Way back in 2016 I wrote a series of articles about “Beating The Market”, where I said right up front, “If you were hoping these articles discuss methods for beating the market, then you can stop reading.”

Instead, those articles summarized mountains of behavioral and market data indicating that beating the market with any consistency is essentially impossible.  Nonetheless, I occasionally find myself dwelling on the unmindful question of how one might attempt the seemingly impossible feat of beating the market, which is today’s fuzzy topic.

Background

Beating the market is the notion that an investor can achieve higher returns than a broad market index (a benchmark) that is relevant to their investing style.  So, a U.S. stock picker might compare their performance to the S&P 500 Index, while a U.S. bond picker might compare their performance to the Bloomberg U.S. Aggregate Float Adjusted Bond Index.

Funds that try to beat the market are often referred to as “active” funds.  The fund managers sift opportunities and, through some form of professional judgment, try to select a subset of opportunities that they hope will outperform a relevant benchmark.

So-called index funds take a very different approach by eliminating judgment almost entirely.  Index fund managers simply mimic the investments in an index that is built upon rigid rules.  The use of such index funds is sometimes referred to as “passive” investing but I think that rather convenient dichotomy is misleading.

I recently reviewed an annual study of “active” fund managers’ ability to beat their benchmarks.  Unsurprisingly, the track record of professional stock and bond pickers is still just as dismal as it ever was, with only about 10% of active funds beating their benchmarks over a decade or more.  And when measured against their active fund peers, only 1% of such funds can stay in the top performance quartile for five years running.

Some Hypotheses

So, it would seem futile to consider ways to beat the market.  Even so, I’ve run across some intriguing beat-the-market hypotheses over the years.  Some of these hypotheses appear stronger than others, and all of them are subject to data constraints and implementation uncertainties.  But to me, none of them seem entirely proven yet.

1. Be A Math Genius

A few years ago someone pointed out to me that Renaissance Technologies’ Medallion Fund, started by mathematician Jim Simons in 1988, has an utterly amazing long-term record of beating the market.  Here are a few amazing stats for the fund from 1988 to 2018:

• Never produced a negative annual return in 31 years
• A compound annual return of 63%
• $100 invested in 1988 would have grown to $398.7 million!¹

By comparison, $100 invested in the S&P 500 over the same period would have garnered a paltry $1,910!

The exact tactics producing these results are closely guarded secrets.  The Medallion Fund appears to hold thousands of short-term positions at any given time.  It’s alleged that Medallion bets correctly on these positions only 50.75% of the time.  But when compounded over millions of such positions, that slight edge produces huge dollar margins.

Do you want some?  Well, you can’t have it.  The Medallion Fund is only open to current and former employees of Renaissance Technologies.  Given that Renaissance’s publically available funds don’t perform nearly as well, it appears that the Medallion Fund has severe size constraints.  If it was open to the public, it would be flooded with new money and the strategy would likely stop working.

So, the market can be beaten, but the vast majority of us don’t have the smarts to do it.

2. Pick A Better Fund Manager

Given that the Medallion Fund proves there is an exception to the rule, it seems logical that other exceptions might exist.  I already noted that about 10% of active funds beat their benchmarks over periods of one to two decades.  So, why not just pick one of those funds and beat the market that way?

The problem is the second observation that only 1% of active funds have consistently superior performance.  In other words, if you pick one of the funds that beat their benchmark for the last decade, chances are they will fail to continue that success in the next year, much less the next decade.

For example, I recently saw this question on the Bogleheads Forum: why not just pick the ARK Innovation Exchange Traded Fund (ETF) to get market-beating returns?  The question was likely a product of the wide publicity about the fund (ticker ARKK), which performed exceedingly well over the last few years as shown in this graph.

Given that ARKK is a technology-focused stock fund, the above chart shows a comparison to the technology-heavy NASDAQ index (blue line), the price of which climbed by a handsome 163% in this period.  But ARKK easily won the beauty contest with a 572% price increase.

At the end of 2020, there was no obvious reason to assume that ARKK would suddenly falter.  But here’s a graph for someone who bought ARKK in June of 2020 hoping for the party to continue.

