Beating the index, passively

Can we have something semi-passive that beats S&P 500?

November 13, 2020

Snir's investing desk is a newsletter focused on intelligent, value investing for the individual investor. The subjects are evergreen and deals with the essence of investing, mental models, and concepts.


Index investing is on the rise

It's no secret that index investing is the darling of the retail investor world.

The common hedge funds, those a regular retail investor can get, will underperform the index most of the time (>70%). Those who perform better are usually private funds for invitees only, usually with >10M$ for investing.

This is all part of the hedge funds structure that leads to that, but this is a topic for another issue.

So, should we go with the 6-7% annual growth of the S&P 500 over the long run and be thankful for it? (That is if you insist on not to be an active investor)

S&P 500 is one strategy

Invest in the largest 500 companies in the US by their relative size and rebalance to it frequently.

That's it. That's what it means to invest in the S&P 500 index fund.

A consistent strategy that over a long period of time have proven to yield returns of 6-7% annually.

This is weirdly specific though. What if we take another "simplistic" strategy and implement that? Could we have measurements that consistently yield better results?

Other successful strategies

The idea that there are other strategies based on basic companies measurements that yield better results is one most prominent in the quant-based investing world.

Many great investors already thought of and tested a wide range of strategies. Here are some:

The magic formula

As appears in Joel Greenblatt's book "The little book that beats the market".

The magic formula uses companies Earnings yield and Return on capital to give them a score, by which you invest your money. The full "algorithm" is available on theĀ Wikipedia page.

And the performance? It depends on the period, but here is an excerpt from the 2010 edition of the book:

That is 23.7% annual compounding for the magic formula vs 9.55% in the S&P 500 in the same period.

10,000$ invested in 1988 would be:

  • ~1,000,000$ - magic formula

  • ~75,000$ - S&P 500

That's compounding for you.

Can we do better? "Acquirer's Multiple"

Entering Tobias Carlisle and his excellent book "The Acquirer's Multiple".

Just look at this graph. Chefs kiss.

He made some improvements to the magic formula, mainly dropping the Return on capital criteria, backtested it, and got better results.

I highly recommend reading his book too. He shared many insights on the ideas behind it, and understanding why it works is essential for implementing it.

Can we do even betterrrrrr??? "What works on wall street"

Yes, we can.

We always can, depending on the period we are looking at.

"What works on wall street" book by Jim O'Shaughnessy is leading the way in everything quant-analysis. He both explains the approach, the pitfalls, and various competing strategies. Highly recommended read.

The "trending value" strategy suggested in his book, is widely agreed upon to perform even better! Although, it is a bit more complex strategy to implement.

Why doesn't everyone just do this?

These strategies, even though they are not "active" in the regular sense, require constant work on your portfolio.

These strategies do underperform the market during certain periods.

Imagine spending 5 years, every month buying companies that look funny, like an Indonesian mining company worth 200M$ in total, just to find out.. you lost.

It does happen. You'll put in all this work to find yourself underperforming the market after 5 years.

Would you be able to stick it? Because these strategies often require more than 10 years of work.

Can you really say you won't break in year 3 after losing -2% to the market while your friends getting rich on the last Tesla?

Don't underestimate how hard it is to keep going through the hard times. But if you will - picking a prevent strategy, any strategy, will probably land you better results than the S&P 500 in the long term.