December 9, 2020
Right at the start, let me point out that, no, I’ve not gone to the bad side! I will not try to sell any actively-managed funds here. If you’re a part of the passive investing crowd, which is a large portion of the FIRE community, you might find the title a bit “click-baity.” Because the thought process of the average passive investor would go like this:
- Underperforming the VTSAX is a non-starter. That’s highly undesirable. The only assets we’d ever consider are those with an expected return equal to or larger than the VTSAX!
- But the problem is that due to efficient markets, nobody can beat the market!
- If we intersect the two sets above, i.e., constrain ourselves to what’s both desirable and feasible we’re left with the VTSAX (or whatever close substitute you might pick, e.g., FSKAX from Fidelity).
That line of reasoning has some advantages: it has probably convinced a lot of folks to get rid of their irrational fear of the stock market and many have benefited from low-cost index investing instead of wasting money on actively-managed funds. My concern here is that I think that this thought process of “nobody can beat the market” is overly simplistic and (literally) one-dimensional. Of course, there are ways to beat the market! Here are eight ideas I can think of…
The easiest way to “beat the market” is so trivial, I am almost embarrassed pointing it out. Since the stock market goes up over time (at least on average) you can easily beat the market through leverage! Let’s see how this would work in practice. First, we have to graduate from the naïve, one-dimensional view. Let’s add another dimension: risk and look at the risk vs. return tradeoff. If you have access to cheap leverage, say by trading futures then you can easily walk up that expected return. If you agree that equity index futures have returns equal to the total return minus a risk-free rate then we can extend the risk-return tradeoff along the straight line connecting the risk-free asset and the 100% equity portfolio.
As always, there are several caveats:
- The extra risk may not be worth the extra return: Let’s face it, for most folks a 100% equity portfolio is already too much. But for very young investors who just start on their path to investing, one could make the case that investing in equities on leverage makes sense. Two researchers from Yale make this point, and it all has to do with Sequence Risk, i.e., over the average investor’s lifecycle, you’ll have way too little equity risk early on but likely too much equity risk right around retirement. The solution? Leverage when you’re young, and then a stock/bond glidepath toward retirement.
- Legal, regulatory and personal constraints: Forget about being comfortable. There are some regulatory restrictions on using leverage, for example in retirement accounts.
- Costs: This would be the least of my concerns because you can get exposure to leveraged equity beta very, very cheaply through equity futures. But for small accounts, if you have to rely on leveraged ETFs, the additional cost through the expense ratio of such funds would make their use a lot less appetizing.
- Skewness risk: This is a big concern for leveraged accounts. If the market goes down by 10%, you’d need a recovery of 1/0.9-1=0.111=11.1%. If you had invested with 3x leverage and your portfolio is down by 30%, then you need a 1/0.7-1=0.426=42.6% return just to get back to zero. That’s more than 3x the unleveraged value of 11.1%! If you had invested with 10x leverage you’d be wiped out and you’ll never recover. So, leverage has to be used very cautiously!
By the way, this leverage issue comes up all the time. Especially now that mortgage rates are so low, a lot of readers have been asking me if it’s wise to keep the mortgage in retirement. I wrote a post on this a while ago (SWR Series Part 21) and the message is still the same. Mortgage rates are certainly lower now than when I wrote the post. But so are equity expected returns, thanks to a very lofty CAPE ratio of well above 30. It’s probably a wash, so we are still sitting here very comfortably here with our mortgage-free home. But again, if you’re still working and especially if you just started to invest you should certainly consider not just 100% equities but even equities plus leverage.
2: Better risk-adjusted returns through diversification
The previous point, beating the index through leverage, demonstrates how incomplete the fixation on average/expected returns is. Of course, you can beat the market – on average and in the long-run – if you lever up the whole thing. But you’ll also expose yourself to a lot more risk. That brings me to the next point: you can easily beat the market if you target a different objective function that takes into account not just the expected return but also risk. Let’s look at the following numerical example:
- Assume 6.0%, 0.9%, and 0.05% expected returns for stocks, bonds (10-year Treasury bonds), and the risk-free asset (e.g. money market account, idle cash balance interest, 3-month (or shorter CDs, etc.). A bit of a conservative equity expected return and the bond yields roughly in line with the current yields.
- Assume 15% and 6% annualized risk (standard deviation) for stocks and bonds. And 0% for the risk-free asset (by definition!)
- Assume stocks and bonds have a correlation of -0.3, which is close to the actual correlation in recent history.
