When we think of an index to track performance of the stock market, the ones that most easily come to mind for most are ones like the S&P 500, Dow Jones or the Russel 2000. These just track different parts of the market though, the S&P 500 tracking the 500 largest stocks in the US by market cap, the Dow tracking 30 large cap stocks picked by S&P and the Russel 2000 tracking the largest 2000 stocks by market cap.
Most individual investors like to try and track their performance against the S&P 500 but this isn’t often the best measure of their performance. The index that accurately acts as a benchmark for an investor’s performance is important because it shows whether the investor is achieving their gains by skill, luck or taking excess risk. I would argue that most of the time it is the latter 2 for most individual investors. This is why I advocate for those that like to actively invest, the core satellite approach to their portfolio: keeping 5% to 10% of their invested assets in investments that they themselves actively manage, while keeping the rest in diversified index funds.
The reason behind this is rooted in my own personal experience. During and after the crisis, I invested heavily in stocks that had been beaten down but I believed would come back. These included stocks such as Wells Fargo, US Bank, Lowe’s and Bank of America. Mostly due to the weighting of these in my portfolio (more Wells and Lowe’s than the others) I ended up beating the return of the S&P 500 for 4-5 years. However, the market shifted towards tech stocks around 2015-2016, in which I was not as invested as heavily and I started losing out to the index. I did not realize this until after a few years and compared my long term investments with what I could have earned if I just invested in the index, I found the index would have been better.
When you hear people say they are beating the index, the first question should be: which index? The second should be whether they feel the index they chose to measure their performance is an accurate representation of the market segment they are investing in. For example, someone investing in large cap US stocks might lean towards using the S&P 500 as their benchmark which someone investing in smaller US companies may want to compare to the S&P 600 Small Cap Index. The third should be: over what time period are you comparing performance? Many investors, including myself, have beaten the index, or at least the S&P 500 over a 1, 2 or even 5 year period. The real challenge is beating it over the long term, 10, 15 or even 20 years.
The longer you stay invested, the greater the effects of compounding become and this is where underperforming the market really starts to hurt. The fact of the matter is that even for professional investors, 95% do not beat their benchmark over a period of 15 years or more. The majority of investors will underperform the market with their own personal investments over a period like this which is why I advocate for the core satellite approach. Underperforming for 5% to 10% is acceptable if the rest of your portfolio at least keeps up with the market. Underperforming by a large percentage for your entire portfolio is devastating.
Now let’s say you do follow a core satellite approach and the majority of your portfolio tracks various indices such as the S&P 500, S&P Small Cap 600 Index, the Barclays Capital US Investment Grade Bond Index and others but you want to track your “satellite” investments that you actively manage yourself and go crazy with. What if you actively short stocks or go both long and short? Is there an index you can track yourself against?
The short answer is yes and in addition to showing you 5 indices that track different strategies, I am also going to prove my point to you that even when following these profitable strategies, all of them still tend to underperform the boring old long only large cap index fund over long period of time.
5 Types of Alternatives Indices and Their 10 Year Returns
The indices I am going to present here are designed to track various hedge fund strategies but hedge fund is a broad term. Hedge funds came about as a means for institutional or ultra wealthy investors to invest in strategies or talented managers that did not follow the conventional long only equity or bond strategies for returns. 40 or even 20 years ago, these strategies were only available to those with large amounts of capital to be able to set up their own funds but thanks to the ETF revolution and other financial innovations that favor retail investors, most regular folks can now emulate these strategies and customize them to their own specific market, sector or company knowledge.
The Short Bias Index
The Eurekahedge Equity Short Bias Hedge Fund Index tracks those funds that are short only funds. Since over the long term stocks have a tendency to go up, a short only fund has to have very specific knowledge and a high conviction that issues will eventually show up in a stock’s price. These funds tend to outperform during market downturns and underperform during up cycles. Since up cycles in the recent past have lasted much longer than the recessionary cycles, this contributes strongly to their underperformance compared to long only funds over the long term.
Source: Eurekahedge
The Credit Suisse Long/Short Equity Index
The long short strategy bus one that is most popular among hedge funds. Again, since stocks tend to go up over time, most funds tend to skew towards the long side long positions about 40% greater than short positions. Nevertheless this allows managers to take advantage of what they believe are either overpriced stocks or even segments while going long on those stocks or se gems ya that they think are underpriced.
Just to use an example, due to the recent market conditions, a manager may take the contrarian view that traditional energy stocks are underpriced and “green” stocks have too high short term expectations placed on them. This manager could short a basket of green energy stocks and go long a basket of “dirty” energy stocks. This is an example of a long/short strategy.
The return of the index for this type of fund for the last 10 years is below as shown by Credit Suisse and compared to the MSCI World Index as well as the S&P 500.
Source: Credit Suisse
Credit Suisse Equity Market Neutral Index
An equity neutral strategy is one where the manager is not taking any market or beta risk. This is best illustrated by an example like pairs trading.
In pairs trading, two stocks in the same industry, maybe competitors, are compared to their historic valuations relative to each other. If this valuation is out of line, say one is overvalued and the other undervalued, a manager would short the overvalued stock while going long the undervalued one. This strategy can offer some unique opportunities, especially when there is high volatility.
Source: Credit Suisse
Merger Arbitrage
When a company is purchased by another company, for example in cash, a purchase price which is a premium to the current market price is offered. For example, say company A offers to buy company B at $40 a share when it was recently trading at $30 a share. Company B will immediately shoot up but not necessarily to $40 a share, this is because there is still a risk that the merger will not close, either because of management thwarting it or not being approved by regulators.
A merger arbitrage fund may take a long position in the company to be acquired and take advantage of this discount. At the same time it may choose to short the stock of the acquiring company, which often fall post merger due to the risk or costs of the merger. Some companies also buy others with stock which dilutes their shares and also offers another opportunity to short the acquiring company stock.
Source: HFRX
Distressed Securities
Distressed securities can include debt, preferred shares, ordinary shares or other classes of securities in companies that are on the verge of or going through bankruptcy. Given the Covid situation, there are now more securities to be found that fit these characteristics currently.
In bankruptcy a firm can be reorganized or liquidated. In either case, a buyer that is not constrained by institutional requirements can take advantage of the mis pricing that arises when large institutions have to rid themselves of securities where the company is about to declare or already is bankrupt. Debt can be converted into new equity or bonds can be restructured which could see their price rise again as the terms become clear and the cash flow burden on the company is lessened. In a liquidation scenario, the selling off of assets may offset a return for the securities owners. The return of the HFRI Distressed Index is displayed below.
Source: HFRI
Conclusion
To put it in perspective, the best of the strategies above (Long, short equity) returned about 55% in total over the last 10 years while the S&P 500 returned 183% over the same period. Clearly it was a good time to just be long large cap stocks. As we enter a new time of uncertainty, strategies like these may get a second look but if you are looking at the long term, it still makes a strong case for why long basic stock indices may be a winning bet.
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