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You’ve probably heard it a million times ‘Just put all your money in index funds.’ Even investing legends like Warren Buffett recommend it. Frankly, they’re not wrong—most active managers fail to outperform simple, low-cost index funds after fees and I invest the majority of my own own money and client money into index funds.
But what if there was a smarter way that could make you more money? What if you could invest scientifically in specific factors or styles that have outperformed regular index funds over statistically significant periods of time? In this article we are going to look at how an index fund is constructed, the potential problem of index funds, how these alternative factor or investment styles work and why if you just beat the market by just 1% a year, this can add huge amounts to your wealth over time.
How 1% increase in returns makes a huge difference
So why even try and beat the market? Why not just use index funds and be done with it? To highlight how important just a one percent increase in return can be, let’s start with Tom, the index investor. Let’s make a few assumptions:
- Tom is 25 years old and has just entered the workforce
- Between him and his employer he contributes a total of £4,000 per year into his pension until age 60
- This contribution rises by 2.50% per year as he hopefully gets inflationary pay increases
- His investments grow by 7% a year over this time
By the time he reaches age sixty, his pension would be valued at £772,504 – which is not bad at all.
But what if Tom was able to eke out an extra 1% returnannually with the same assumptions?
In that case, his pension would grow to £959,963 by age 60 – which is more than an additional £187,000, showing the true power of compound interest.
If he could generate an extra two percent return, he’d end up with £1.2million by age sixty!
What about if I am retired?
That’s great for Tom, who has time on his side, but what would be the implications of a higher return for someone already in drawdown? If you were able to generate a higher return in your pension fund the benefit of this is that the growth would support the longevity and sustainability of the fund and you may be able to take a higher comparable amount of income.
It could lead to a higher remaining fund at your date of death which is really important when you think how pensions, under current legislation and at the time of recording, are usually exempt from inheritance tax which could mean a nice legacy for your loved ones after you have gone.
How is an index fund constructed?
Before we start looking at some of the issues with index funds, we need to understand how they are constructed and how a company makes its way into a stock market index.
With a market-cap-weighted index, such as the S&P 500 or FTSE 100, the market cap of a company is calculated by taking the share price and multiplying it by the number of shares.
The larger a company’s market capitalisation, the greater the weighting it will have in the index. This is why it is a very powerful investment strategy—it guarantees that you catch the biggest winners. This is important because, according to research in 2019, just 4% of US stocks accounted for all the returns of the U.S. stock market from 1926-2016.
Indexing ensures that you at least capture some of these companies, and it also makes you think twice about your skill if you’re trying to beat the market by picking individual companies.
What are the problems of index funds?
That brings me to the problems of market-cap-weighted index funds. As a company’s market cap gets larger and larger, so does its position in the index. This is why the top ten stocks in the S&P 500, largely driven by the magnificent seven, account for nearly a third of the index. If these mega-cap tech and AI companies, which are richly valued and I’ve looked at high valuations in this video, fail to live up to expectations, this could spell trouble for index funds.
If we go back in time, we can see that the concentration within the S&P 500 has now surpassed that of the dot-com crash at the turn of the millenium, when the top ten largest stocks accounted for 27% of the S&P 500, according to research carried out by Goldman Sachs.
But I invest internationally you may be asking or I just I invest using a multi asset fund, I’m more diversified than just the US stock market. Not quite. Looking at the MSCI world index as an example which many index funds and multi asset funds are based off, the US equity market makes up around 71 percent of the index so the performance of such indexes is intertwined with the US.
A better way to construct an index fund?
We know some of the pitfalls of market-cap-weighted indices, but is there a better way? One alternative approach is considering an equal-weighted index. Take the S&P 500 as an example. This would involve giving an equal weighting to each 500 companies within the index, resulting in a position size of 0.20% for each individual company.
Using the magnificent 7as an example, rather than making up nearly a third of the market-cap-weighted index, they would have a collective position size of just 1.40% in an equal-weighted index.
So, how does the performance of an equal-weighted index of the S&P 500 stack up to the traditional market-cap-weighted index? Had you invested in the S&P 500 (B) in 1990 you would have grown your money by around 11.37% a year. What about if you invested in an equal weighted version of this index (A)? You would have grown your money by 12% a year. Although this additional 0.63% return a year sounds trivial, due to the power of compound interest, your fund value would be higher by around a quarter. However, to the best of my knowledge, the oldest equal-weighted ETF was not introduced until two thousand and three, so investing in a fund or ETF to do so may not have been possible at that time.
If we know an equal-weighted index has outperformed over the long term, why not just invest all your money in an equal-weighted index? The first issue is that you want to invest in something you can stick to and won’t deviate from. There is no guarantee that outperformance will continue indefinitely. If we look at the past ten years, the market-cap-weighted index has significantly outperformed the equal-weighted version. It’s unlikely that most people would be able to tolerate this underperformance and would likely throw in the towel, possibly just before the fortunes reversed.
Using the S&P five hundred as an example again, another downside of an equal-weighted index is that the fund charges are higher. As a UK investor, you can access the S&P five hundred market-cap-weighted ETF for around seven basis points. The equal-weighted version can be around three times that, which, while still very cheap compared to traditional active funds, is more expensive.
