Research Brief. Using ETFs to Outsmart the Cap-Weighted S&P 500. Micah Wakefield, CAIA

Transcription

1 Research Brief Using ETFs to Outsmart the Cap-Weighted S&P 500 Micah Wakefield, CAIA

2 2 USING ETFS TO OUTSMART THE CAP-WEIGHTED S&P 500 ETFs provide investors a wide range of choices to access world markets via a liquid, cost-effective vehicle. The growth of ETFs has seen many types of exposure become available, especially in equities. Of course, the most popular ETF is the SPDR S&P 500 (SPY), which tracks the S&P 500. The S&P 500 Index is a cap-weighted index that is based on the market cap of each stock. Market cap is driven by price and shares outstanding; the higher the price, the higher the size of the stock in a cap-weighted index. A hot topic the last few years in the financial industry has been smart beta (or strategic beta). Many ETFs have launched that take various different smart beta or alternative weighting approaches to cap-weighted indices. At Swan, we believe in being always invested and always hedged and that this combination will provide for a smoother and better risk-adjusted experience for an investor over the long-term. To begin, we want to focus on an alternative way to use ETFs to approach the always invested side when considering the S&P 500. There are many different types of alternative weighting methods to a cap-weighted index, like fundamental or factor-based weighting, but the focus of this analysis will be on just one of these, equal sector weighting. Swan believes there are numerous benefits to an equalweighted sector approach to the S&P 500 (let s just call it EQW from here on out). These include: 1. Potential for increased performance 2. Better diversification 3. Potential for lower volatility and beta 4. Ability to lessen the impact of sector bubbles within the stock market 5. Slight tilt to value and mid-cap/smaller stocks (as compared to mega cap) Here are some of the risk and performance metrics between cap-weighted and EQW since late 1998 when the SPDR Select Sector ETFs were launched: Annualized Annualized Sharpe Description Return Std Dev Alpha Ratio Correlation Equal Weight Sectors S&P Total Return Period: 12/1998 to 8/2016 Source: Zephyr StyleADVISOR For each of the past 4 calendar years EQW has slightly underperformed the cap-weighted SPY, but prior to that there were 12 straight years of outperformance. When using the S&P 500 sector indices back to 1990, prior to the launch of the SPDR Select ETFs in late 1998, EQW outperformed in 5 of those 9 years (Source: State Street Global Advisors). The average annual difference over the entire time period ( ) was +1.01% for EQW, with a maximum of % and a minimum of -6.35%. Furthermore, EQW provided better diversification over this time frame and lower volatility and beta than the cap-weighted price-driven SPY. The main points for an equal-weighted sector approach are these: Seeks to avoid the flaws of cap weighting (cap weighting only focuses on price and bubbles/ overvaluation can form more easily) Applies a built-in buy low/sell high discipline that is based on the principle of mean reversion An equal weight approach is more value conscious and tilts to mid/smaller stocks Numerous studies across various assets indicate an

3 equal-weight approach outperforms cap-weighted The only thing that matters to a market capitalization index is price; nothing else is taken into consideration. This means an anti-value approach is taken. As stocks and sectors become overvalued, bubbles can develop within a cap-weighted index. This can be easily seen during the years leading up to the Tech Crisis and the Financial Crisis. Tech stocks in 1999 and Financial stocks in 2007 became overvalued and occupied a larger than normal portion of the S&P 500 index. As seen below, the leading sector in the S&P 500 can vary over time and be driven to abnormal percentages of the index. The graph visualizes the largest sector of the capweighted S&P 500 and the weighting of it over time. An equal-weight approach helps to avoid this potential for bubbles and some of the collapse that inevitably follows them. In fact, the last three bubbles all occurred in the largest sector of the S&P 500 at the time; sectors which had grown to be the largest in a relatively short period of time (Energy in the 80 s, Technology from , and Financials in ). 3 Source: Bespoke Investments Charles Mackay once said: Men, it has well been said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one. Stock markets have a tendency for this to happen as people herd into stocks, usually within a particular sector. Although there might be a good reason for the enthusiasm initially, eventually business conditions change and the sector can t keep up with investor s expectations. With an equal weight sector weighting, exposure to any specific sector or bubble is always kept limited. This will mean underperformance while that sector is on the upswing, but outperformance when it falls back to earth. This approach, however, does not completely insulate the investor from overvalued and price-driven stocks since it is still cap-weighted within the sectors, but it does have less dependency on the largest holdings. An equal-weight approach is essentially factor neutral, despite its minor tilt to smaller size and value, and gives no credence to technical, fundamental, or pricedriven factors. It is therefore less predictive in nature. At Swan, we believe predicting the market is difficult if not outright impossible. While some evidence can be

