisions, not the market. You deserve credit (or blame) for their results. All indexes are essentially static, or at least they should be (see, Unmanaged Index?). Sure, the folks at S&P occasionally add a stock or drop one from an index, and even the staid Dow Jones sometimes changes, but that's not the same as quarterly or even annual rebalancing. The Russell indexes come closest to this with their June reformulations, but that's strictly driven by quantitative characteristics rather an attempt to boost performance. So whether your allocation decision calls for static or dynamic asset allocation, the appropriate benchmark is the original blend of indexes. If you change the benchmark each time you rebalance, you eliminate any possibility of outperforming through asset allocation, thus eliminating any opportunity to add value in an ETF portfolio. In essence, you're giving the index credit for your allocation decision and trading rules. The appropriate benchmark in our example is the static blended index. Once you realize that, you'll notice from Chart 2 that the dynamic ETF portfolio actually beat it (51.7% vs. 49.7%, respectively). Net of fees and commissions, it was ahead of the benchmark by 1.0%. The allocation decision added value. The static ETF portfolio might end up adding value, too. Remember the trading rule was never tripped during the three year measurement period. It's conceivable that had that occurred, the rebalanced ETF portfolio might have picked up at least 0.3% and bested the benchmark. Although it's also possible that had the market moved against it, rebalancing could have reduced return, that still doesn't diminish the fact that the trading rule offers the opportunity for you, the investor, to add value relative to the index. Many otherwise astute investors fail to see this. Indeed, many professional investors shun ETFs on the belief that the only way they can add value for their clients (and justify their management fees) is by cherry-picking individual stocks or timing the market. Some are successful, but others (most?) end up creating concentrated, risky portfolios with no assurance of market-beating returns. That's not to say the procedure we've outlined here offers any guarantee, either. Your results are only as good as your dynamic asset allocation process or static trading rule. If the market moves against you, you won't add any value. There are no guarantees in investing. The point, however, is that you don't have to be a mystic stock picker to "beat the market". You don't have to rely on rapid-fire trading or costly market-timing procedures to add value. Instead, you can do that with a diversified portfolio utilizing just a handful of ETFs and the proper benchmark. Building a successful long-term portfolio is difficult enough without giving the index credit for your hard work. You'll never beat the wrong benchmark, but you can beat the appropriate one. Search this site! Just enter you key word or words:
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NE OF THE TOUGHEST LESSONS from the equity bubble of the 1990s was just how difficult it is to beat the market. When the bubble was building, speculation was high and everyone was a stock picker. The rising market lifted all stocks with the riskiest providing astonishing short-term returns. But all that changed when the bubble burst.
