The Growth of Alternative Indexes

Investors have become enamored with alternative ways to slice and dice the indices. According to Morningstar, “Strategic Beta” now accounts for 21% of total industry (ETP) assets, up from under 5% in 2000.  As assets have exploded, so too has the number of strategic-beta ETPs, which have grown from 673 to 844 in the past year, while assets grew 25% to $497 billion.

While much of the focus is on the nomenclature- “smart” vs. “factor” vs “strategic,” perhaps the most important aspect is being overlooked; like all things investing, the product won’t to be drive returns as much as your behavior will.

growth 1

growth 2

To demonstrate this point, I chose five popular strategies that differ from the traditional plain vanilla cap-weighted index: Nasdaq US Buyback Achievers Index, S&P 500 Equal Weight Index, Nasdaq US Buyback Achievers, MSCI USA Momentum Index and the S&P 500 Low Volatility index.*

Every one of these Smart Beta strategies has outperformed the S&P 500 from 2007-today**. The problem investors run into, as you can see below, is that very often the best performing in each year lagged the S&P 500 in the prior year. Myopia is a huge impediment to successful investing as much of our “discipline” is driven by “what have you done for me lately?”


Each of these five strategies has outperformed the S&P 500 over the previous eight years.

growth 3

Had you chased the prior year’s best strategy, you would have compounded your money at just 3.5%, less than the 6% you would have earned if you invested in the prior year’s worst strategy. This goes to show that mean reversion is a powerful force for a proven, repeatable process.

growth 4

Anything other than a plain vanilla market-cap-weighted index has shown to outperform overtime. My friend Patrick O’Shaughnessy, in his great book Millennial Money,  notes that “if you bought all large stocks in the United States that started with the letter C, you’d have outperformed the S&P 500 by 0.5 percent per year since 1962.”

One of the fundamental drivers of investors’ returns is having a disciplined process. The key is to find a strategy that you can live with; something that meshes with your investing DNA. Jumping from strategy to strategy is guaranteed to lead to poor returns.

*I used index returns for SPLV and MTUM; the ETFs are four and two years old, respectively.

**The earliest common date for these five products is 2007.

Annual Stock Market Returns

After a strong year for stocks, does it make sense for investors to dampen their expectations? That’s what many investors, professional or otherwise, were saying heading into 2014, following a year when stocks made new all-time highs and gained ~30 percent.

Looking at the data shows that stocks have actually performed better than average following an exceptionally strong year. Since 1901, there have been twenty-three instances that the Dow Jones Industrial average was up at least 25%. The average annual return following these periods was 11.8%, nearly 50% higher than the 7.9% average we have seen over the last 114 years.

There are a few other interesting facts worth mentioning about annual returns:

  • Double digit returns are the norm, not the exception. Historically, the Dow is almost three times more likely to be up double digits than up single digits.


  • On average, the Dow has returned 25% or more once every five years
  • The Dow has been up double digits 48% of all calendar years.

The average annual return for all years is 7.3%, however it’s important to keep in mind that average returns and expected annual returns are two very different animals. Stock market returns don’t follow a schedule and have a tendency to be erratic.

Of the forty years when the Dow was negative, the average return was -15.3%. What’s important to understand is that a 15.3% gain does not negate a 15.3% loss. A decline of 15.3% requires an 18.1% gain to break even. The good news is that the average positive return is 19.4%. The better news is that the market has historically had positive returns nearly twice as often as it’s had negative returns. The takeaway is that patience has rewarded the disciplined investor who was able to sit through the bad times in order to enjoy the good times.


A Junky Rally

Stocks are continuing to rally from deeply oversold conditions. While the rebound is welcome, it’s worth taking look under the hood to see whats driving the recent performance. Here are the YTD returns for the six strongest stocks in the S&P 500 today:

FCX: -45%
JOY: -63%
CNX: -66%
WYNN: -52%
SNI: -28%
GNW: -36%

What is interesting about this list is that although these stocks have been pummeled in 2015, there are not too many shorts reaping the benefits. The short interest in all of these companies other than SNI is under 5%. With that said, the most heavily shorted stocks in the market are having quite a run.

