How to Beat a Benchmark [Part 2]
Before discussing another way to cheat, let us first discuss the magnitude of Beating Their Benchmark. Let's look at the performances of VSMGX and VSCGX over a few time periods. In 2016 through September 30th, VSMGX outperformed VSCGX by 0.24% which is not much. That 0.24% is less than many of the single day movements in the NAVs (prices) of either of these funds. It is not above the noise level. I don't think we can predict right now which of the two funds will end up with a better performance by the end of 2016. But over the previous 5 years and 10 years, VSMGX outperformed VSCGX by an annual average amount of 1.95% and 0.36%, respectively. The point is that "outperforms" does not mean a 10% a year nor 5% a year nor even 2% a year. We are talking about Beating Their Benchmark by a small amount every year. This does add up over many years though.
One might choose to try to "Beat Their Benchmark" by 1% a year which can be quite difficult to do. Indeed, as just shown the 10-year average annual return of VSMGX did not Beat the Benchmark of VSCGX by 1% over at least one 10-year period (nor the 3-year period, nor the 15-year period ending on 9/30/2016).
Or one might think, it is not even worth trying to Beat Their Benchmark if one is only trying to Beat Their Benchmark by 1% a year. While that will be true for many investors, others might enjoy that 1% if they have large portfolios. For instance 1% of a five million dollar portfolio is $50,000. But this also shows that paying an advisor 1% of Assets Under Management (AUM) or using investments or funds with an extra 1% embedded cost (higher expense ratio?) is going to destroy any chance of Beating Their Benchmark. That is keeping costs as close to zero as possible is paramount.
Nevertheless, let's say that 1% extra return per year is the goal. Anything lower just gets lost in the noise and is probably not worthy of one's efforts. Besides, one wants an attainable goal that is sometimes missed. And a miss is not so bad as long as one at least matches the Benchmark or at least does not underperform the Benchmark by very much. One percent extra per year seems to fit the bill of not too easy and hopefully not too hard.
Now some math: In order to get that extra 1% per year, one's portfolio is going to need to be riskier than the Benchmark at least some of time during the year. Here are a few ways to get 1%:
- Invest 1% of the portfolio in something that goes up 100% or more. That is, it doubles in value. If stock market averages go up 10% during the year, then the investment has to go up not only that 10%, but the additional 100%.
- Invest 10% of the portfolio in something that goes up 10% more than the stock market averages.
- Invest 20% of the portfolio in something that goes up 5% more than the stock market averages.
- Disinvest 10% of the portfolio in something (in the Benchmark) that drops 10% more than the stock market averages.
It should be clear from the examples that one has to invest differently than the Benchmark either by taking on more risk when stock market is going up or less risk when the stock market is going down. One can also change risk level by changing duration and credit quality of the fixed income side of the portfolio. In other words, there ain't no such thing as a free lunch. There is only cheating. Cheating would be to temporarily change the risk level of one's portfolio by temporarily changing the asset allocation of one's portfolio. Another term for this might be "Market Timing."
Many people believe that "Market Timing" is a binary thing: Invest 100% in equities sometimes, then cash out and hold cash until the next time. Rinse and repeat. Good luck with that! For me, I would like to consider another kind of Market Timing: Maintain an asset allocation and set of investments similar (if not identical) to the chosen Benchmark, but change the asset allocation temporarily at selected times, then restore the portfolio back to match the Benchmark. Consider this: Suppose your portfolio is ahead of the benchmark by 1% in March. If you simply invest in the Benchmark from April through December, then you will be 1% ahead of the Benchmark at the end of the year, too. As they say in sports: Offense scores points; Defense wins championships. Or something like that (but see
Does Defense Really Win Championships? - Freakonomics Freakonomics). Many people have seen sports teams run out the clock once they are sufficiently ahead on the scoreboard.
If one puts the previous two paragraphs together, then one can see that another way to cheat is to do a little bit of Market Timing. In fact, it is pretty much required to increase the risk in a portfolio above the risk of the Benchmark in order to outperform the Benchmark. That increase in risk could be market timed. That's not only cheating, but almost everyone says that Market Timing does not work.
Let's back away from Beating to "Not Underperforming" for a moment. I am not going to do any statistical research on the following for a while, so what I write may not be true, but I am going to write it anyways. If one has a 60/40 portfolio and goes to a 100/0 portfolio by exchanging all their bond funds into equities, then that is quite a bold change. If equities drop 2.5% which is well within a normal one-day movement of equities, then the 100/0 portfolio will underperform the 60/40 portfolio by 1%. Ouch! I personally think that is too much risk to take even for Market Timers. If one has a 60//40 allocation and shifts to a 70/30 allocation and equities drop by 2.5%, then the 70/30 portfolio will trail the 60/40 portfolio by 0.25%. That is a little more reasonable and probably in the noise. By the same token, if equities go up by 2.5%, then the 70/30 portfolio will only gain 0.25% on the 60/40 portfolio. That's not much of big deal for a one-time change.
But if one can successfully Market Time a shift from 60/40 to 70/30 four times in a year with an average 2.5% gain each time, then that adds up to a 1% outperformance and meets the goal of "Beating Their Benchmark" by 1% in the year. Or maybe one only needs a 5% increase after going to 70/30 twice a year. Or a 3.33% increase after going 70/30 three times a year. I hope you get the idea.
So the idea is to identify potential days to shift from a 60/40 asset allocation to a different asset allocation such as 65/35 or 70/30. Some folks might even call such a shift "Rebalancing" and not "Market Timing."
Of course, one cannot with certitude identify the days or weeks where equity markets are going to go up significant percentages. Predicting the future with any certainty is impossible. The goal is NOT to be 100% correct all the time. The goal is NOT to catch EVERY such day. The goal is NOT to miss potential down days with one's 60/40 asset allocation. After all, the Benchmark will not miss those down days anyways. Instead, the goal is catch enough of the UP days with an extra allocation to equities to counteract any down days that are also caught sometimes. One has to accept some extra losses sometimes, but also to keep those losses relatively small. The goal is to work some of the probabilities. The goal is also not to make a killing and not to be killed.
So we give up trying to do Market Timing perfectly and in a big way. We accept trying to do Market Timing with mistakes and in a small way. If we are wounded, we know we will live for another day and another year. And we know that we might have to do some tax-loss harvesting (TLH) along the way.
And speaking of TLH, we want all our transactions to be tax-free. That might mean our transactions are done in tax-advantaged accounts or if we have to sell and realize a gain in a taxable account, then the capital gain is always offset by a previous realized capital loss or otherwise not taxed.
[End of Part 2]
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