Can You Hold Your Own Against An Index Fund?

 |  Includes: EEM, EFA, IWM, SPY, XLE, XLF, XLI
by: Geordy Wang

Warren Buffett believes that most investors, including many professional money managers, would be better served investing in a low cost index fund instead of an actively selected portfolio of individual stocks. The statistics certainly seem to support Buffett's view. Almost every study on the subject conducted since the 1960s concluded that the majority of mutual fund managers continue to underperform their benchmarks. I'll leave the explanations of this curious phenomenon to the experts, but there's no debating that the question "Can I beat an index fund?" is one that every serious investor must ask himself. If you can't, then you might as well save yourself a lot of time and energy and put your money into a group of low expense index or sector funds like the iShares Russell 2000 (NYSEARCA:IWM), the SPDR Financial Select (NYSEARCA:XLF), or, of course, the SPDR S&P 500 (NYSEARCA:SPY).

There's just one problem. The task of figuring out whether or not you're good enough to outplay the market isn't nearly as simple as it first appears. Calculating the index return is easy, it's calculating your portfolio return that's the tricky bit. As a result, there are many investors out there who mistakenly believe that they can outperform the index, when their true returns actually fall short. In this article, we'll explore some of the more common methods for assessing your portfolio's overall returns and analyze some of their advantages as well as drawbacks.

Approach #1: Plug the initial and current net worth of your portfolio into a Compounded Annual Growth Rate calculator and adjust for the time passed.

This is by far the easiest approach if you invest a certain amount of money into the market and then never touch it until it's time to cash out. However, most of us don't invest like that, and that's where the limitations of this method begin to manifest. We don't just put a lump sum into the market and leave it there, we're constantly funneling more money into our account when the paychecks come in and taking some out when we need a little more spending money. As a result, the "return" that this approach regurgitates may be way off the mark.

Here's a personal anecdote to illustrate the shortcomings of this method. When I was still in college, I worked as a reporter for the campus newspaper. One of my assignments was to write a story on the exploits of our school's investment club. I noted in my article that the club had grown their endowment fund from $100,000 to $300,000 over five years, handily outperforming the S&P 500. I wasn't very financially savvy back then, and my editor didn't know any more about investing than I did, so the piece ended up getting published without anyone raising an eyebrow.

Looking back, my mistake was obvious: There was almost no way the club grew their capital that quickly through organic returns. We were a good school, but we didn't have a class of Warren Buffetts running around. Obviously the club's endowment fund had benefited from additional donations from alumni and others since its inception. With the limited information I had, it was impossible for me to figure out its real return rate. For all I knew, the investment club had received $500,000 in extra donations and lost $300,000 in the market over the years.

Approach #2: Calculate the return rate of all your investments individually and average them together.

A better approach, but still burdened by some glaring design flaws. This method doesn't account for the fact that our portfolios usually aren't weighted equally between all of our positions. For example, I might be bullish on both Altria (NYSE:MO) and Sirius XM (NASDAQ:SIRI), but since I believe Sirius to be a riskier play, I decide to underweight it in my portfolio compared to Altria. A year later, Sirius drops 20%, while Altria gains 20%. If we used this approach for calculating our return rate, we would end up with a mean return of 0%. However, since I was overweight Altria, my spot-on risk analysis would've netted me a real positive return on my portfolio instead of a flatline.

Approach #3: Calculate the year-by-year return of your portfolio and average them together.

By far the most effective approach we've looked at so far. This is the approach many mutual fund managers use to report their average annualized return, and for most investors, this is probably your best bet for estimating your own portfolio returns. However, this method isn't perfect either. If you had given your portfolio a large capital infusion or cashed out on a big slice of your holdings in the middle of the year, you'll need to adjust for that. The easiest way is to just ignore the addition/subtraction of funds for this year's calculation and begin to account for them the following year.

