Beating the S&P500: Less difficult than you thought

Friday, June 16, 2006 | 07:31 AM

Spx_beat In Wednesday's WSJ, Wharton Prof Jeremy Siegel (Stocks for the Long Run) discusses the virtues of indexing. Prof Siegel claims we are "on the verge of a revolution in indexing" in The 'Noisy Market' Hypothesis.

I don't think so. Indexing has been an under-performing strategy for the past 10 years, and needs to be freshened up. The Prof is part of the refurb job.

Blasphemy! How can you say that? Everyone knows indexing is cheaper, more tax efficient, and a successful strategy for the longer term. Right? We all know that 80% of active fund managers fail to beat the index, right?

Well, not quite. Indexing -- essentially a variation of buy and hold -- goes through periods of over and under performance. In a secular bull market, indexing works great. (See secular chart here). But whenever something else is occuring -- like recently -- indexing falls flat. 

Indexing in the '90s became a huge success due to the heavy impact of the mega caps. But starting in 1999, when things began to sour -- a stealth bear market had actually started in 1998, based on breadth -- indexing became a proxy for under-performance. After long periods of underperformance themselves, emerging markets, commodities, and small caps have become the newest stars.   

And, it turns out that beating the S&P 500 is less of an accomplishment than it used to be. More than half of all active managers have done so since 1999 (see chart above), according to Jonathan Clements of the WSJ:

"Over the past six calendar years, the S&P 500 has fallen a cumulative 6.6%, including dividends. Meanwhile, the Dow Jones Wilshire 4500 index of small and midsize stocks is up 18%, Morgan Stanley Capital International's Europe, Australasia and Far East index has gained 7.2%, and the Lehman Brothers Aggregate Bond index has notched 48.5%.

Thanks to that disparity in returns, it's been a cinch to beat the market -- assuming you define the market as the S&P 500. In fact, if you haven't outpaced the S&P 500 over the past five or six years, something is likely seriously wrong with your investment strategy.

After all, as part of a well-diversified portfolio, you ought to spread your money across large stocks, smaller companies, foreign markets and bonds. Any mix of that kind should have handily beaten the S&P 500."

I'm cheating a bit with this data. Its not fair to benchmark the universe of emerging country, commodities, or small / mid cap stocks against the ponderous SPX. And I am not taking into account fees, taxes etc.

But its pretty surprising that something everyone takes for granted -- active managers underperform the S&P500 -- turned out to be less true than many people probably assumed.

I expect this trend to continue, until the next secular bull market. Then buy and hold will once again rule, and the active managers will again under-perform.

But we ain't there yet, and may not be for another 5-10 years.




>

UPDATE: June 16, 2006 12:27pm

Geez! What a response. A few replies are in order:

This is not an anti-indexing post; It is an anti-market cap weighted, mindless buy & hold post. If you bought a non-cap weighted S&P500 fund, you dramatically outperformed the SPX.

The key takeaway is not to assume that the what is commonly defined as Indexing (Buying the S&P500) is a great strategy at all times.

>

Sources:
The 'Noisy Market' Hypothesis
JEREMY J. SIEGEL
WSJ, June 14, 2006; Page A14
http://online.wsj.com/article/SB115025119289879729.html

Forget the S&P 500: Here's How to Tell If You Are Really Beating the Market
Jonathan Clements
WSJ, May 3, 2006; Page D1
http://online.wsj.com/article/SB114661720164842132.html

Friday, June 16, 2006 | 07:31 AM | Permalink | Comments (42) | TrackBack (2)
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» Apples to indexes still favors indexes from Investing Insights
Barry Ritholtz, who I genuiely admired and liked when I worked at TheStreet.com, has an anti-indexing post up that just cries out to be debated. He's citing some Vanguard data that WSJ investing columnist Jonathan Clements wrote about back in... [Read More]

Tracked on Jun 16, 2006 10:19:47 AM

» Other Voices: Links for 6/16/06 from The Personal Finance Weblog
Read: 1. John Waggoner in USA Today opines that some mutual funds should carry heavier warnings about their risks, such as Emerging markets are based in countries that are more likely to collapse than other nations are. If the fund... [Read More]

Tracked on Jun 16, 2006 10:49:21 AM

Comments

I concur. I have trouble with indexing because I don't believe in helping out badly run companies that I wouldn't touch with a ten foot pole.

Posted by: D. | Jun 16, 2006 8:09:55 AM

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