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The financial crisis and associated recession, which we seem incapable of making an escape from, has not resulted in too much good fortune for ratings agencies. I feel pretty comfortable in saying that it is rather apparent that the rating agencies played a role in causing the financial crisis or at the very least the exacerbation of the crisis – with the caveat that you can decide how significant that role was. Personally, it seems troubling to me that so many large institutions were legally required to consult with rating agencies (e.g. required to hold securities rated AAA by S&P) as opposed to conducting their own internal risk valuation of securities. A good risk analysis of any security before purchase or discharge is extremely advisable and that is especially true for our most trusted institutions (i.e. pension funds, etc). So why it is that they decided to outsource this is beyond me? I suppose it is because they thought Moody’s (NYSE:MCO) and Standard & Poors were better equipped to handle risk analysis as they didn’t feel they had the right expertise in-house. As it turns out, outsourcing their risk management didn’t get them very far at all.

Perhaps in the future, these institutions will begin hiring new people to actively conduct analysis (risk and otherwise) in-house. This will actually help promote some job growth. A few of you real sticklers might argue it won’t be efficient for every sizable pension fund, treasury department, mutual fund, and wealth advisor to hire their own employees to conduct due diligence when they could just outsource it to a few key players - as it creates unnecessary overlap. My response would be, it might not be as efficient in the pure economic sense of the word…but it will probably be substantially more effective.

Given that the ratings agencies did so poorly when it came to evaluating the risks of asset backed instruments and derivatives thereof, one might be inclined to ask whether they do any better with picking stocks. There is tremendous support for passive investment strategies by a wide array of people, especially Jack Bogle and the likes. Before accepting there supposition at face value, shouldn’t someone take a few minutes to explore whether passive investment management actually does the best job for the average investor? Let’s face it, passive investment management is defined by investing in an instrument designed to track an index that is actively constructed. Which leads me to wonder just how well S&P built the S&P 500 stock index and whether there is a simple, easy to act on alternative for the average investor that might actually be better than the S&P 500 itself...but is still passive.

This analysis basically explores whether 10 industry index funds could be constructed in such a way that is still simple but might actually outperfom the S&P 500.

The 10 industries that were used as are as follows:

· Technology (NYSEARCA:XLK)

· Energy (CLE)

· Consumer Discretionary (NYSEARCA:XLY)

· Consumer Staples (NYSEARCA:XLP)

· Financials (NYSEARCA:XLF)

· Materials (NYSEARCA:XLB)

· Healthcare (NYSEARCA:XLV)

· Utilities (NYSEARCA:XLU)

· Industrial (NYSEARCA:XLI)

· Telecommunication (NYSEARCA:VOX) – Since SPDR didn’t have a telecom ETF that at the time that they created the other 9 funds, I opted to use the Vanguard telecom index fund VOX.


click to enlarge

It is fairly easy to observe many key differences between industry groups and the S&P 500. Some industries have outperformed the index while others have underperformed the index (since 2004). Some of the industries are far riskier (measured by volatility for our purposes) than the S&P 500 and some of the industries are substantially more stable.

We don’t know which industries are going to perform better than others in the future. We estimate, forecast, predict, read tarot cards and price charts, count acorns, watch baseball games or the super bowl all in an effort to guess what the stock market will do in the future. But in the end, after all of this, it is still a guess which is susceptible to error regardless of how much work went into that guess.

So is Standard & Poors better at forecasting what the future holds in store compared to the average investor? Advocates for allocations to passive index funds argue that active management cannot consistently outperform the benchmark S&P 500...thus investors should simply allocate capital to the S&P 500. I am not really sure how they reconcile the fact that the S&P 500 index is constructed via committee coupled with a few rules which inherently makes a market call via a heavier weighting on certain sectors relative to other sectors. And I would dare speculate, they actually try to pick individual stocks within industries that they believe will perform well for investors.

Take a look below.

The S&P 500 Index is weighted differently across industries. It doesn’t take too much thought to conclude that for whatever (whether it is a rule based on revenue, market cap, or committee selection) S&P inherently believes that information technology and financials are stronger sectors compared to utilities and materials. The reason why they select these weights really doesn’t matter. The important question to ask is whether they are good or not and if this is the best, easy to implement, investment option for the average person just trying to gain exposure to equities.

If an individual investor approaches the asset allocation problem from a perspective of modesty by stating that he or she cannot appropriately forecast which industries will outperform or underperform the S&P 500, is there still a superior way to invest compared to buying the S&P 500 index fund? Sure there is. If an investor can’t pick the best industries to invest in, why should he or she try? Why not just hold an equal weight of capital in each industry? Or even better yet, why not hold an equal risk exposure to each industry? What would that portfolio look like? To tell you the truth, it looks pretty solid.

This portfolio was constructed by calibrating each industry weight in the total portfolio to approximately the volatility level of the S&P 500. The entire portfolio is then levered up until the portfolio is fully invested. The net result is the portfolio shown above.

The portfolio has generated an excess return of about 2.4% per year over the past 5+ years. Doesn’t seem like much right? But after adjusting for all of the compounding that occurs during the life of the investment so far, the total return for the portfolio stomps the S&P 500. The real total return for the portfolio is 24.6% which compares very well to the S&P 500 which had a total return over the same period of 8.5%. That is nearly a 3x improvement in return for simply acknowledging that predicting returns is a nearly impossible task.

Where does the extra return come from? It is generated from better diversification of risk. The S&P 500 is weighted towards specific industries and it will always be that way. The top weighted industries change as market cap changes but nonetheless investing in the S&P 500 is taking a market stance on specific industries at the expense of other industries. Volatility destroys the value of compounding. Therefore reducing volatility increases the value of compounding. While 1 percentage point of volatility doesn’t appear to be that significant, depending on when and how that volatility is realized, it can make all the difference in the world – or in this case nearly 300% better returns. In reality it is in the correlation of the underlying instruments that helps drive down the volatility of the overall portfolio. That is, when stuff really heads South, there is a little bit more support from a few of the underlying securities (most likely consumer staples and utilities) which have a modest dampening effect on the total portfolio in comparison to the S&P 500.

Can we conclude that Standard & Poors does a better job predicting stock returns in comparison to how they handled asset backed securities' ratings? No, not really. Is the S&P 500 the best way for the very bare bones investor to invest their money? No, not really. An investor that takes has taken an equal weight risk exposure to each industry has performed better simply through superior diversification over time. It seems reasonable to argue that this portfolio will do a better job of compounding in the future in comparison to the S&P 500 because it modestly assumes that you do not know more than the market.

The chart shown immediately above is the value $10,000 invested in the portfolio compared to the same $10,000 investedin the S&P 500. Clearly the portfolio constructed by equally weighting the volatility risk exposures by industry is preferable to investing in the S&P 500.

Disclosure: No position in stocks mentioned

Source: Is Standard & Poor's Any Better With Stocks Than Asset Backed Debt?