Is the Tech SPDR Really Riskier than the S&P 500?
The S&P 500 is the most popular index fund by far among investors, because they think it’s better to be more diversified, to manage risk. Reality tells a different story though.
The world of investing is riddled with so many myths that it would even be fair to categorize the whole thing as mythology. There are some pretty big myths out there, but perhaps none as mythical as those surrounding our understanding of the way that risk and return fit together.
If we just buy into the myths out there, we won’t even know that they are myths, and just keep on making the same mistakes over and over again and never have any idea that anything is wrong. If we blame anything, it’s the market, but the market is never to blame for anything because it’s just the sum of everyone’s collective actions. If your actions don’t correlate well enough, it can’t be the data that is at fault, and if there is anyone who is to blame, it has to be us because we are the sole agent here.
Investors end up settling for less than they should due to their not really understanding the relationship between risk and return. These are not stand-alone issues, where we should ever view one or the other exclusively, as it is the way that they fit together in a given situation that is what is meaningful.
We wouldn’t just want to look at an investment’s return rate without looking at risk, because it might be too high to make sense of the investment, such as a bet which doubled your investment or you lose it all, where you could have gotten 20% by not choosing this bet. It’s not hard to understand why this would be a bad bet, because your expected value would be 1 where not taking the bet would provide an expected value of 1.2, even if you could stand losing all of your money on this.
If we instead offered a chance to triple your money or lose it all, this at least offers a higher expected value on average, 1.5 instead of 1.3, but you still may not want to take the bet because the pain that being broke would involve would be greater than the pleasure of tripling your money, if that’s all you had in the world. If this only represented a tenth of your portfolio, you might take the bet, because this is more an amount that you could afford to lose.
There are two parts to this therefore, the actual numerical calculation, the objective side we will call it, and the subjective side, what the results mean to you and your situation. We are wise to consider both, but not so wise to consider either, and not considering either is the sin that the majority of investors commit, even though they may not be all that aware of it.
The amount of thinking that we actually put into our investments is embarrassingly small, and this applies both to the great majority of investors and the great majority of people they look to get advice from.
The starting point for this discussion, even though it’s rare that we even get to the starting point, involves our looking to define our risk in the first place. We need to not only realize that risk means a chance of loss, we need to specifically assess the situation properly. We might not think that we neglect this step, so we’re going to pick an example of comparing investing in the S&P 500 and a sector SPDR to illustrate how this happens and how widespread the problem is.
First, we need to start by asking ourselves why people invest in an index fund such as the S&P 500 in the first place. In olden times, before funds were created, investors were limited to trading in individual stocks to own stocks because that’s all there was at the time. This did not make trading in stocks very accessible to the masses, as this required that you come up with your own trading ideas or pay a full-service broker to come up with ideas for you.
Even if you were up for this, you probably didn’t want to meddle in stock selection, but these brokers were just brokers and often didn’t know much more about what they were doing than their clients, little to nothing in other words. People sure paid them plenty of money to do this though, several percentage points in commission for each trade.
This also limited the number of stocks you could hold, and if you were given a real turkey, or if you got caught in a bear market, and especially if you held them like you were told to do, this could end up being very painful and expensive, losing a bunch of money instead of making a lot like you were told you were going to.
Then came something called mutual funds, where a lot of investors could pool their money and hire someone whose job wasn’t just to generate trades and at least knew more about trading stocks than your broker did. This also allowed for your portfolio to be stocked with a lot more stocks, which was seen as spreading the risk around, even though it didn’t really serve to do that very well, for reasons we will mention soon.
The people who ran these mutual funds really didn’t understand risk and return that well though, and especially placed a much bigger premium on variety than they should have, where this diversification became so overrated that it even trumped the reason why we invest in the first place, to make money. Having things spread around a lot became the main goal, and provided that this was satisfied, whatever returns you got became conditioned by that.
Meanwhile, we started tracking baskets of stocks called indexes, such as the S&P 500, to give investors, including these mutual funds, an idea of how they were doing. If they had a bad year, they could look to these market averages that these indexes were held to represent to see if they lost less, and if they did, this became something to crow about, even though no one should ever be proud of losing money.
If they made money, they could compare their gains with the indexes to see if they managed to beat the “market” or not. Beating these averages should not be such a difficult thing, as a random selection of the stocks that they track would have been enough to keep up, and over time, if you had any skill at all, you should be able to beat doing nothing.
This hasn’t worked out quite that way though, and the random basket of stocks ended up beating most of them, for a number of reasons, which include simply not being selective enough with their picks. If we want to throw in a lot of extra components into our funds, ones that underperform the averages, this is going to bring our results down of course.
Index Funds At Least Take Human Mistakes Out of the Picture
We then got the idea to just offer the index to investors, called index funds, and while they were also cluttered up with stocks that were placed there with no regard to performance or any regard for anything other than someone put them in the index, this at least took the skill part out of the equation, the lack of skill in this case, the tendency for fund managers to make so many mistakes that they ended up with below average results.