4 generated to support any prediction, there is truly no way to know how technology, utilities, and materials will perform going forward. In addition to being factor neutral, equal weighting captures another important stock price behavior: mean-reversion. An equal weight portfolio has builtin alpha as it must be rebalanced periodically; the portfolio is in effect buying the losers at low prices and selling the winners at high prices, which benefits automatically from short-term mean-reverting price behaviors. This buy low, sell high approach is what drives the improved performance numbers behind more frequent rebalancing. Profits are always being taken and discounts are always being bought. In the Financial Crisis, EQW was buying financial stocks as they fell and selling them later as they rose. A more recent example, EQW was consistently buying energy stocks as they fell in 2015 and has been selling them throughout its strong bounce in late 2016 as the sector rises in comparison to the other sectors. This is referred to as a mean reversion strategy and there is an ample amount of research spanning many decades that support this concept (i.e., the benefits of rebalancing). The underlying principle of mean reversion is that investors can and will behave irrationally, resulting in stock prices that take large swings away from their fundamentals. Although this behavior does not lead to extremes all the time, the strategy patiently waits until it does and then takes advantage of any illogical market moves, like the Tech bubble in This means it can routinely underperform for long stretches of time when the market is driven by strong trends and momentum. For example, the three worst performing sectors over the last 3 and 5 years have been Energy, Materials, and Utilities. Over the past 10 years, only Financials has been worse. The contrarian mean reversion argument is that these three important overweight sectors to an EQW approach likely won t remain the worst performers forever and the recent EQW underperformance could come to an end. By nature though, an equal-weight approach will likely trail during strong bull markets such as the current 7-year bull market. In a strong bull market, usually a few sectors begin to lead out and take the market higher. Some proponents of cap-weighted argue that the world s new economy is now driven by technology and healthcare. Although it seems apparent that these sectors should have a big impact on the economy going forward, this doesn t mean that stock markets won t overprice and inflate the value of the stocks within these sectors as more investors pile into a popular trade. Historically, stock markets tend to overvalue and inflate the popular, leading to ever increasing higher valuations and bubbles. If the current bull market continues for a few more years, led by Technology and Healthcare as it has been, the conditions will continue to point to an equal-weight approach as being more prudent and potentially beneficial for the long-term investor. 4 Source: Alps and Bloomberg

5 Now we will take a look at the last two benefits and how equal sector weighting can benefit from its tilt to value and mid-cap/smaller stocks as compared to the tilt to mega cap and growth stocks in a cap-weighted index. As a reminder, an equal-weight approach is essentially factor neutral, despite its minor tilt to smaller size and value, and gives no credence to technical, fundamental, or price-driven factors. It is therefore less predictive in nature. At Swan, we believe predicting the market is difficult if not outright impossible. While some evidence can be generated to support any prediction, there is truly no way to know how technology, utilities, and materials will perform going forward. But what about this slight tilt to value and smaller size with an equal sector weighting? The biggest and most popular stocks and the hottest sectors drive cap-weighted indexes. A cap-weighted approach tilts to growth stocks, while EQW tilts toward value stocks. When a bear market begins, usually those sectors that led the rise in the market also lead in the decline (i.e., Tech stocks in 2000 and Financial stocks in 2008). Since an equal-weight approach will always be underweight the largest sectors, the gap of underperformance between equal-weight and capweighted will likely rapidly close during a bear market. In prior bear markets, this can be seen by spikes in outperformance in 2000 and 2007 for EQW as the bear markets began. In the long-term, research has shown that biases toward value and small cap can be rewarding. 5 Source: Zephyr StyleADVISOR

