by Maz Jadallah
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The S&P 500 has returned 10% annualized over the five years ended 6/30/2018 (13% if you include dividends). Those are great returns especially when you put them into context. The number of 5-year investment windows between 12/1949 and 6/2018 that returned an average of 10% annualized or more is 290 out of a total of 763 windows, or 1 in 3 odds. Those aren’t exactly great odds. So why is the prevailing wisdom amongst today’s investors and the financial media so clearly biased towards index investing (i.e. playing the market gamble)?
Perhaps the answer becomes clearer when looking at the market’s more recent performance. Taking a narrower view of the same data, the number of 5-year investment windows between 2008 and 2018 that returned an average of 10% annualized or more is 51 out of 66, or almost 8 in 10 odds! Wow, that’s dramatically different from the long term historical average! Based on recent returns and knowing what we know about investors’ behavioral tendency to chase performance, you can’t fault investors for feeling great about taking the market gamble. Add to this the fact that investors today can bet on the S&P 500 and pay near zero fees AND that investing in a market cap weighted index will save them from ever having to make a stock or manager selection decision – the proposition becomes very appealing.
Unfortunately, the above logic, while all too common, is dangerous in our current market environment. Why? An investor today would do well to consider how their odds of achieving 10% returns or better might change relative to the interest rate environment that prevails. Taking the longer time horizon (1949 to 2018), the odds the S&P 500 returns 10% annually or better over five years during periods when interest rates are on the rise, drops from 1 in 3 to 1 in 5! Our analysis looked at 5-year investment windows where the US 10Y Treasury rate at month 60 (ending month) was greater by 50 basis points or more than the interest rate at the inception month. The S&P 500 did 10% or better in only 67 of 312 investment windows that met the above criteria. This is exactly the environment that today’s investor is facing. The conclusion is clear, investors taking the market gamble today should be very concerned.
Investors would do well to take a more balanced approach. There’s nothing wrong with allocating to traditional market cap weighed indexes but investors should also access strategies that seek to outperform the overall market. The challenge then becomes how can investors access such “active” strategies without being tripped up by the usual associated pitfalls such as high fees and the pain around manager selection? This is exactly where AlphaClone’s active indexing approach can be a powerful weapon.
Not only does active indexing help solve the manager selection dilemma once and for all, it can give investors a more affordable and efficient way to access active ideas compared to the average active mutual fund or hedge fund. Balancing traditional passive and affordable/efficient active strategies also adds resilience to an investor’s portfolio by allowing them to take the long view (not the 5-year view, but the 10, 15 or 30 year view) instead of trying to time when to invest in traditional passive vs active strategies.
Markets tend to struggle during environments like today’s where interest rates are increasing and equity correlations are low. That’s exactly when active managers tend to do better. AlphaClone’s active index performance over the past year has been a beneficiary. See table below for performance of two of our strategies derived from the same group of ten managers. AlphaClone Select Long/Short is dynamically hedged* and available to investors in a separate account. AlphaClone Hedge Fund Masters Index (ALFMIX) is long only and is investable through an ETF.
*AlphaClone’s dynamic hedge in separate accounts will vary a strategy’s market exposure from long only to S&P 500 neutral (50 long, 50 short). The hedge is triggered on when the S&P 500 closes below its 200 moving average at any month end. The hedge is triggered off when the S&P 500 closes above its 200 moving average at any month end.