Here are the returns for the first four trading days of the week:
Average of all S&P 500 stocks: +2.8%
Average of top 20 most heavily shorted S&P 500 stocks: +4.7%

Not only are they up almost twice as much as the average S&P 500 stock, but every single one of the top 20 most heavily shorted stocks is positive for the week. To be fair around eighty percent of the S&P 500 stocks are positive, so it’s not only the beaten down stocks that are rallying.

Here is the average short interest for each of the ten S&P 500 sectors.


Energy stocks are having quite the week. They are outperforming the S&P 500 to a degree not seen since the end of 2008.

xle spy

The bounce in Energy is a tailwind to large cap value as it represents 14% of the index. The Russell 1000 value is having its second best week of the year.

It’s also worth pointing out that we might be seeing some capitulation in Emerging Markets. VWO and EEM, the two most widely traded Emerging Market ETFs, lost ten percent of their AUM last week (I am definitely not calling a bottom, nor will I reference this post if this is indeed the bottom).

It’s very nice to see that stocks are rallying, but a closer look at what is leading the charge paints a less rosy picture.

Inside the Market of Stocks

Over the last five and ten years, less than twenty percent of large-cap managers beat their benchmark. Should we be surprised to see that eighty percent of these funds fail to deliver returns above the S&P 500? Let’s turn to the data.

On average, 50.6% of stocks beat the market in any given year. This makes intuitive sense, half the stocks beat the index and half do worse. Over the last twenty-four years, the percentage of stocks beating the index got as high as 66.5% in 2001 and as low as 29% in 1998. This data begins in 1991 which is as far back as S&P member performance goes on Bloomberg.

I suspect that the aftermath of the tech bubble helped fuel the recent explosion of hedge funds because this was the best time in the last quarter century for stock pickers. In 2000, 2001 and 2002, 64, 66 and 62 percent of S&P 500 stocks beat the index. In no other year since 1991 has 60% of stocks beat the index.


Tilting away from expensive tech stocks was very lucrative as the euphoria surrounding dotcom stocks unwound.

post tech

Look at the total returns from 2000 through the end of 2003 for the indexes in the table above:
Dimensional U.S. Small Cap: 74.9%
Dimensional U.S. Large Cap Value: 37.1%
S&P 500: -19.7%
NASDAQ Composite: -48.9%

In 2000 as the market peaked, the average winning stock outperformed the index by 50%. This is one of the allures of stock picking. Over the last twenty-four years, the average winning stock outperformed the index by 29 percent. The average losing stock underperformed by just 21 percent. If only picking winners and avoiding the losers was so easy.

In 1999, the average winning stock outperformed by  76%. However, only thirty-one percent of stocks outperformed that year, the second lowest reading of the data set. Even if you remove Qualcomm, which returned 2600%, the average outperformance of the winners was still 60%. In other words, only a few stocks outperformed, but the outperformance was massive.


A few other interesting things worth mentioning.

As the tech bubble gained momentum, it was obvious that fewer and fewer stocks were participating in the rally. I don’t know that calling the top was obvious, and I wasn’t in the markets then, but the data i’m referencing was available, and no doubt was pointed out by some at the time. The S&P 500 (TR) was up 28.58% in 1998, but the average stock was up 15% and the median stock was up just 7%. In 1999, the S&P 500 returned 21% while ~28% of stocks fell 20% that year. Furthermore, the median stock was flat even though the index experienced a 21% rise.

2008 was a bad year for the indexes and a worse year for individual stocks. Just 5% of stocks were positive that year.


Not only were so few stocks up, but it’s also true that so many got annihilated. 77% of stocks lost at least twenty percent. Thirty-two percent of stocks lost at least 50% and one out of ten stocks lost at least 70%.


It often helps to look inside the market. Stocks and indexes do not spend much time at the average. The average annual S&P 500 total return since 1991 is 11.85%. However, only two years saw returns between eight and twelve percent.  The point is that some years stock selection is a futile effort, while other times it can be a endeavor worth pursuing. The tricky thing of course is that we’ll never know in real time whether we’re investing in the stock market or the market of stocks.

How to Win in Wall Street: by a Successful Operator

One of my favorite investing books ever is The Money Game, by Adam Smith. This book absolutely nails Wall Street and what’s so fascinating is that it was published in 1967.  “Adam Smith” probably wouldn’t be surprised to know his book is still just as relevant fifty years later because in The Money Game, he references a book that was written 86 years prior. How to Win in Wall Street: by a Successful Operator, was published in 1881. Amazingly, this book is available online.