6 Also, what about an equal-weight approach in other settings other than the S&P 500? Although these indexes take an equal-weight approach with individual stocks and not sectors, the concept of avoiding the flaws of a cap-weighted approach still apply and the benefits are consistently and readily seen across many assets: 6 Source: MSCI; performance summary for selected MSCI indexes. Net Index Monthly Returns, January 29, 1999 to July 31, Past performance is not indicative of future results. From January 1999 to July 2015, equal-weighted versions of MSCI flagship indexes delivered significantly higher returns than their cap-weighted counterparts, outperforming 11 out of 12 indexes. Equal weighting benefits investors who wish to reduce concentration of mega or large-cap stocks in their portfolio, obtain more exposure to smaller-cap and value stocks, take advantage of potential market price inefficiencies, and adopt a disciplined rebalancing process. In contrast, a market-capitalization approach is 100% dependent upon the whims of the market and no built in sell high/ buy low discipline is in place. These advantages occur whether equal weighting sectors or stocks. Another study using the long-term global equity market data built by Dimson, Marsh, and Staunton (this data set is available through Morningstar), makes a strong case for an equal-weight approach. Even though the study is referring to global portfolios, as seen above the concept of equal weighting applies just as well across multiple countries. In this global equity study, an equalweighted portfolio of 20 major countries from was compared to its cap-weighted counterpart. The difference is graphed out in the mountain chart below, as it tracks the long-term growth of $1 in the world equity portfolio (weighted by market cap) and an equalweighted version of the world portfolio.

7 7 Source: The Investor s Field Guide, Patrick O Shaughnessy An astonishing difference to say the least, with the equal-weighted approach outperforming its market-cap counterpart by over 6 times! One study on the returns of the equal-weight and capweight versions of the S&P 500 back to 1926 estimates that the equal-weight version returns outperforms the cap weighted version by 2.8% per year (Source: Mutual Fund Observer, September 2016 issue). S&P s researchers have the advantage at around 180 basis points per year from one of their studies. These numbers are fairly close to the 1.7% per year outperformance that has been seen since late 1998 when the SPDR Select Sector ETFs launched. periods of outperformance generated through and after bear markets as overvalued and overweighted sectors correct. Although no one can predict the market, long-term and short-term evidence points to an equal-weighted approach being a more prudent and potentially beneficial choice over cap-weighted. This is why at Swan we allocate our core equity component in our S&P 500 Defined Risk Strategy using the SPDR Select Sector ETFs in an equal sector weighting. We believe this core equity position coupled with a longterm hedge and our option income component, are the best way to achieve consistent long-term risk-adjusted returns in today s risky market environment. In summary, equal-weighting of the sectors provides for better diversification, lower volatility, and the potential for better long-term performance as compared to capweighted. These benefits are mostly driven by the

8 8 Important Disclosures: Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy ( DRS ). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms. Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS ) composite, Swan s DRS Select Composite, which includes non-qualified discretionary accounts invested in since inception, July 1997, and are net of fees and expenses. Swan claims compliance with the Global Investment Performance Standards (GIPS ). All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may cause the performance results of your portfolio to differ materially from the reported composite performance. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client s investment portfolio. All Swan products utilize the Defined Risk Strategy ( DRS ), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results and comparing results among the Swan products and composites may be of limited use. The adviser s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at or visit swanglobalinvestments.com. 277-SGI

9 9 ABOUT SWAN GLOBAL INVESTMENTS Randy Swan started Swan Global Investments in 1997 looking to supply investment management services that were not available to most investors. Early in his financial career, Randy saw that options provided an opportunity to minimize investment risk. His innovative solution was the proprietary Swan Defined Risk Strategy, which has provided market leading, risk-adjusted return opportunities through a combination of techniques that seek to hedge the market and generate market-neutral income Swan Global Investments, LLC 277 E. 3rd Ave, Unit A Durango, CO Telephone: