How to beat the S&P 500 (by only investing in the S&P 500)

This month’s issue of The Samra Report puts an end to the age-old debate of active vs. passive investing.  The ‘Oracle of Omaha’, Warren Buffet, chairman and chief executive officer of Berkshire Hathaway, earned his fortune and reputation through value investing, an active strategy.  In February of this year, Warren Buffet, however, slammed Wall Streets’ active managers, while praising passive investment pioneers such as Jack Bogle, founder of The Vanguard Group.  This month’s issue of The Samra Report explains: how Warren Buffett’s remarks were taken out of context, how to beat the S&P 500, and provides insight from Benjamin Graham, Warren Buffet’s mentor, professor and widely known as the father of value investing. 

“In 2008, Warren Buffett wagered half a million dollars that a professional investor wouldn't be able to select hedge funds that, over a decade, could match the performance of a low-cost Vanguard index fund tracking the S&P 500.”  “Over the last nine years, the hedge funds have delivered a compounded annual average return of just 2.2%. That pales in comparison to the index fund's 7.1% gain.  In other words, $1 million invested in the hedge funds would have gained $220,000, while the index fund would have been up $854,000.”  Unfortunately, Warren Buffett’s annual letter was taken out of context by the media, and to clarify, an index fund is a traditional investment vehicle, whereas a hedge fund is considered an alternative investment.  In stressing the importance of this difference, at Samra Wealth Management, we believe no client should allocate more than 30% of their entire portfolio towards alternative investments, and depending on the client, the ideal range falls between 5% to 30%.  

Most investors compare their portfolio returns to that of the S&P 500, a common mistake on the part of the investor.  In reality, the average investors are risk averse, looking to accept lower returns than the benchmark, with lower volatility.  The S&P 500 has a standard deviation, a measure of risk(volatility), of 18.1%, whereas a moderately aggressive benchmark: the DJIA Moderately Aggressive Index, carries almost half of the risk at 10.31%.  At Samra Wealth Management, when our clients are asked about their expectations for returns, taking into consideration: “higher expected returns correlate with increased volatility”, our clients understand their portfolio expected returns require lower correlation to the S&P 500.  In simplifying, most investors will not take on additional risk, in search of higher returns.  

Although Warren Buffett’s wager gained a lot of media attention, it should be noted, that this was a calculated statement by the ‘Oracle’.  Historically speaking, hedge funds underperform during bull markets, however, outperform during bear markets.  At Samra Wealth Management, it is our opinion that no investor, should allocate 100% of their portfolio to any form of alternative investments, let alone make a 100% allocation towards hedge funds.  Eight years into a bull market, it should be no surprise Mr. Buffett was right, however, it is our belief that Mr. Buffett would be reluctant to place the same wager as economic indicators start to show a slowing of economic growth.  The graph below shows the Credit Suisse Hedge Fund performance appreciation with a lower slope, than the MSCI World Index, and S&P 500, during bull markets.  However, their is less exposure to the downside, during bear markets. 


Although Warren Buffett was right to question, in our opinion, excessive fees charged by hedge funds, typically “2% of assets under management, and 20% of profits above a predetermined benchmark.”  It should be noted that as of April, the majority of active stock-based mutual fund managers beat their benchmarks in the first quarter. 

Financial advisors attempting to keep up with the S&P 500, utilizing “off-the-shelf” investment products, would have great difficulty, mainly due to holding period requirements.  At Samra Wealth Management, we believe research based portfolio management is the key to success.  In our post-election edition of The Samra Report, published November 30, 2016.  We advised our investors not to stay on the sidelines and recommended increasing allocations towards Technology, Healthcare, Industrials and Financials.  An equally weighted portfolio invested in these sectors would have a year-to-date return of 13.30%, almost 3% higher than the S&P 500 year-to-date return of 10.34%.  The S&P 500, widely known as “the market”, is distributed amongst 11 sectors.  The key to beating the market, while only investing in the S&P 500, is not to over-diversify into all 11 sectors.  Research and common sense help in determining sector allocation, and guidance.  The rationale behind our sector allocation is as follows:

Financials: We expect financials to continue to perform, as the FOMC continues with its plan for unwinding its bond purchase program, known as quantitative easing.  Placing the U.S. economy in a rising interest rate environment.  Retail banks look to decrease their dependence on human capital and rely on technology, while the current administration leans towards deregulation with President Trump’s Wall St. friendly demeanor. 

Technology: Although technology is up 21.34% year-to-date, we believe there is still room for growth in this sector, this belief is based on: expected changes in the corporate tax code, allowing for repatriation of assets held abroad.  Robotics, 3D printing, and automation will continue taking the place of human capital, while AI continues to innovate at a faster pace.

Industrials: The White House has indicated, and is pushing for a $1 trillion infrastructure spending plan over the next 10 years.  Given increased tensions in North Korea, and the Presidents choice of James Mattis for Secretary of Defense, Defense spending looks to increase.

Healthcare: There is a growing demand for emerging market healthcare, as internet penetration in rural areas increases, along with access to smartphones in growing middle-class regions, technology and advancements in medicine make this an attractive investment area.  In the United States, it is unlikely there will be a total repeal of the Affordable care act, as hospitals and insurance companies have heavily invested in ACA implementation.  ACA continues to provide large tax revenue for the government, and it is unlikely the government will allow twenty million Americans to lose healthcare coverage.

Benjamin Graham, widely known as the father of Value Investing, and Warren Buffett’s Columbia professor, separated investors into 2 categories: (1) Enterprising Investors (Active), and (2) Defensive Investors (Passive).

1. Enterprising (Active) investors who have the time and skill to analyze stocks in an attempt to outperform the market averages.

2. Defensive (Passive) investors who either don’t have time or the skill to actively analyze securities, but nonetheless want a satisfactory return while preserving the safety of their principal.

Regardless of how much wealth an investor has accumulated, they now have access to active investment management.  Although the media will lead you to believe active management lags behind that of passive.  It should be noted, many of the most well-known names covering the financial news have no formal education specializing in finance, and are usually graduates of journalism.  Since any investment manager, or portfolio can be considered actively managed, it is important to be able to distinguish the difference between an actively managed, and closet-actively managed account.  True actively managed strategies are measured by their active share ratio, a measure in percent, active share represents the portion of portfolio holdings that differ from its benchmark holdings.  That being said, true actively managed investment vehicles, those portfolios with an active share ratio of greater than 60% beat their benchmark, after fees, across all markets cycles studied, 62% of the time, with a better downside capture, providing a higher sharp ratio (risk-free return).  Those investors who invest in a portfolio with a higher active share ratio, have been found to outperform the underlying benchmark by an average of 1.26% a year, after fees and expenses. Finally, answering the age-old debate, actively managed accounts outperform passive portfolio's, when they are actively managed, and not passively managed accounts disguised as actively managed. 








All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.  All economic and performance data is historical and not indicative of future results.  All views/opinions expressed herein are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. The information and material contained herein is of a general nature and is intended for educational purposes only.  This does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities. Before investing or using any strategy, individuals should consult with their tax, legal, or financial advisor.