Some investors are motivated by numerous academic studies that disprove the idea that one can consistently beat “the market,”.
Many investors have decided to forego the strategy of picking individual stocks in favour of investing in equities through a variety of vehicles designed to mimic the performance of the S&P500 index, the reference index against which most equity managers are judged.
The first such investment some made was with Vanguard, in a mutual fund that tracked the S&P 500 index and automatically bought and sold stocks and bonds to keep its holdings in line with the index’s specifications.
Soon after the introduction of that product, numerous competitors flooded the market with similar investments. Exchange-traded funds (EFTs) heralded yet another new era of financial products.
The SPDR contract (symbol SPY) was introduced in 1993 with the intention of achieving the same goal as its mutual fund fore-bearers, but with a number of significant benefits.
In contrast to mutual funds, which require entry and exit at the closing price on the date of the trade, SPY can be bought and sold at any time during the trading day because it trades like a stock.
Mutual funds, on the other hand, may incur unwelcome taxable events if they engage in trading to achieve the rebalancing necessary to meet their investment objective. With SPY, you won’t need that function.
Sone investors experience with third-generation products is limited to a managed account’s ability to replicate the index’s performance while also harvesting tax losses.
In the event of a significant (subjective) loss in any index component, the fund manager will look for a suitable replacement stock.
They would sell the stock at a loss to take advantage of the tax write-off, and then buy a substitute stock with the intention of maintaining the same level of market exposure as the original stock.
The S&P500 index is the most widely used yardstick for gauging the success of equity managers, so it’s no surprise that investors find products that try to replicate the index’s performance appealing.
Based on this data, if you can match the index’s return, you will likely do better than most professional managers. Someone has to outperform the index, but determining whether or not their success was due to skill or chance is challenging, if not impossible.
Not even a run of excellent performance can guarantee that it will be repeated. It’s more likely that things will regress to the mean.
We’ve recently taken an interest in the Nasdaq100 index in addition to keeping tabs on the S&P500 index, which is made up of 500 large-cap stocks (i.e. stocks with large aggregate market values) across a wide range of industries.
The Nasdaq100 consists of the 100 most heavily traded stocks on Nasdaq. While the S&P index uses a weighted average of the component prices to give more weight to larger companies, the Nasdaq index uses a simple average.
Furthermore, while both indexes share some common company names, the Nasdaq index is dominated by technology companies and does not include financial institutions.
While there is often close correlation between various stock market indices, not all of them share the same degree of volatility.
Historically, the Nasdaq index has been more volatile than the S&P, which has resulted in both greater gains and greater losses for the Nasdaq.
We have analyzed the growth of these two indices on an annual basis since 1986 and have come to the following conclusions:
- In 36 of the 38 years, the movements of the two indices were in lockstep. Both went up in 29 years but then crashed and burned in only 7. During the two years of divergent movement, there were only minor shifts.
- In 22 of the 29 years (76 percent), the Nasdaq index performed better than the S&P 500; in 6 of the 7 years (86 percent), the S&P 500 performed better than the Nasdaq.
- The Nasdaq 100 index outperformed the S&P 500 by an enormous 82.42% in 1999 (Nasdaq 100 index up 101.95 percent; S&P 500 index up 19.53 percent). By a margin of 26.70% (Nasdaq100 down 36.84%; S&P500 down 10.14%), the S&P500 outperformed the Nasdaq in 2000.
- The difference in returns between the Nasdaq and the S&P 500 has averaged 7.67% over the entire 38-year history. Since the Nasdaq 100 gained 101.95% in 1999 (roughly equivalent to how the average income of a group of people increases when Bill Gates shows up), it’s possible that this figure is inflated. Even if we disregard this outlier, the difference in performance between the Nasdaq100 and the S&P500 over the remaining 37 years is still 5.65% on average.
We are still skeptical about picking individual stocks, but we are more open to the idea of “tilting” a portfolio by adding a diversified component to an S&P500 core.
This allocation appears to provide a good chance of outperforming the market (the S&P 500) in bull markets, but is likely to underperform in bear markets.
The difficulty in predicting market turns makes this strategy risky, but if you think that there will be more bull markets than bear markets over the long term, you might want to consider diversifying your core S&P500 portfolio with an index fund focused on the Nasdaq 100.
An investor’s only truly important choice would be how much of their portfolio to devote to each of these two broad classes of equity.
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A word of caution: while combining these two indexes may appear to provide a good chance of outperforming the S&P500 in the long run, there will likely be some bumps in the road along the way that could be quite discomfiting; and the larger the share of the Nasdaq100 component, the bigger the bumps will be.
Nonetheless, this strategy may be worth thinking about if you’re interested in trying to outperform the market.
You’ll need to be able to stomach some years of poor performance on the assumption that the years of exceptional performance will more than make up for it. This makes sense, but there are no assurances.
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