If we look at the return stats of stock/bond portfolios, where stocks are x% and bonds 100%-x%, then you achieve…
- The maximum expected return with 100% in the highest expected return asset. Obviously!
- The maximum Sharpe Ratio, calculated as the difference between the portfolio and return and the risk-free asset return divided by the portfolio risk (=risk-adjusted return), at around 40% equities, 60% bonds.
- The minimum volatility on the efficient frontier is at around 20% stocks. (but admittedly, that’s also pretty close to minimum expected returns!)
So, depending on your exact objective function we should most definitely consider allocations with less than the equity return. Maybe not so much when still accumulating assets but certainly in retirement, which brings me to the next point…
3: A 20-40% bond allocation lowers the “tail risk” in safe withdrawal rate simulations
People often ask me whether it’s a good idea to stay at 100% equities throughout retirement. The only people who should do that would be the early retirement bloggers with enough cash flow from their blog and other business ventures or their spouse’s income so that they don’t have to worry about Sequence Risk. The rest of us will be better off with at least some additional diversifying assets.
I quickly simulated a few different asset allocations, between 50% and 100% stocks, the rest bonds, over a 30-year retirement. See Part 28 of the SWR Series for the link to the Google Sheet. Despite the lower expected return, you’ll do better with a moderate allocation to bonds. In other words, in the final 20-40% of the portfolio, you do better with bonds from a Sequence Risk perspective. The success rate of the 4% Rule is highest and the failure probability is the lowest at around 70% stocks, 30% bonds.
4: Tangency point plus leverage
Remember #1 (leverage) and #2 (better risk-adjusted return) above? We can now combine the two and reach an expected return above equity returns while keeping risk at the same level or lower than with 100% equities. I wrote a blog post on this topic a long time ago (“Lower risk through leverage“) and this is the perfect opportunity to revive this vintage article.
Let’s go back to our numerical example again with the expected for stocks/bond/cash at 6%,0.9%,0.05%, and the same risk parameters. Not too far from today’s environment. If we plot the efficient frontier and find the maximum Sharpe Ratio as the tangency point of the straight line starting in the “Cash” point, then we could keep investing in that max-Sharpe portfolio through leverage and get into the area to the left and above the original efficient frontier (i.e., higher return and lower risk). We can even mark that green triangle up and to the left of the 100% equity allocation. Along the hypotenuse of that triangle, we observe higher expected returns and lower risk than the stock portfolio! Sweet!
And you know what’s the beauty of this approach? It’s still purely based on the index returns. No stock picking!
Also, if you wonder if this is just some theoretical pipe dream that would never work in practice: When I worked in the industry, we indeed offered a product (to institutional investors only!) that’s based on this approach. It had a 30-year return history of beating the S&P 500 by 3% a year. Admittedly with a ton of additional bells and whistles, but the core of this strategy was based on the idea of an unconstrained portfolio optimization problem that allowed for some modest leverage to get you past the constrained efficient frontier. So, this idea really works in practice! Not every year, but on average and over the long-term.
Notice that in items 1-4 above, I still operated in the confines of the broad index only. No stock picking! Let’s go beyond that and look at what can be done by deviating from the broad index weights. We will not go all the way to picking individual stocks but maybe go “half-way” by picking certain styles within the broad market. This brings me to items 5 through 7…
5: High-beta stocks
OK, so let’s assume that leverage (see #1 or #4 above) isn’t your thing; sounds way too dangerous! Here’s a way to achieve leverage through the “backdoor” without ever explicitly employing leverage. Simply buy stocks with built-in leverage in the form of higher-than-average market beta. With beta, I mean the (regression) slope estimate with respect to the overall market. Higher beta stocks have higher expected returns. And no, this a no violation of any efficient market hypothesis. Quite the contrary, it is a direct implication of the CAPM model according to which the expected return E(R) of an individual stock should be related to the risk-free rate RF and the market expected return E(Market) via:
E(R) = RF+ beta*[E(Market) – RF]
Thus, if beta>1 then E(R)>E(Market) and you “beat” the market, at least on average.
How do you find the beta of stocks? Yahoo Finance displays the beta right on the stock summary page:
In Google Sheets you can use the function googlefinance:
… gives you a value of 1.20 (as of 12/5/2020).
Fidelity also has a great stock screener to look up the beta of a whole list of stock tickers. So, simply screen your watchlist for stocks with betas greater than 1 and you get leverage and the boost in the expected returns without ever having to mess around with margin loans or futures trading. Sweet!
