A Simple Way To Outperform The Market With Beta Power

Includes: AGG, SPY, TLT, VTI
by: Dale Roberts


The total market that includes the small and mid cap companies has the ability to outperform the broader market S&P 500.

Long Term Treasuries are one of the best risk-reducing agents available.

What happens when we create a simple portfolio of 75% Total Market VTI and 25% long term treasuries by adding TLT? We still have an market outperform.

What if we reduce volatility even further by creating a portfolio of market beating dividend growth companies with those long term treasuries?

One way to outperform the market is to well, simply buy more of the market. The accepted index for the broader U.S. Market is the S&P 500. If you pick your own stocks and obtain or beat the market returns, well you are in rarefied territory with Warren Buffett and a few others. A recent study on Warren's success suggested that less than 1% of investors beat the market over extended periods.

Here's the article that mentions the Salil Mehta study. Mr. Mehta is an independent statistician. His blog is entitled statistical ideas. The article details that ...

From the beginning of 1965 through the end of 2013, he outperformed his own chosen benchmark - the S.&P. 500-stock index, including dividends - by 9.9 percentage points, annualized.

That is truly incredible to say the least. But recently Warren has admitted that he has been unable to beat the market over the last 5 years. Many will be surprised that Warren suggests that investors simply go out and buy the S&P 500 in the most cost effective manner. For retirees, Warren suggests they simply purchase 90% of the broader market and throw in 10% bonds for good measure. Ha. Not sure how long Mr. Buffett thought about his asset allocation for retirees. That said, he is probably right and that would work for many if they also maintain a healthy cash account.

But here's an easy way to perhaps beat the market (and Warren Buffett?) with a simple index, the total market (NYSEARCA:VTI) from Vanguard. As we know small caps and mid caps will outperform the broader market over longer periods. There's more hidden value found in those less followed smaller companies.

VTI outperforms the market over longer periods due to the value of the mid to smaller cap companies. Here's VTI from its inception date of June 2001 vs. SPY.

The above portfolio's total return was 116.4%, outperforming the SPDR S&P 500 ETF's total return of 89.7% according to low-risk-investing.com. Please note low risk investing has issues when inputting VTI, you will at times get a higher return for the broader market (NYSEARCA:SPY).

That's a very decent return and outperform as well, but what if an investor had a lower risk tolerance level and SPY and VTI offered too much volatility? What if we add perhaps the best volatility-reducing agent known to investor-kind and that is long term treasuries?

As you can see from this article, long term treasuries, available in ETF form as (NYSEARCA:TLT) are often inversely correlated to the broader market, especially when needed when the stock markets are in free fall. That's when investors need those shock absorbers known as bonds. In severe market declines, that's when investors make the majority of their mistakes.

Here's a chart of TLT vs. the broader market.

That's nothing short of incredible. That's as if TLT and SPY and looking at each other in the mirror, mimicking the other's actions exactly, but moving in the opposite direction. That inverse relationship has presented itself in the big crash of 2008 through 2009, and even in the more recent market tremors. Long term treasuries have done their thing in all of the major corrections and recessions over many decades.

What happens when we add 25% of TLT to the mix to lower the portfolio's volatility? That would create an asset mix in the medium risk category compared to a medium to high risk level of the total market. TLT's inception date is June of 2002, we'll run the numbers on low-risk-investing.com from that date.

That 75% - 25% portfolio's total return was 166.9%, outperforming the SPDR S&P 500 ETF's total return of 137.5%. Not only that, the Total Market Low Beta portfolio TMLB would have higher returns from inception compared to the total market VTI due to the lower beta and the ability to recover much more quickly from the stock market correction.

Adding the bonds actually increased the returns.

When a portfolio falls by 50%, remember it then needs to double to get back to square. A portfolio that only falls by 30% then only needs a 43% return to get back to the recent top before that correction.

At Tangerine Investments we launched our three balanced portfolios in January of 2008, just months before the stock markets collapsed. The balanced income portfolio is still in the lead. That's a portfolio with 70% bonds, go figure. And that's with a very aggressive stock market surge over the last five years. Sometimes, beta produces alpha. Here's an interesting look at risk and returns moving through the recession and recovery.

