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 May 2006 Capsized The Reason P5 Has Beaten It's Benchmark
P5 is a purely quantitative model that can draw from any market capitalization and style. Its entire universe of potential holdings is limited to nine exchange traded funds (ETFs) represented by the familiar Morningstar "stylebox". The model is reoptimized every calendar quarter with no limits placed on the weightings of its holdings. As a "multicap" model, the S&P 1500 Super Composite was chosen as its benchmark. Unlike the well-known S&P 500 which is comprised on only large cap stocks, the 1500 includes mid caps (as measured by the S&P 400) and small caps (from the S&P 600), too. It's a multicap benchmark for a multicap model. So it's quite an accomplishment for P5 to have such a record against the S&P 1500 in both up and down markets. From this it would appear it's made excellent use of the various capitalizations and styles, so it wouldn't be surprising to see P5 ahead of most, if not all, S&P style and capitalization indexes. But looking back over the four-year period, that's not the case. How can that be?
Weight Watching Although P5 is ahead of the S&P 1500, it trails the majority of the other indexes. In fact, the only ones it does manage to beat are the large cap indexes. That's not particularly good "multicap" performance, is it? Looking at Chart 1, it's puzzling how P5 can beat the Super Composite Index yet fail to best most of its component parts. It's like winning the war after losing every battle. Can this really be the case? Indeed it can. The secret lies with the benchmark, not with P5. Not all indexes are created equally. In fact, very few indexes are created equally. Many -- including the S&P indexes -- are capitalization weighted. This means that larger stocks carry more weight in the index while smaller ones carry less. That seems reasonable, but it can be the source of some odd results. For example, in 1999 the 50 largest companies in the S&P 500 managed to provide all the return for the index while the other 450 smaller constituents simply cancelled one another out. This wouldn't have happened in an equal-weighted index. Equal-weighted indexes contain the same dollar amount of each stock. As a result, each has the same weight in the index. A $1 move in one stock has the same effect as a $1 move in any other. It doesn't matter if one is a large company stock while the other is small; the move has the same impact on the overall index.
Like the S&P 500, the 1500 is cap-weighted. Larger stocks have a much greater bearing on the overall index than smaller stocks. The stocks of the S&P 500 overshadow those of the other two constituent indexes, making it possible for P5 to compare favorably to the overall S&P 1500 even though it lags behind most mid and small cap indexes. That's probably not what you'd have expected from a composite index like the 1500, and it came as a surprise to us as well. In fact, it was intriguing enough to call for further examination.
Equal in the Eyes of the Index Next we backtested it against P5 to see how they would have compared over the January 2002 - December 2005 period. The results are shown on Chart 2.
P5 didn't do too well this time. In fact, it fell significantly behind the equal-weighted index. As you can see from Chart 2, the difference didn't just occur in one brief period, but rather continued to grow as time passed. In the end, the equal-weighted index returned over 3% more per year on an annualized basis (see Chart 3, below). The most striking thing from Chart 2 isn't that P5 fails to top the list but rather that it has such different results versus the two benchmarks. After all, they're both composed of the same stocks, just different weightings. It actually makes sense if you reflect back on what's been happening over the past four years. Small cap stocks have been the clear leaders (look back at the small cap indexes on Chart 1) while large caps have trailed. Mid cap stocks have also had a pretty good run, but not at the pace of small caps (again look back at Chart 1). The S&P 1500 Super Composite puts an inordinate weight on not only large caps but the largest of the large caps -- the very segment of the market that's lagged ever since the equity bubble burst at the turn of the century.
An Easy Mark While large caps have been struggling, P5 has relied heavily on mid caps. There are two things to notice about that: First, this is almost like gaming the index because the benchmark is dominated by large caps and P5 invested elsewhere. As a multicap model, there's nothing wrong with this and in fact, this strategy resulted in benchmark-beating returns.
But in a way it's been a failure, too, and that's the second point. Again, if you notice from Chart 1, it's been small caps that have dominated the market in the past four years while P5 has been tied up in midcaps. Sure the model beat the S&P 1500, but it could have done a lot better by focusing on small caps. As a multicap model, this option was open, but not utilized. In essence, P5 didn't get the optimal returns from the available alternatives. Needless to say, these are disappointing conclusions. P5 was created in the hope of capturing the best returns from any segment of the domestic equity market. Instead, it's focused on good areas but not the best. Of course small stocks tend to carry more risk than their large or mid cap counterparts, but even this doesn't explain P5's mid cap focus. As you can see from Chart 3, P5 has more risk (as measured by standard deviation) than the large-cap dominated S&P 1500, but compensates for it with higher return. However, its risk is roughly the same as the equal-weighted index, but its annual return is about 3% lower. In other words it's not doing a very good job on a risk-adjusted level, either. This is a much bigger issue than small caps' recent run because P5's benchmark is the cap-weighted S&P 1500 Super Composite. With small caps having such little bearing on the index's overall return, P5 really hasn't been penalized by investing elsewhere. That would definitely change if large caps returned to dominance. Ideally, should that occur, P5 would shift into large caps, and indeed, this could happen. P5 is no stranger to large caps or more specifically, large cap growth. In its backtest to 1995, it put up to 82% in this segment. As recently as 2002 it still carried 26%. Currently there is 9%. So it's not inconceivable that P5 may indeed move accordingly when the market transitions. There are, however, two things we do know for certain: First, P5 has done a good job beating its benchmark index, the S&P 1500 Super Composite. It's consistently done so throughout the four-year period in which it's been out of sample. That's commendable. But not so commendable is the fact that it could have done much better. Had P5 emphasized small caps rather than mid caps, overall returns would have been significantly higher. The purpose of this model is to provide optimal returns from all areas of the domestic equity market represented by the Morningstar stylebox. In this regard, it's been somewhat of a failure. While its results relative to its benchmark look stellar, they are somewhat tarnished by the fact that the benchmark itself fails to capture the full scope of the stylebox. As with many things in life, it's often not what you measure, but how you measure it. In this case, the cap-weighted index has given P5 quite a break. Search this site! Just enter you key word or words: Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
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UDGING FROM THE NUMBERS versus its benchmark, Portfolio 5 has been a ringing success. On a capital appreciation basis, this purely quantitative model has beaten its benchmark, the S&P 1500 in each year of its four-year existence. This period covers not only the recent bull market but the final year of the bear market as well. None of our other models -- and few active managers -- can boast of such a record.