What is ‘smart beta’ – can it beat an index fund?
The momentum factor:
Something else to consider is investing in factors that have outperformed the market over statistically significant periods of time. You may have heard this ostentatiously referred to as smart beta.
One of these factors is called momentum. This involves looking back at a particular timeframe, with 12 months being a popular choice, and investing in the stocks that have gone up the most during that period. The idea is that investments that have risen will continue to do so.
Academic research shows strong support for the momentum factor across various asset classes and geographies. In Larry Swedroe’s excellent book on the momentum factor, he puts the momentum premium in U.S. stocks at 9% per year! That’s an additional 9% on top of the standard market cap weighted return of an index.
But what are the criticisms? The first is that much of the empirical research is based on going long the stocks with the most momentum and going short on the stocks with the worst momentum. If you invest in a typical long-only fund or ETF that tries to replicate the momentum, factor, it will typically be long only. However, in a 2014 research paper, they found that 52% of the U.S. momentum premium came from the long only stocks, which is pretty decent when considering the 9% premium over the general market which Swedroe claims in his book.
Let’s compare the MSCI World index which is an index made up of 23 developed countries. We’ll compare the standard market cap weighted index which many global equity index funds try and track and we’ll compare this to the MSCI World Momentum index.
The data goes back to 1975 which is a decent sample size:
During this period the standard market cap weighted index (B) rose by a very respectable 11.47% per year. How about the momentum version over the same period? Over the same period a lump sum investment would be triple that of the market weighted index with a whopping annualised return of 14.52% per year.
That all sounds great, but what are the downsides of this strategy? The first is that momentum investing doesn’t work all the time, and when the market crashes, the falls can be spectacular and more volatile. As is often the case with investing, especially factor investing, the volatility can cause you to jump ship and abandon the strategy at the wrong time.
Another criticism is that nobody is exactly sure why momentum works. One argument is that it relates to investor behaviour—the idea that investors underreact to new information and are slow to adjust, for example, to improving fundamentals, or that investors sell when a stock goes up despite improving fundamentals.
Another reason to be less optimistic about the continuation of this outperformance is that this type of investing is now widely known, with more money focusing on this strategy, potentially leading to the premium being arbitraged away
The value factor
Value investing is an investment strategy focused on purchasing stocks that appear to be undervalued by the market. Pioneered by Benjamin Graham and popularized by Warren Buffett, this philosophy seeks to identify companies whose stock prices do not reflect their intrinsic value.
The key to value investing lies in assessing intrinsic value, which is typically estimated through a company’s fundamentals. This includes analyzing financial statements such as earnings, revenue, dividends, and cash flow. Investors also consider ratios like the price-to-earnings and dividend yield.
Like the momentum factor, there is substantial evidence supporting value investing. According to Larry Swedroe, he estimates that the value factor has a premium of around 4.80% per year for U.S. stocks between 1927-2015.
As we did with the momentum factor, let’s compare the performance of the market cap weighted msci world index against the equivalent value index which also goes back to 1975.
As we know the standard market cap weighted version rose by approximately 11.47% per year. Meanwhile the value weighted version had risen by 12.25% per year which is not quite as impressive as momentum over the same period, but as we know, an incremental increase in returns by just one percent per year can make a huge difference. Over this timeframe, your ending portfolio would be 35% higher which again highlights the power of compound interest.
So why not invest all your money into a value factor fund or shares? Firstly, value investing is prone to periods of significant underperformance. Take the past ten years or so, during which value has experienced one of its worst periods, underperforming both growth stocks and market-cap-weighted indices such as the S&P 500. It’s unlikely that many investors could stomach such ghastly performance and would simply lack the fortitude to hold their noses and wait for it’s potential comeback.
Another argument against value investing is that they tend to be more traditional companies, such as bricks-and-mortar businesses, banks, oil and gas and manufacturing companies. In today’s new era of high tech, software, and intangible assets, the rules of the game may have changed, along with the influx of money into these strategies, meaning value investing may not work like it once did.
If you are considering factor investing or allocating some of your money away from market cap weighted indexes, I wouldn’t suggest throwing all your money into one particular factor strategy. It’s always a good idea to invest in several of them be it value (C), momentum (A), smaller companies or companies with high quality characteristics (B) which I haven’t discussed for the sake of brevity as historically they have worked at different times with value often working well when momentum isnt etc.
I think the success in harvesting these potential premiums comes down to the ability to stay the course over the long term and not throwing in the towel when they have the inevitable slow periods.
This isn’t to say index funds are bad and in fact I invest both my own money and client money into index funds, but if you are considering a way to potentially increase the returns of your portfolio, factor investing or breaking away from market cap weighted indicies with a portion of your portfolio could be something to consider. There is no guarantee these factors discussed will continue to work in the future which is why I would be wary of investing all or even a large proportion of your money into these strategies.
The value of investments and any income from them can fall as well as rise, and you may not get back the original amount invested. Past performance is not a guide to the future. HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen.