Another way is to overweight your gain or loss based on how early on in the year you made the principal shift in your portfolio. For example, let's say that in June I find a wallet on the street containing $10,000. Since I'm a good Samaritan, I go through all the proper channels to locate the owner of this wallet, but to no avail. The cops tell me that the money is now legally mine, so I wire it to my brokerage account and use it to buy shares of Annaly Capital Management (NYSE:NLY). When portfolio check up time comes around half a year later, my investment in Annaly has returned 12% through a combination of capital appreciation and dividends. Since I held it for six months, I multiply this return by 2, to calculate this year's total annualized return for Annaly to be 24%.

With the first adjustment method, you're basically pretending that you didn't invest the money until the end of the year, and with the second, you're pretending that you had invested it in the beginning of the year. Whether to round up or down depends on how aggressive or conservative you want to be when estimating your total return rate. It also depends on when in the year you made the principal shift. If you made it in the first half of the year, it probably makes more sense to use the second method, and if you made it in the second half, the first.

Approach #4: Create a virtual benchmark portfolio on a site like Yahoo Finance, and invest into an appropriate index fund in sums that mirror your actual portfolio.

This is my own favorite approach, because it's definitely more accurate than any of the ones mentioned above. This method is simple to execute and be surgically precise. To demonstrate how it works, let's say I begin my investment career with $100,000 to invest, and after some extensive research, assemble a portfolio with the following five stocks: General Electric (NYSE:GE), Exxon Mobil (NYSE:XOM), BHP Billiton (NYSE:BHP), China Mobile (NYSE:CHL), and McDonald's (NYSE:MCD). I create a tracking portfolio on Yahoo Finance to keep tabs on how my investments perform over the coming days. But since I also want to assess my own performance as an investor, I create a second virtual portfolio where I track a hypothetical $100,000 invested in the SPDR S&P 500, my chosen benchmark index.

Six months later, my great uncle Earl passes away and leaves me with an inheritance of $20,000, which I decide to put into my stock portfolio to grow. In my real portfolio, I invest these funds into a sixth stock that I've been waiting to buy for some time: General Mills (NYSE:GIS). In my benchmark portfolio, I "buy" another $20,000 worth of shares of SPY at its current price to mirror this new position.

Three months after that, I decide that it's time for me to live the American dream and become a homeowner. My dream house requires a down payment of $40,000, so I sell off some large positions in my investment portfolio to raise the funds. In my benchmark portfolio, I likewise liquidate $40,000 worth of SPY shares to mirror the activity in my real portfolio.

It's the end of the year. The S&P 500 advanced a total of 12% this year, dividends included (you always want to include dividends). My real portfolio has a total market value of $110,000. My virtual portfolio is worth $100,000. Looking at these results, I know that for this year, I've outperformed the S&P 500. A dollar in my hands has produced greater returns than a dollar invested in SPY. My decision to actively manage my own portfolio instead of investing in an index fund has been vindicated.

The idea of the benchmark portfolio is that it assumes that you're fully invested at all times. Therefore, you only take money out of it when you wire funds out of your brokerage account, not when you sell a stock. For example, if you run into a situation where you're anticipating a market downturn and switch part of your portfolio over to cash, you wouldn't sell any of your SPY shares in your benchmark (unless you don't want to be rewarded for accurate market timing or punished for inaccurate calls). It's only when you're removing capital from your portfolio permanently that you liquidate an equivalent position in your benchmark.

Astute readers may notice that the annual return for the S&P doesn't match the return on invested capital for my benchmark portfolio. I started with $100,000, put in $20,000, then withdrew $40,000 for a cost basis of $80,000. My benchmark portfolio was worth $100,000 by year end, but 12% on top of an $80,000 cost basis is only $89,600. This deviation occurred because our capital base didn't remain constant throughout the year. We put more money in at the 6-month mark and took money out at the 9-month mark. If the S&P had suffered a steep decline right after we took our money out, our benchmark return would be higher than the index return, since we would've suffered a smaller loss due to our fortunately timed withdrawal. For the purpose of measuring our performance, we need only compare our results to the benchmark return. We don't care about the S&P return (for now, at least -- we'll be using that figure later).