And speaking of beta, here's the total market low beta portfolio TMLB during the market correction from Dec 2007 to Jun 2009.

We can see that the portfolio fell by some 30% while the broader market fell by 50%. That may be the difference between a medium to high risk portfolio and a medium or low-medium risk portfolio. Many more investors would be able to hold on with a 30% correction. And we should keep in mind that the last correction was the most severe since the Great Depression.

The low risk portfolio TMLB would have returned to its 2007 portfolio value in January of 2011. The S&P 500 at that point was still some 7% underwater.

SPY would return to positive territory some 13 months later in February of 2012, spending over 5 years under water. That's a long time for an investor to be patient.

We should certainly keep in mind that investors who were investing through the bottom, picking up shares on the cheap would have been able to recover much quicker, and would even boost their returns. There's nothing like buying on a regular schedule and buying at and near the market bottoms, that's where the "real" money is made.

From January of 2007 to December of 2013, the Total Market Low Beta TMLB would still be above SPY total return. To April of 2014 TMLB would have the lead 60.5%, outperforming the SPDR S&P 500 ETF's total return of 53.1%.

And if we do a returns calculation from TLT inception date for every year end from 2003 to present, there is only one period where SPY would have beat TMLB.

The pattern largely holds true by investing with two thirds VTI and one third TLT, further reducing the portfolio's volatility.

So how far can we take this intrusion of bonds before it starts to really beat up on our total return? Well here's a shocker, if we invest 50% VTI and 50% TLT and invest back just over ten years from January of 2004 to present, the Super Low Beta TMLB portfolio outperforms the broader market SPY, 107.7% to 106%. Here's that chart.

That outperform of course is largely due to beta, and then the hard charging total market in the good times. There's the combination of really good shock absorbers in the market correction, and enough high test fuel in the recovery phase through VTI, even though that portfolio is still riding the brakes (due to bonds) while it attempts to accelerate. Certainly if we give it a few more months, SPY will likely overtake the 50-50 TMLB, the question is when is the next market correction coming? That will knock the snot out of the total stock market portfolios while the low beta portfolio likely coolly and calmly cruises on by. it's the classic tortoise and the hare, as the hare has to rest every now and then. The recent stock market bull run (hare portfolio) is already historically very long in the tooth.

The stock portfolios can pass the lower beta portfolio here and there and then it runs out of gas, to use another analogy.

And one last thing, promise. We know dividend growth stocks have a history of outperformance over the markets, with lower beta. What's not to like there? What if we combine low beta stocks (with outperform) and that lower beta agent known as TLT? Here's Vanguard's VDIGX with TLT from that January 2004 start date.

Somebody yell Bingo! We now have a return over 117% topping the original TMLB return of 108%. We have higher returns and now even lower beta. Remember that's the 50-50 asset mix comparison. Here's the ridiculously low beta moving through the recession.

If we go back to the traditional 75% equity to 25% bonds allocation we see the dividend growth super low beta portfolio delivering 129% returns vs. 106% for the broader market SPY, from January of 2004.

We now see a portfolio that would not have been under water from that start date and a significant lead that may be hard to catch.

And you may ask, did this strategy work with a broad based bond ETF such as (NYSEARCA:AGG). The answer is yes. But AGG did not delivery as strongly on the beta front. Again, in that world TLT has been the champ.

More important than the above returns is the emotional component and the risk reducing capacity of bonds and especially TLT. One of the smart folks at Tangerine has a great answer when clients ask ...

What is the greatest risk?

He will smartly reply "you". They might have a laugh, and then of course my friend will go on to address market volatility and risk. But it is true, the greatest risk is selling out of fear, of being in a portfolio that does not match your risk tolerance level. There's a question an investor should always be asking him or herself, can I handle a 60%, 40%, 20% or 10% portfolio value correction?

When you have your answer, apply bonds or other measures as required. And as this article details, you might not have to give up much or any in the way of total returns.

Happy investing, and be careful out there.

Disclosure: I am long SPY, DIA, VYM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Dale Roberts is a mutual fund associate at Tangerine Bank. The Tangerine Investment Portfolios offer complete, low-fee index-based portfolios to Canadians. Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.