An ETF Package That Outperforms the S&P 500

For over 20 years as an individual investor, my goal has been to develop a relatively simple, conservative, system that would beat the total return of the S&P 500 index, year after year. Since the S&P 500 accounts for more than 92% of the total U.S stock market and is a benchmark for many stock mutual funds, it was selected as a comparison.

Interestingly, more than 75% of U.S. domestic equity funds trailed the S&P 500 index in 2007. This homemade mutual fund has had better total returns than the S&P 500 exchange traded fund (SPY) when started at the beginning of any of the past 7 years.

Using standard portfolio ideas of diversification, dividends, buy low, and buy and hold, this Homemade Mutual Fund [HMF] can easily be created by individual investors with $10,000 to invest. This plan uses exchange traded funds (ETFs), which are purchased in the same manner as stocks.

The HMF has 9 categories of asset classes, covering each of the Dow Jones U.S. Total Market Industry Groups: basic materials (XLB), consumer goods (XLP), consumer services (XLY), financials (IYG), health care (XLV), industrials (DIA), oil and gas (XLE), technology and telecommunications (XLK), and utilities (XLU). The only change from the ten standard groups is that Technology and Telecommunications are combined to one, resulting in 9 groups. The Technology Select Sector ETF (XLK) contains both technology and telecommunication holdings.

Dividend rates and management fees were considered in selecting these specific ETFs. The system involves allocating 1/9th (11%) of your domestic stock investing funds into each of the nine ETFs.

If you choose to keep the portfolio going year to year, the only other required action on this account occurs once each year. On the first trading day of the year, a single trade in the portfolio is made. Using the dividends received from the prior year; buy whole shares in the ETF that has fallen to the lowest percentage of the group, as of the last day of the year. This results in only one annual trade, at a total annual transaction charge of $4, based on the fee at the brokerage firm holding my accounts.

To test this system, seven starting dates were used - the first trading day of 2001 (the first full year all the funds were available) through 2007. In all years that are possible to test (2001-2007), this Homemade Mutual Fund has had better total net returns over the year compared to SPY when started: 2001 (+18%); 2002 (+12%;) 2003 (+1%); 2004 (+6%); 2005 (+4%) ; 2006 (+0.3%); 2007 (+4%).

For the most recent example, assume $10,000 was invested on January 2, 2007, with approximately 11 % ($1100) in each of the 9 ETFs. (Only full shares purchased). As a comparison, assume $10,000 was invested in full shares of SPY, the S&P 500 ETF. For the following calculations, brokerage fees and 15% dividend tax are included.

[click all tables to enlarge]

Comments

[veeblefetzer:]

This sort of strategy will work when certain sectors get beaten down one year and rebound the next. But even though it's worked well the last few years, there's never any guarantee about the future.

2008 Jan 14 08:30 AM

[bala:]

Very timely for me. I am planning to set up a similar portfolio and this past data will be very useful. However, I was wondering why you chose DIA and IYG for industrials and financials instead of XLI and XLF. DIA has lot more sectors than just industrials and why is IYG better than XLF ? Would appreciate your response. Thank you. Great article.

2008 Jan 14 09:18 AM

[Tramper Al:]

Gary,

I enjoyed the article, and use something like this in place of TSM for part of my domestic portfolio. I divide the total by 11, and double weight technology and financials because they have historically made up high percentages of the total. We're both of us greatly overweighting industries like materials and utilities, if I remember correctly.

I wonder if your case would be significantly stronger if you simply used sector SPDRs for all of your industry ETFs? Why DIA and IYG when there are SPDRs available? Your comparison is to S&P 500, but you are vulnerable to criticism for including ETFs that reach outside the 500.

2008 Jan 14 09:41 AM

[Geoffrey Lordi:]

Hi,

I imagine this allocation model is more a general concept exercise than a directive to select only iShares' products. There are, after all, less expensive etfs, and better performers, as well. Still, as a domestic only exercise, it's an interesting concept.

I've seen some folks build some models solely on market capitalization, as well (the famous/infamous "9 square" model), which is also a fine study, albeit difficult to keep appropriately tuned.

2008 Jan 14 10:30 AM

[User 139762:]

the lazy persons portfolio.

underweighting finaciials-just financials-last year woul dhave resulted in big outperformance--and given the news that woul dhave been easy to see coming--overweighting utilities, energy and materials would have helped too.

nuff said.

2008 Jan 14 12:35 PM

[Augustus:]

A much longer backtest would be more informative in evaluating the model. As noted, the simple underweighting of the financials would have led to improved performance over the SPY.

2008 Jan 16 02:33 PM

[Gary Hickman:]

bala,
As I briefly mentioned in the article, dividends and management fees were the main reasons for the ETF selections within a category. In perhaps an oversimplified look, DIA yields 2.3% with expenses of 0.17% vs. XLI yielding 1.6% and 0.24% expense ratio. For IYG vs. XLF, IYG has a slightly higher dividend, but more importantly it has outperformed XLF in each of the last 7 years, even with a higher expense ratio.

2008 Jan 16 04:25 PM

[Gary Hickman:]

bala,
just one correction to my earlier reply. IYG has had an average greater return than XLF over the past 7 years , with better performance in 5 of 7 years.

2008 Jan 16 04:59 PM

[mslasky:]

Another take on "reversion to the mean", but 7 years is too brief for statistical comparisons and analysis.

2008 Jan 20 12:57 AM

[Ahoy Matey!:]

This approach combines elements of two investment approaches. The first, equally weighting market sectors, is similar to an equally weighted S&P 500 Index, which has been shown to outperform the market cap weighted S&P 500. This outperformance introduces a small cap bias to the equally weighted S&P 500, and small cap stocks have done well thsi decade. The second element, reinvesting in the worst performing sector, is simply buying out of favor stocks. Staying power is crucial to success with such investment strategies. Putting the two together may or may not result in excess returns over the longer periods than the seven years the author examined.

2008 Mar 10 11:29 AM

[User 367896:]

Very interesting results. Simply asked...why does it seem that the sum of the parts "S &P" parts as choose by each ETF select sector manager beat the total average year after year? Statistically.. I see this but do you have a proposed reason.

Thanks

Mar 02 12:01 PM