Image Source: Unsplash
 

One of the great truisms in investing is that it is difficult for professional investment managers to beat the Standard and Poor 500 (Index: SPX) with any regularity over time.

According to S&P Global, the market capitalization-weighted S&P 500 beat over 88% of all Large-Cap stock funds over the last 15 years. The index' relative outperformance over these funds over the decades it has been around has resulted in the S&P 500 becoming the benchmark by which the professionals measure their performance.

In a 2023 paper, Rob Arnott, Chris Brightman, Xi Liu, and Que Nguyen propose a method by which it might be possible to regularly beat the S&P 500 by improving how it selects the component stocks the index adds and removes over time. They note that the index frequently adds overvalued stocks while deleting temporarily undervalued stocks, which lowers the index' returns for investors. They argue there's a practical way to avoid the lower returns that result from this practice.

Here's how they describe their approach:

What if we no longer chase soaring winners and abandon tumbling losers, and instead choose stocks based on a more stable metric, namely, the size of the underlying business? Suppose we select stocks based on their economic scale, their relative size in the macroeconomy, rather than on the market’s expectation of the company’s future success. This strategy will come very close to matching the portfolio held by existing cap-weighted indices. Big businesses are usually large-cap and small businesses are usually small-cap. Thus, if we select stocks based on the economic scale of the underlying business rather than on market-cap, the result is a portfolio with superb liquidity and capacity, fully comparable to popular and commercially available market-cap indices.

We propose the creation of a broad-market capitalization-weighted index by selecting the constituents using fundamental measures of the size of the underlying company, and cap-weighting them. We call this Fundamental-selection Cap-weighted (FS-CW) index. Instead of cap-weighting the largest market-cap stocks, we would be cap-weighting the largest businesses. Additions will be companies that have grown onto the list of the largest businesses, important enough in the macroeconomy to matter, instead of stocks that have soared onto the list of the most popular companies. Deletions will be companies that have diminished in macroeconomic scale, by enough to no longer matter, instead of unloved stocks that have tumbled off the list of the largest market-cap stocks.

How well does that work compared to how the S&P 500 selects its component stocks today? Here's the conclusion to their paper where they summarize how their proposed improvement to an S&P 500 index fund performs in comparison to the benchmark performance set by the current version of the S&P 500 index:

By construction, a cap-weighted index puts more of an investor’s money into overpriced stocks and less into underpriced stocks, but—as indexers will happily point out—How to know which is which. That said, why should we hasten that process by mostly adding stocks based on newly elevated market-cap, when they are priced at “peak froth,” and mostly dropping stocks just after their market-cap has cratered, priced at “peak fear”? We propose a better way to create a cap-weighted index. Using FS-CW, which bases additions and deletions on a company’s fundamental measures and thus de-links index constituents from the stock’s recent price movement, we can create a superior cap-weighted index fund.

With this simple expedient, FS-CW US 500 earns 46 bps of annualized excess return (with less risk!) versus the S&P 500 in a 30-year historical simulation. The live results of the FS-CW model portfolio, since launched in September 2021, have exhibited a stronger outperformance. An additional benefit of this index is that by anchoring index stock selection with fundamentals, we can lower portfolio turnover and potentially markedly reduce trading costs.

Investors can benefit most from the Fundamental-Selection Cap-Weighted index where and when equity markets are less efficient and thus offer more mispricing opportunities. FS-CW’s live portfolio performance, in markets around the world, supports our findings that the index can provide greater outperformance during market turbulence and in higher-volatility markets. After adjusting for relative risk—with FS-CW offering slightly lower turnover in most markets—the result is a superior cap-weighted index, improved by largely eliminating the buy-high/sell-low dynamics inherent in the rebalancing process for most commercially available indexing products.

Given how hard it is for professional investment managers to beat the S&P 500 already, imagine how hard that might become if the method by which the index adds and deletes its component stocks can be easily tweaked to deliver even better returns. It will be interesting to see how well the authors' 'improved' version of the S&P 500 truly performs over time.

References

Rob Arnott, Chris Brightman, Xi Liu, and Que Nguyen. Reimagining Index Funds. Journal of Investment Management, Vol. 21, No. 4. pp 15-31. 2023. DOI: 10.2139/ssrn.4591461. [Ungated PDF document].

More By This Author: