Tag Archives: indexing

Which Smart Beta Was Smartest in October?

It’s no secret that October was a bad month for stocks. The S&P 500 Index dropped nearly 7%, including dividends. Granted, the index still had a positive return for the year after the decline, but October wiped out nearly all the gains the index had posted for the year up to then.

Given the increasing popularity of “smart beta” strategies – portfolios tracking an index organized around a factor such as a stock’s valuation, size, dividend payout, price momentum, etc…, we thought it would be a good time to see how various strategies held up during the difficult month. It turns out, value and dividend strategies tended to hold up better than growth and momentum strategies.


For example, using mostly a variety of iShares funds, the iShares Core High Dividned ETF (HDV) was the best fund on our list, clocking a loss of 2.21% for the month. The second-best fund was the iShares Select Dividend ETF (DVY), which posted a 3.9% loss.  Every dividend factor ETF that iShrares has outpaced the S&P 500 for the month.

Similarly, all value strategies did relatively well for the month. And the value-over-growth theme was on display in the Russell 1000 returns too. The iShares Russell 1000 Value ETF (IWD) posted a 5.16% loss for the quarter. That was a favorable showing versus the 6.84% loss of the S&P 500 and the 8.91% loss of the iShares Russell 100 Growth ETF (IWF).

Minimum volatility strategies such as the iShrares MSCI Min Vol USA EGTF (USMV), which lost 4.05% for the month, also did relatively well. Minimum volatility strategies were first developed by a professor of finance named Robert Haugen, who didn’t agree with the modern academic finance notion that volatility defined risk. The theory states that higher return must come from higher volatility or, to say the same thing, higher risk stocks. But Haugen thought lower volatility stocks could produce higher returns over long periods of time. A student of Benjamin Graham, Haugen suspected that higher volatility stocks were those Graham called “glamor” stocks that were market darlings for a time, but whose businesses ultimately couldn’t support the lofty prices the market awarded them. Better to own the steadier stocks of steadier businesses that didn’t inspire infatuation – and then great disappointment — in the market, thought Haugen.

Sure enough, those glamor stocks struggled in October. The iShares Russell 1000 Growth ETF (IWF) lost nearly 9% while the iShares Edge MSCI USA Momentum Factor ETF (MTUM) lost nearly 10%. The top holdings of the Russell 1000 Growth Index are Apple, Microsoft, Amazon, Facebook, and Alphabet. Two of those, Microsoft and Amazon, are also top holdings of the momentum fund in addition to Visa, Boeing, and Mastercard.

It’s important to note that I examined a lot of iShares funds, and many of them have a unique way of doing smart beta. Often different factors can emphasize different sectors. For example, a quality sector may emphasize consumer staples and consumer discretionary, while a value factor emphasizes energy, materials and industrials, which generally trade at lower valuation multiples than, say, technology and healthcare. The iShares funds, however, do things a little differently. The quality fund picks the highest quality stocks from each sector. So the fund’s sector distribution is the same as the S&P 500 Index, which wouldn’t be the case if the fund simply chose the stocks that scored the highest on a quality screen. The difference between the fund and the index is simply that the fund emphasizes different stocks in each sector than the index.

In any case, the results from October suggest that investors should be alert to a rotation from more aggressive and inherently richly priced sectors to cheaper ones.

This Long-Short Fund Has A Little “Magic” In It

At the end of March, the institutional share class of famed value investor Joel Greenblatt’s Gotham Index Plus fund (GINDX) passed its three-year mark and garnered a 5-star rating from Morningstar. That means, over its first three years, the long-short stock fund landed in the top-20% of the large blend fund category for its volatility-adjusted return.

Long-short funds have high fees because they pay dividends and margin costs on short positions, and this fund is no exception with an eye-watering 3.61% expense ratio. But it’s a good time to look under this fund’s hood to see if it still deserves a place in some portfolios.

Background on Greenblatt and the “Magic Formula”

As I wrote in a previous article, Joel Greenblatt began his career has a hedge fund manager using a strategy that could be described as special situations. He looked for corporate restructurings including spinoffs and bankruptcies and managed to post a 50% annualized return for a decade, albeit with significant volatility as he tells it. Greenblatt likes to write and teach, including holding a position as an adjunct professor at Columbia Business School, and the book that emerged from that experience became a hedge fund cult classic, You Can Be a Stock Market Genius.

After closing his fund, Greenblatt devised a strategy that could accommodate more assets called the “Magic Formula.” The strategy is really a simple smart beta two-factor model, picking stocks with the best combination of EBIT yield and return on invested capital. Greenblatt ran a backtest and realized picking the stocks that scored best on these two factors at the start of each year would have beaten the index by 4 percentage points annualized over a quarter century. Three books came out of testing this strategy – The Little Book that Beats the Market, The Little Book that Still Beats the Market, and The Big Secret for the Small Investor.

When I was at Morningstar I calculated that the strategy beat the S&P 500 Index, including dividends, by 10 percentage points annualized from 1988 through September of 2009, based on Greenblatt’s back-tested numbers from his first book on the strategy and funds he was running at that time. That doesn’t mean the formula beat the index every single calendar year. In fact, it showed patterns of underperforming for as many as three straight years before recovering and overtaking the index again. Value investors must tolerate fallow periods. In fact, value strategies work over the long run precisely because they don’t work over shorter periods. Everyone piles out when the strategy is faltering, leaving stocks poised for outperformance. The “magic” of the formula is really based on the human psychology or behavior that causes many of us to be bad investors.

Using the Magic Formula to Go Long & Short

Now Greenblatt and his partner Robert Goldstein have based a series of long-short funds on the strategy, which, to varying degrees, own the stocks that score best on his formula and short the stocks that score the worst on it. For each dollar invested, the Gotham Index Plus fund gains 100% exposure to the S&P 500 Index. It also selects long and short positions from the 500-700 larges U.S stocks that are that most expensive or cheapest on Gotham’s assessment of value or the Magic Formula. The resulting portfolio is 190% long and 90% short.

So the fund combines full exposure to the index with active management. Part of the fund tracks the market, and another part of the fund uses a value strategy to own and short stocks. The benefit of having both market exposure and exposure to an active strategy is that investors who still want to beat the market don’t have to withstand such severe fallow periods that every value investor endures and that the fund would likely have if it were just invested in the magic formula strategy.

The Verdict

With such a high expense ratio, however, the fund must outperform significantly when the strategy is working – and not underperform significantly when it’s not. The avoidance of underperformance versus the index is especially true since one of Greenblatt’s objectives is to provide an index-like experience for investors so that they won’t get shaken out when the active strategy is out of favor. That seems like a tall order. Nevertheless, for the 41 months the fund has been in existence it has outperformed the index. Over that period, the fund’s compounded annualized return is 14.54%, while the S&P 500 Index’s return is 12.75%.


Over long periods of time that difference – 1.79 percentage points – adds up to serious returns. For example a $100,000 investment earning 7% for 25 years would grow to around $540,000, while the same investment for the same period of time earning 8.79% would growth to around $820,000,

Interestingly, the Gotham Index Plus fund has a 1.42% Sharpe Ratio for the past 36 months according to Morningstar, while the index has a Sharpe Ratio of 1.55%. This implies that the index has a slightly better volatility adjusted performance. But the Sharpe Ratio views all volatility (up and down) as the same, whereas investors obviously don’t. Indeed, the Sortino Ratio of the fund, which penalizes an investment only for downside volatility, is higher – 3.42% — than the index’s 3.30%. Additionally, the fund has captured 105% of the index’s upside moves and 77% of the downside moves.

So far, despite its breathtaking expense ratio, the Gotham Index Plus fund has delivered on its promise – outstripping the index by a decent amount over a 41-month period, while delivering a roughly similar volatility experience. Investors should consider that other long-short funds must pay dividends and margin costs too. It’s noteworthy though that if the stock market endured a steep decline, the fund would then be paying even higher fees assuming dividends weren’t cut too badly in that event. If the expense ratio on the fund reached, say, nearly 6% instead of nearly 4% now, the fund might do fine, but would it overcome the index as easily? Of course, such a big decline in the stock market itself, although painful in absolute terms, might be a relative boon for the fund as both its long and short magic formula components could outperform the index during a big drop. And stocks would be cheaper after such a decline, arguably favoring the fund’s strategy.  But 6% or more seems like a rather high hurdle.

It’s difficult to recommend a fund this expensive. But paying dividends and margin costs is part of shorting. And if you aim to find a mechanical, smart beta-like long-short fund that can beat the market over the longer haul, this fund’s strategy has a decent chance.

The Problem With Indexing

Indexing your investments is a good way to increase your chances of doing better than average. Most active investors trying to pick winning stocks (and avoid losing ones) don’t beat the index. Those who do are hard to identify ahead of time. Once you think you’ve identified a market-beating manager, they often allow their fund to get too big, which typically reduces their chances of repeating their past success. And sometimes they’re on the cusp of retirement. Or they’ve lost analysts who’ve helped them be great. In other instances, you might be correct in thinking they can outperform over the long term, but you’re about to capture one of their fallow periods. Nobody ever said this game was easy.