And a caveat: The value of beta depends on the horizon over which you run that CAPM factor model regression. I’d normally look at the 5-year beta. Shorter horizons create very noisy estimates! I am not sure what methodology and what horizon Google is using. Yahoo Finance evidently uses a 5-year horizon with monthly return data.
6: A market anomaly: “Betting against Beta”
After referencing the plain old CAPM model, people will be quick to point out that there are all sorts of well-documented holes in that CAPM theoretical construct. Glad you mention this because a lot of the CAPM abnormalities can then be used to – you guessed it – beat the stock market. One deviation from the CAPM that I found really intriguing is this: Researchers Andrea Frazzinia and Lasse Pedersen pointed out that the capital market line in actual data tends to be flatter than predicted by a simple one-factor-CAPM model. Their paper is called “Betting against Beta“. In other words, high-beta stocks have expected returns a little bit below the blue capital market line, see the chart below, while low-beta stocks have expected returns a bit above the capital market line.
The researchers document this phenomenon empirically, not just in the U.S. but in essentially all other country indexes and even other asset classes. Also, I should stress that low-beta assets do not necessarily do better than high-beta assets. The line between the purple dots is still sloping upward. But low-beta assets do better than what the CAPM would predict. An overweight to low-beta stocks and underweight to (or even shorting) high-beta stocks would give you excess returns or at least excess risk-adjusted returns.
The researchers also provided a pretty compelling theory for this CAPM abnormality. Too many leverage-constrained investors try to use the high-beta play to get higher returns without the explicit use of leverage (see item #6 above). That drives down the expected return of high-beta stocks and leaves more for the investors willing to invest in the undesirable low-beta stocks.
7: Other market anomalies: “Size” and “Value”
Well, as I hinted at in the previous point, in that CAPM equation, the market factor may not be the only explanatory variable of stock returns. Long before the BAB factor was discovered, people showed that in addition to market exposure, the size of the corporation and the price to book ratio account for a lot of the equity return volatility. And so the three-factor model was born (market beta, size, and value). And quite intriguingly, the small stocks and value stocks have outperformed the overall index since 1926, which is as far back as the Fama-French factor database goes.
Personally, I am skeptical about a persistent and continued outperformance of the small stock and value stock and small-cap-value style. See my 2018 post My thoughts on Small-Cap and Value Stocks. But you’ll find a ton of people online who will swear by these two factors. In fact, the two-factor premia are so engrained in the thinking of finance professionals, the idea of a small-cap and value premium has become almost a “natural law” in finance. For example, if you look at the JP Morgan Long-Term Capital Market Assumptions, there’s always a higher expected return for small-cap and value stocks, see the table on page 118 of that report. But keep in mind that the higher expected return also comes with a higher volatility estimate!
8: Adding other uncorrelated assets
One important issue that often gets lost in the VTSAX-mania is that some assets, when compared side-by-side to the passive index fund, might seem unattractive. Homeownership, for example, gets a bad rep in some circles in the personal finance community, but that’s mostly because people don’t know how to calculate returns correctly. Homeownership can be significantly more profitable than the stock market (my own experience here: “My best investment ever: Homeownership?!“). But even if my homeownership return had lagged the stock market by a percentage point per year, it’s still a decent low-risk investment. Especially in retirement, you will benefit from the stable “income” in your own home in the form of not having to pay rent. It’s one of the best Sequence Risk hedges, even if the homeownership return may lag the equity return by a little bit.
The same is true with my other non-equity-index strategy: Selling put options, see my 2019 post on what exactly I’m doing. Over the long-run, I’ve slightly outperformed the S&P 500 with my strategy. But in 2020 I’m lagging by 2 percentage points. Is that a failure? No, because I also had significantly less risk: the S&P500 volatilely was about 25%, my put strategy only 11%.
I hope the post wasn’t too much “false advertising”. If I had to put the eight “beat the market” ideas into different buckets I’d use these:
- Bucket 1: The “beat the market” suggestions #2, #3 still have a lower expected return, but at least they offer better risk-adjusted returns than the stock market.
- Bucket 2: #1, #5, and #7 have potentially higher returns but that “beat the stock market” comes at the cost of higher risk.
- Bucket 3: Only #4 truly offers a higher return and lower risk, at least in expected terms. #6 and #8 might get you there too. Though, to be conservative, I’d still put those in the first bucket “lower expected return but better risk-adjusted return”.
If you’re skeptical, I don’t blame you. Stick with your VTSAX. But for the rest of us who are interested, there are indeed a few things we can do beta, uhm I mean, beat the market!
So much for today! I will likely take some time off from blogging for the rest of the year. So, have a great Christmas season everyone, and a good start to the New Year!