In this period the NASDAQ increased by 52%, while ARKK blew up and then fell down with a net gain of only 10%.  And people who jumped on the ARKK bandwagon at the start of 2021 have lost nearly half (45%) of their initial investment in one year!

You could luckily pick an active fund that will beat the market in the next decade, but evidence suggests that you have a 90% chance of instead underperforming the easily available market return.  Practically speaking, it seems like picking a market-beating fund is about as difficult as picking stocks and bonds on your own.

3. Pick A Better Index

Both the do-it-yourself and manager-picking methods seem like hard roads, and they both spurn the use of indices.  So, maybe we would have better chances if we embrace the index idea instead.

First, consider that some index funds perform better than others, even though they may not be strictly comparable by any reasonable definition of the term “benchmark”.  For example, small-cap, value, and international stock indices have sometimes outperformed U.S. large-cap stocks for long periods.

But can we pick the “right” index with any consistency?  As an example, here’s a graph showing how tilting a portfolio away from the S&P 500 and toward small-cap stocks has performed since 1972.  The vertical axis represents the additional return above or below an equivalent 100% investment in the S&P 500.

Sometimes the magic works, and sometimes it doesn’t.  You see this sort of back and forth performance in almost any two stock indices you might want to compare.

So, rather than trying to luckily pick a better indexing style, to consistently beat the market, we need an index that purposefully tries to create better rules for indexing.  Common sense suggests that the rules thus far created in existing indices are not necessarily the absolute best set of rules that anyone could ever devise for selecting high-performing stocks or bonds.

I’m sure there are many examples out there, but I have first-hand experience with one such index fund, which is the Shiller CAPE Exchange Traded Note (ETN).²  This large-cap stock fund is linked to an index and rules that examine the relative performance of the nine company sectors in the S&P 500 and essentially invests in the four most undervalued sectors.  This graphic summarizes the approach in a bit more detail.

There is no day-to-day professional judgment in the operation of the ETN.  It just adheres to rules that are intended to identify a subset of large-cap stocks in the S&P 500 that will perform better than the S&P 500 as a whole.

Here’s a graph of the annual returns of the CAPE ETN since its inception minus the returns of VOO, a low-cost S&P 500 index fund using data from Portfolio Visualizer.  All values assume reinvested dividends and are after fund costs.  Positive numbers in the graph indicate CAPE had higher annual returns than VOO and negative numbers indicate the opposite.  Results for 2022 are year-to-date.

CAPE performed better than the S&P 500 index fund in 8 out of 10 years so far.

This next graph from Portfolio Visualizer shows the growth of $10,000 invested in both funds over this same period (blue line = CAPE and red line = VOO).

An investor in CAPE would now have an account value of $43,149 as compared to $37,672 for the VOO investor.  It’s no Medallion Fund, but CAPE is beating the market so far³.  Time will tell whether this was a lucky streak or something different.

4. Game The Indices

Rob Arnott at Research Affiliates has proposed a simple way to beat the market.  The idea preys on the very fact that the index funds have no option but to “track” their indices as closely as possible.  All stock indices have to routinely jettison stocks of companies that no longer meet their index rules.  And those outgoing companies have to be replaced with incoming companies that meet the index rules.

Given that index changes are publicized in advance, arbitragers of all types buy up the stock that will be added to the index, which increases that stock’s price.  The arbitragers know that they can then sell those stocks to the index funds when the incoming stock is officially added to the index.  And the index funds have no choice but to buy the stock exactly on the exchange date regardless of how expensive it might be.  The opposite happens for stocks that leave the index.  Everyone knows that index funds are about to sell massive amounts of the outgoing stock.  So, they sell that stock before the exchange date, which causes the prices of that stock to fall even more.

For a recent example, Tesla entered the S&P 500 and replaced Aimco (Apartment Investment and Management) in late 2021.  Tesla prices increased in the period between the announcement and its official entry into the S&P 500 by 57%, while Aimco prices fell by 17%.