I went through it and pulled a few bits and pieces I found interesting. This was written 134 years ago, enjoy.


On luck

“Sometimes a very ignorant man will gain great wealth in speculation in defiance of all rules. And again, a man of vast experience, deliberate judgment and close observance of the accepted rules of the “street” will steadily lose, until a fortune will slip away.

We often hear of men making fabulous sums of money in Wall street, who were not only very ignorant but quite reckless of what they did. But sweep your mind’s eye back over those of that class whom you have known and ask how many have kept their money or have a dollar to-day? And you can constantly hear men say ‘It is all luck, this speculating in Wall street!’ A gross mistake! While it is to be admitted that a man may for a time make money by chance there, I assert that the tenure of all men who depend solely on ‘luck’ in Wall street is only for a season. And yet there are many, thousands, who enter into speculations thee dependent solely on the chapter of accidents to pull them through. Those are the ‘Lambs; and it is on these that Lions thrive and fatten. ….But there are rules in all of these which no man can long despise without paying dearly for his ignorance or indifference at the end”

On speculating

“Unlike the miner, who has gone down into the dark earth and brought forth gold where it has been hidden since the days of creation, to contribute to the commerce of the world; unlike the farmer who has sown his seeds in the naked soil and appealed to nature and to time; unlike any man who toils with hand or head, you contribute nothing whatever to the worth, to the wealth, to the beauty or good of the world. You simply take that which another man has had. And doubt not that he is depressed as much by what he has lost as you are elated by what you have won.”

On short selling

“And yet, a worthless thing ought to be sold. There is much more money in that than anything else, if you hit it right. But it is much more risky. For if its friends have been able to lift it up in the face of shrewd men there, thus high, may they not be able to take it away up out of your reach? And then it seems to me it Is not a magnificent nature that takes the ‘bear’ side and bets on the fall of a property, or the misfortunes of the country.”

“And yet, as I said before, the ‘bear’ must necessarily be a sore-headed, sour-natured creature, who doubts and disbelieves everything, and waits for and even desires disaster, that he may profit by the fall of others.”

On what moves stocks

“In London we always swept the horizon for a little speck of war. Any trouble or disturbance, even at the extreme part of the earth, whether under the British flag or not, always brought a tumble in stocks. But here, I observe, through all British disasters, the Boer battles which affected even British consols, nothing of this kind disturbs Wall street, and I imagine that even a very considerable battle with the Indians at the frontier would make little impression. So that the causes which shake the market of the two countries are quite different.”

On dividend stocks

“Under the loose and unregarded law of this country a stock company can, and often does, no doubt, sell bonds and pay a dividend that never has been and never will be earned. The purpose is, of course, apparent. But the poor, heedless little lamb, for whom the snare was laid, counts it ‘a dividend-paying stock,’ and, to the extent of his hard-earned and limited means, buys it, simply because it seems cheap.”

On desires

“I doubt if you could sell a gold or silver mine to much advantage if you should locate it in the state of New Hampshire- although I am told there are excellent mines in that state. But put it in the region of the Rocky Mountains, or, better still, in Alaska, and you will certainly find buyers for it.”

On buying

“Buy only about once or twice a year. Make no haste about buying. These stocks are going to stay there. They will not leave town. They will remain, my friend, and be bought and sold, cursed, blessed, wept and wailed over, when you and I and all of to-day are in the dust. So take your time and wait till you are perfectly certain that they are low, and are about as low as they are likely to go for the next half year.

On day trading

“Neither are my suggestions of any more use to the ‘eight and one quarter per cent man’ than to the ‘tape man.’ For the ways of the ‘eght and one quarter percent man’ are not may ways. He is a nervouse, narrow creature , who fights quite outside of all law or rule. He is called a ‘scalper,’ and I can but think that he took his name from the Indians of the border who skirmish and scalp without either order or rule.”

On having a plan

“For my part, I always despise money made in Wall street by accident or by ignorance. I like to lay my plans of battle, fight it out according to discipline and tactics, take my time and win my victory as a general wins a campaign.”