Yet, there are problems with indexing too. “Indexing” generally means following what’s called a “capitalization weighted” index. That means the rank of the stock in the index is determined by how much the stock market values it. Market capitalization is the total shares of a stock outstanding multiplied by the price per share. But is taking the stock market’s verdict about where a stock should be ranked in an index reasonable? Many people think it isn’t. After all, you necessarily own more shares of the most favored and possibly expensive stocks in a capitalization weighted index.

When the first index fund – the Vanguard 500 Index Fund – came to the market in the early 1970s, academic finance was dominated by the notion that the market prices stocks properly – or accurately, based on available information – at all times. That made it seem reasonable to rank stocks by how the stock market says they should be ranked.

But there’s a case to be made that ranking stocks based on their underlying companies’ economic fundamentals such as sales, earnings, dividends, and book value might also be reasonable. And if stock markets don’t always set prices properly, if they are sometimes the victims of emotion gripping their participants, maybe focusing on economic fundamentals of the businesses is a smarter approach to indexing. And, after all, if you rank stocks based on companies’ underlying economic fundamentals, you’re arguably not showing any disrespect for markets. You might just be elevating the markets for companies’ goods and services over the market that trades those companies’ stocks.

An easy way to “break the link” (as Rob Arnott, founder of fundamental indexing, puts it in describing all “smart beta” strategies) between market capitalization and index rank of a sock is to start with a capitalization weighted index, but then rearrange it in a way that equally weights the stocks. No attention to underlying economic fundamentals needed.

This is the subject of a new paper published by Standard and Poor’s. First, the paper documents the outperformance of equal-weight indexes compared to their capitalization weighted equivalents. According to the paper the S&P 500 Equal Weighted Index has outperformed the S&P 500 Index by 2.1 percentage points. Moreover, this outperformance or “alpha” exists in international markets as well.

How much money is 2 percentage points annualized? It can amount to $50,000 in a scenario that’s not difficult to imagine for an ordinary investor. For example, if you invest $5,000 for 25 years and earn 5% annually on the investment, you’ll wind up with just under $340,000. If you invest the same amount for the same time frame, but earn 7% annualized instead of 5% annualized, you’ll wind up with just under $390,000.

The most obvious reason for the outperformance of the equal-weight index is its greater exposure to smaller stocks. The plain S&P 500 Index is concentrated at the top. Only 10% of the names – 50 stocks – account for nearly one-half of the index’s total weight, and the largest 30% of stocks – the top 150 – account for 75% of the total weight. Conversely the smallest 40% — the bottom 200 stocks – account for only 10% of the index’s total weight.

An equal-weight index will elevate the exposure to the smaller stocks in the index, and this “size bias” explains a “considerable portion of the S&P 500 Equal Weight Index’s long-term returns,” according to the paper. Another smaller part of the explanation is related to the fact that the equal weight index undergoes periodic rebalancing. This means that stocks that have done well are periodically sold and stocks that have done poorly are purchased to keep the fund’s allocation equally weighted to the 500 stocks. So equal weighted indexes have a kind of “anti-momentum” strategy. And while momentum is viewed as a legitimate factor that can beat a plain index, so does an anti-momentum strategy. In fact, performance of the equal weighted index relative to its capitalization weighted counterpart can indicate how momentum is faring overall in markets in a given period, according to the paper. When momentum is doing well, the equal weighted strategy tends not to do well, and vice versa.

Another feature of an equal weight index is how it treats the sector components of the index. During the technology bubble of the late 1990s, technology stocks began to overwhelm the index in the sense of becoming a larger and larger component of it. And although an “equal-weight index effectively allocates to each sector in proportion to the number of stocks held in that sector,” according to the paper, this is enough to mute the bad or overwhelming effects that a sector run-up can have.

Overall, the evidence suggests that an equal-weighted index captures a greater share of the stocks that achieve above-average returns. This doesn’t mean such a fund should be the only stock holding in a portfolio. For example, it can complement trend-following or relative strength strategies, helping to increase a portfolio’s volatility-adjusted returns when used that way. An equal-weight strategy can also mute the tendency of a low volatility strategy to go through periods of underperformance.

Although the paper doesn’t characterize a capitalization weighted index this way, its analysis begs the question of whether such an index is itself a kind of a momentum strategy. In any case, investors should be mindful of the problems inherent in plain capitalization weighted indexes especially at a time when indexing is garnering so many investor dollars. Capitalization weighted indexer will do fine over time, if investors can stick with the approach through thick and thin. But, at some point, they might wonder why they didn’t consider alternatives.