You might think that the way to beat the market is to copy the arbitragers and buy and sell the affected stocks between the announcement date and the exchange date.  But Arnott suggests it’s easier to wait until after that mad scramble is over because these stocks tend to revert to more objective valuations after the index exchange.  Going back to our example, since its entry into the S&P 500, Tesla’s stock price has gone essentially nowhere, while Aimco stock is up more than 44%.

So, the market-beating play is to sell the incoming stock if you own it, or short it as it enters the S&P 500, and then buy the outgoing stock and hold it for a year or so.  Arnott looked at past index exchanges and found that the outgoing stock is likely to beat the S&P 500 over the next year by about 20%.  So, you don’t even have to sell or short the incoming stock to beat the market; that would just be gravy on top in most cases.

This tactic is probably not going to work every time.  But if you invested like this on a routine basis, history suggests that in aggregate, your trades could beat the S&P 500 pretty consistently.

5. Leveraged Risk Parity

I should also make a brief mention of the concept of leveraged risk parity.  Risk parity is the idea that assets in a portfolio should be allocated for balanced risk (usually measured by volatility) instead of by dollar values that achieve a desired expected return.  Adding leverage (for example by using borrowed money) to a portfolio of relatively uncorrelated assets increases the expected portfolio return disproportionate to the increase in volatility.  The classic risk parity portfolio has a majority of bonds and a minority of stocks, the two of which have been somewhat negatively correlated for the last 25 years.

As best I can tell, risk parity originated as a way of maximizing risk-adjusted returns, not as a scheme to generate absolute returns that beat the market.  Nonetheless, many flavors of leveraged risk parity have been proposed specifically to beat the market.

I assessed one such approach in detail in a post in late 2020.  Using that example as a surrogate for the beat-the-market style of leveraged risk parity, I estimated about a two-thirds to a one-half chance of that strategy successfully beating the S&P 500 given today’s high stock valuations and rising interest rates.  Interestingly, I didn’t see a high chance of catastrophic losses that are sometimes associated with using leverage.  However, it’s notable that almost everyone discussing this strategy agrees that it’s extremely risky and investors should avoid betting the farm.

So, like some of the other ideas in this post, beating the market with leveraged risk parity involves a considerable amount of luck and a whole lot of bravery.

Conclusions

There’s one more beat-the-market idea called Tactical Asset Allocation that I’d like to explore.  However, there are enough details and different viewpoints on Tactical Asset Allocation that I’m going to post about it next time.  Stay tuned.

With regards to today’s post, I have to admit that it appears entirely possible to beat the market.  Some approaches require extraordinary skills and some involve quite a bit of luck.  And others, look very enticing but haven’t been road tested for very long, which makes you wonder what will happen when they reach a new bump in the road.

However, I can’t help coming back to the more mindful question, why try to beat the market at all?  If you’ve been investing for a while, you should have at least a rudimentary investing plan.  And that plan should include some estimate of the expected future returns of your portfolio and a determination of whether those compounded returns will be sufficient to meet your investment goal, like retirement, by a desired future date.

So, if your investing goal is likely attainable with a mindful portfolio that reaps the easily available market return, why would do you need to beat the market?  The only two reasons I can think of are:

1. You’re behind your investing plan schedule and need to catch up
2. Greed for more money or to get to your goal sooner.

If you want to beat the market for the second reason, then that’s your business and good luck.  If it’s the first reason, simple math shows incontrovertibly that increasing your savings rate is a much more effective way to catch up than trying to increase your returns.  And this assumes that your beat-the-market gamble pays off, even though we’ve seen multiple examples where beat-the-market can easily turn into lose-to-the-market.

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1 – All these statistics account for trading costs.  But they don’t include any management fees, because outsiders don’t know what if any fees Rennaissance charges to fund investors.

2 – If you’re curious about how an ETN differs from an ETF, you can read a comparison of them here.

3 – Full disclosure: I’ve had a relatively small investment in CAPE, since close to its inception.  And the information here is in no way intended as an endorsement or advertisement for CAPE.  I’d say that my investment in CAPE was one of the last unmindful investment decisions I ever made, which in that sense was a mistake.  I’ve only kept it because I don’t want to incur capital gains, and I’m fascinated by the continuing story of CAPE’s superior performance so far.