#96: How to Outperform the S&P 500 Index

Today’s spotlight will be longer than most. It is not financial advice; you review and see if this makes sense for you.

S2N Spotlight

We all know that outperforming the S&P 500 index is the holy grail of equity investing, and achieving this goal is extremely tough. According to Ginsglobal, 94% of active managers underperform the S&P 500 index over 20 years and 83% over 10 years. I am going to show you how you can do it over even longer periods, and I think now is one of the best times to apply this research.

Index Definitions

This is going to be a deep dive into the difference between the S&P 500 classic index, which is market cap weighted (the bigger companies take up more weight in the index), and the S&P 500 equal weighted index, which simply divides the index by 500 with each company having 0.2% of the index.

Different Angles of Measurement

In the chart below, you can clearly see that the Equal Weight Index massively outperforms the Market Cap Index over 50 years. At the bottom of each chart, I subplot the difference in annual return between the market cap and the equal weight index. As you can see, in the last 2 years, the market cap has outperformed.

In the chart below, you can see that the Equal Weight Index and the Market Cap Index are almost identical over 20 years.

In the chart below, you can see that the Market Cap Index clearly outperforms the Equal Weighted Index over 10 years.

All Data: Detailed Analysis

The table above provides a detailed analysis of performance over 53 years of data. The difference in cumulative returns is staggering; what might seem like a small difference in CAGR% really does compound over time. The Equal Weight Index also has a superior Sharpe Ratio when looking at risk-adjusted returns.

Concluding Thoughts

As with everything in finance, there are never simple choices.

According to the data, only 27 companies that were in the S&P 500 over 50 years ago have survived the index. Around 40% have survived the last 20 years and 75% have survived the last 10 years. What you can see is that what might have been a great company for a period of time does not mean it will always be great. This is the fundamental difference between the 2 indexes. The market cap index has a built-in momentum feature where it over weights the larger companies. This is a good strategy when a large company is doing well, but not good when a large company is doing poorly. This is why I believe the equal-weighted index is the best passive index investing strategy.

If you want to achieve the best returns over the long run with a passive index strategy, I think it is best to avoid any form of overweighting bias and invest in an equally weighted index. We are all fooled into believing we can forecast which stocks to overweight. At the start of this note, I shared how few outperform the index over time.

What I have shared in this note is that even within an index of the same 500 stocks, there are sometimes built-in biases. The best way to achieve superior passive returns over time is to make sure that you have a survival bias in your favour.

S2N Observations

The only observation I want to make is that the current extreme left and right state of the political landscape is a worrying and telling tale that all is not well in the world, and we should be expecting surprises to the downside. This is not the time for the risk premium to be near all-time lows. This is not about being bearish or bullish. This is about being aware of the geopolitical climate we are in.

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