Over the years, I have had a lot of people ask me for advice regarding their personal investments. My thoughts on the subject stem from a simple truth: most attempts to beat the market fail.
It has been a wonderful year for the SPDR S&P 500 ETF Trust (SPY) - running over 65% of mutual funds and trouncing 88% of hedge funds. It outperformed most foreign markets. It competes with a bond market that sports a negative real return. If we sustain a recovery, it could do well. If we decline in real terms, but maintain credit expansion on its current trajectory, the SPY could still sustain a nominal bull market for years. What is there not to like? Well, plenty.
While indexes and Exchange Traded Funds (ETFs) linked to those indexes were huge improvements over predecessors such as high cost actively managed mutual funds, there are still flaws that investors need to be aware of before making an investment.
Indices were originally constructed as tools to measure the performance of the market. Today, those indices are no longer simply measurement tools; they have become massive asset management businesses. Unlike an actively managed mutual fund, an ETF charges a very small fee, which means they have to manage a larger pool of assets in order to make the business profitable. As a result of their size, some of these indexes no longer measure the market, they move it.
Stocks in the major indexes like the S&P 500, Russell 1000, or Russell 2000 tend to garner a higher multiple than stocks not included in the index. So if you buy an index of the S&P 500 like SPY, you are paying a premium to own those stocks simply because they are in the index. This phenomenon alone won't cause you to underperform the index, but it certainly may cause you to underperform the market, if it were measured differently.
Most of the major indices and ETFs use the market capitalization of companies to methodically determine their weighting in the index. Not only is this market cap weighting arbitrary, but when rebalanced, it enforces a policy of "buying high and selling low" such that these ETFs are particularly swayed by fads and panics.
There are no market participants with more constraints and more assets to fit within those constraints than index funds. Most ETFs have period rebalancing or reconstitution of their constituent stocks. They also have forced selling rules-based around corporate events like spin-offs or merger securities. These rules, constraints and reconstitutions create a mess of opportunities for arbitrage and a resultant penalty on conventional index and ETF investors.
What Kills Spiders?
Are there any securities that offer a similar potential upside as the SPY but are better structured and defend better against savvy arbitrageurs? I offer three answers for your consideration. These securities are of no interest to me as an arbitrager seeking a mispriced bet, but may have be quite interesting to anyone who wants to protect their assets from such efforts and get the most from their index.
My first nomination is the Guggenheim S&P 500 Equal Weight ETF (RSP) which seeks to replicate the performance of the S&P 500 Equal Weight Index. It reduces a bias towards larger capitalization companies within the S&P, including companies with temporarily large capitalization due to recent manias. It also has reduced sector volatility relative to the SPY.
Equal weighting is arbitrary, but it is less arbitrary than market cap weighting. At $125 billion under management, a behemoth like SPY must overweight larger cap securities in order to function. At $3.7 billion RSP is closer to the size of a hedge fund than a massive ETF and can add larger weighting to smaller cap names without influencing their price substantially.
My second nomination is the WisdomTree Total Dividend ETF (DTD). While I would prefer weighting according to asset value or cash flow, dividend weighting is a huge improvement upon market capitalization weighting because it takes out the circularity and auto-catalyzing nature of the SPY. A passive, long-term investor can gain diversified equity exposure with a focus on the dividends that one owns without fixating on the random fluctuations in ever changing market capitalizations. My last nomination is the Formula Investing U.S. Value Select Fund (FNSAX). This mutual fund constructs a diversified portfolio of securities based on factors including earnings yield and return on capital. One of the reasons why this fund is particularly promising is that its creator, Joel Greenblatt is one of the great hedge fund managers and investing writers of all time. He knows as well as anyone how to exploit little weaknesses in a counterparty and he designed this fund to be invulnerable to such exploitation. The methodology needs three to five years to work, but so does any equity fund in order to reach statistically significant performance.