• John Hawver

S&P 500 - The “Active” Index

It’s hard to beat the market. Just ask Hedge Fund managers, their recent performance has been, at best, disappointing. And it is their job to beat the market. So, why is this the case?


Let’s take a look at the S&P 500 by using the ETF SPY. Since 1993, when SPY was conceived, you have a 54% chance that the daily return is positive and a mean annual return of 10%. Those are some pretty extraordinary numbers. In Vegas, the best odds you can get are 50/50. If you work hard, learn to count cards, you just may be able to increase your odds to 51% in blackjack, just maybe.


Any investor can easily buy the SPY ETF and get 54% odds without much effort. The only price is patience.





Given these statistics, you can see why even the “best and brightest” have a hard time beating the Index. To be fair, for many of these hedgies, that isn’t their objective. Their objective usually comes packaged with the term “risk-adjusted returns”, meaning don’t judge them by their returns, but by their “Sharpe Ratio.” (Simplistically, the Sharpe Ratio is returns divided by standard deviation of returns annualized.) But it is hard if you’re a hedge fund investor, who needs X% returns each year, to match diminutive risk-adjust returns to large liabilities, especially after incurring large fees (2% per year, 20% of upside performance). This is why many asset managers are simply moving their assets to Index investing (implemented using ETF’s) with reasonably straightforward asset allocation strategies.


Let’s take another example. In the book, “The Little Book That Beats the Market,” Joel Greenblatt outlines a very straightforward strategy, sort all stocks by their earnings yield and return on capital, averaged. Select the top 20 and invest for a year and repeat. In essence, this is a simple way to replicate Warren Buffett's approach: buy cheap stocks that produce cash. This strategy worked for years and Mr. Greenblatt built a business around it. However, back-testing (without costs) this strategy over the last six years shows that it has lost any meaningful edge over the market.





Returning to the S&P 500. These numbers seem almost too good. So, how does this happen? What is the S&P 500 Index that makes it so hard to beat? From Wikipedia: “The S&P 500, or just the S&P is an American stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE, NASDAQ, or the Cboe BZX Exchange.”


So the S&P 500 is the best of the best; The Seal Team Six of the stock market.


That explains part of the excellent numbers I suppose, but the real trick lies in the “Selection Criteria." On a regular basis, a selection committee determines which stocks are included, and rejected, from the Index. And if we look at the history of these changes since 2000 (chart below), we can see that up to 6% of the Index has changed each year.





Passively investing in an index isn’t completely passive.


And… so what? Well, as an investor, it’s important to understand the assets you are invested in and the “edge” that you have in the market. In the case of SPY (or any index ETF), if you have the patience to be a long-term investor, you get some nice benefits very cheaply, the efficient tax structure of an ETF that continually invests in the best 500 companies.


It's a hard combination to beat and we all should thank Jack Bogle for this contribution to the investing landscape.


John



##### Code to Replicate ####


# Setup

library('quantmod')

library('PerformanceAnalytics')


# Get Data

spy <- na.omit(getSymbols('spy', auto.assign = F)[, 6])


# Calc returns

spy_rtns <- na.omit(CalculateReturns(spy))

spy_yrly_rtns <- annualReturn(spy)


# Return Stats

mean(spy_rtns)

mean(spy_yrly_rtns)

mean(spy_rtns[spy_rtns>0])

mean(spy_rtns[spy_rtns<+0])

sum(spy_rtns>0) / length(spy_rtns)


# Plot

hist(spy_rtns, 50, col = 'blue', main = 'Histogram of SPY daily returns from 1995', xlab = 'SPY Daily Returns'); grid(); abline(v=0, col = 'green')


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