For this approach, we can easily determine the exact dollar value that we've outperformed or underperformed our benchmark index by, but how do we derive the percentage? After all, when we're talking about our investment results, we usually don't say "I beat the S&P by $10,000." That statement alone is meaningless because the other person doesn't know how much principal was invested. Instead, we say we beat the index by X%, which is a performance report that is relevant regardless of your initial capital base.

To derive your performance result relative to the index in percentage terms, first express the difference between the market values of your real portfolio and your benchmark as a percent. Let's use our example above and carry it forward by 10 years. One decade after I first began investing in the stock market, my real portfolio is worth $450,000, and my benchmark portfolio, which I've been keeping up to date this entire time, is worth $300,000. Expressed in percentage terms, I've outperformed the index by 50% over ten years.

The next step is to translate this value into an annual growth rate: 50% over 10 years becomes 4.14% compounded growth per year. Remember when I said earlier that the S&P growth rate will become useful later on? This is that time. To proceed, we need to calculate the compounded annual growth rate of the S&P over the entire decade: let's assume it's 10.5%. For the final step, we multiply the CAGR of my real portfolio relative to the benchmark by the CAGR of the S&P: 1.0414 x 1.105 = 1.15, or 15%. This is the true annual growth rate that I've achieved for my portfolio over the last ten years. In other words, our portfolio's value is the same as it would've been if we had invested in an index fund returning 15% compounded for a decade instead of 10.5%.

Now, when I want to brag to my hedge fund buddies about what an investment whiz I am, I can say I pulled in a 15% annual return for my portfolio over the past decade, beating the S&P by more than 4 percentage points.

One final note: there's no reason to use only the S&P 500 as your benchmark, it's just common practice. You can always create a custom tailored benchmark portfolio that consists of multiple index funds, selected to be more reflective of the sectors and industries that your companies operate in. For example, our initial five stocks in our virtual portfolio were General Electric, Exxon Mobil, BHP Billiton, China Mobile, and McDonald's. Instead of using just SPY, we can create a benchmark portfolio that contains the SPDR Select Industrials Fund (NYSEARCA:XLI) to mirror GE, the SPDR Select Energy Fund (NYSEARCA:XLE) for Exxon, the iShares MSCI EAFE Fund (NYSEARCA:EFA) for BHP, the iShares MSCI Emerging Markets Fund (NYSEARCA:EEM) for China Mobile, and finally, SPY to benchmark McDonald's. Considering the incredible proliferation of exchange traded funds in recent years that cover almost every imaginable category of stocks, designing your benchmark portfolio can take almost as much work as designing your real money portfolio, if you're willing to put in the effort.

Can You Hold Your Own Against An Index Fund?

It's important for all investors to be able to accurately assess their own performance so that they don't, as Buffett once put it, "shoot the arrow of performance and paint the bulls-eye wherever it lands." If you can't outperform an index fund over time, then you may wish to reconsider whether the work you put into actively managing your own portfolio is worth it. Likewise, if you can consistently beat the market, you'll want to know that too. Most importantly, being able to accurately track your performance allows you to gauge which techniques and ideas are working for you, which are not, and whether or not you're improving your skill as an investor over time.

I say this with one caveat. Those who find that they cannot outperform an index fund still have one very good reason to continue to pick their own stocks: because they enjoy it! Passively investing in an index fund may be the most effective course of action for the majority of investors, but it's also not very sexy. You're certainly not going to be telling stories at cocktail parties about how your brilliant investment in SPY made you $20,000 last year. If you find true enjoyment in the process of finding, researching, and buying great companies at great prices, then by all means, track your performance, but don't let the results stop you from doing what you love: investing in stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.