Index funds grew in popularity, and are still growing today. The S&P 500 then became the gold standard and achieving as good or better returns than these indexes became the golden calf, and fund managers still seek this, even though 4 out of 5 of their funds fail each year.
With those bleak numbers, and it being not so easy for investors to tell who will beat the market next year, as we often see different ones among this 1 in 5 that do it in any given year, it’s not hard to understand why these index funds are more and more popular every near now.
This has led to the popular view that we cannot beat this “market” consistently, even though all that would require is that we exclude some of the worst stocks in the index, and you can build a basket of them just by exclusion that would beat the averages if you knew anything about what you are doing.
Stocks do not behave randomly and move in trends, and some stocks just do better than others. Stocks that are trending well are the ones that we have a better profit expectation with, and those that are not trending well have a lesser and sometimes even a negative expectation. This is not a difficult task at all, but the funds don’t get the fact that to beat the market you need to be more selective, and their desire to be diversified enough ends up preventing them from doing this properly.
While there are several reasons why so many actively managed funds fail to beat the averages, the biggest one by far is that they hold too many below average performers. If this was not true, they would be beating the market for sure because this would mean that their holdings would be on balance above average.
We could build our own baskets with a little instruction and a little sense, but we realize that a lot of investors don’t want to do this and may instead have a strong preference for investing in funds. That doesn’t mean that the choice is down to index funds or active funds, as there are some funds that do all the work for us and are actually structured to provide better results, and do so in a manner that make them far preferable if we bother to even look. On the whole, we do not bother.
Big cap stocks just do better performance wise, so choosing an index like the S&P 500 as our basket to select from is a good place to start. There may be stocks that are well worthy of our attention that aren’t in this basket, but we want to keep this as simple and easy as we can because that’s what the people want.
We’ve chosen the S&P 500 index fund as preferable over managed funds, due to the fact that the S&P 500 wins most of the time, but the next decision that we need to make is whether we want to own all of them or not. This is a question that does not get asked all that often, but one that needs to be.
Stocks do not perform identically or even substantially similarly, as there are some that do better than others, and these differences are far from random but emerge as trends. We invest in stocks in the first place to follow trends, the trend upward over the long run at the very least, and there are certain types that trend better than the averages and some that trend worse.
The typical answer to the question of why we would want to invest in the whole 500 is that this provides us with more diversification, and in particular, expose us to a variety of different types, different sectors as they call them.
This is usually where the deliberation ends, as diversification is somehow seen as an end in itself, a requirement even, without even wondering whether other approaches may be better.
Even without knowing anything else, we should at least be wondering whether owning stocks in certain sectors may be doing us more harm than good, and also wondering what the good with some sectors might even be. Owning stocks in the energy sector for instance has added both more risk and lost a lot of money at the same time, and that sure can’t be sensible.
People generally don’t want to go off and put together a home-made basket, so the idea of offering index funds in specific sectors emerged. They broke down the S&P 500 into 11 different categories, called SPDRs, which was done to offer investors who want more flexibility with which stocks they own in the big index, where they can pick less than 11 and also proportion the amount that they have in each as they choose.
The way that this was promoted is for investors to mix things up more but still pursue plenty of diversification, even though this is not the right way to use such a thing, and pretty clearly not in fact. If we’re rational creatures, we need reasons to include any sector that we choose, which requires at least a cursory view toward the net benefits of including any sector.
This brings us back to our working out risk and return, which we will be doing to both compare sectors with one another and also comparing with the big index, and unless we are choosing better options than going with the broad index fund, we are just hurting ourselves.
Investing exposes us to a number of risks, with the main ones being market risk, sector risk, and stock risk. Market risk is going to apply regardless, and we’d need to time our positions to address this, although in this example that’s not required as we want to make our plan as simple as possible, and buy once and then just hold fits the bill.
Beating the Market Can Just Involve Holding A Better Portion of It
You don’t have to time your positions to beat the market, even though that certainly works well if you know what you are doing, and even if you don’t, for instance with selling into this latest bear market where everyone knew where we were headed from this virus. However, you can just pick better stocks, and you don’t have to even pick them to accomplish this, you just need to pick the right type.
Of these 11 SPDR sector funds, just about anyone would know what the best performing sector has been, the technology sector. Even people who know precious little about stocks know that these stocks have performed better than regular stocks, including the big indexes.
If you ask investors why they don’t have all of their money in this sector fund, they would tell you that they believe this would be far too risky for them, and if they knew about the types of risk, they would tell you that it is sector risk that they are worried about. What this involves is a sector such as the technology sector going down more than the market at any point.
Often times, they are worried about market risk, but this gets understood as sector risk because they don’t know the difference. If the market loses half its value, and a sector loses 55%, the sector risk isn’t 55%, it’s 5%, the difference between investing in this sector versus the broader market.
When sector and market risk converge, this is what really scares people, like for instance with our recent bear market. If you asked your typical investor at the start of the year to decide between having all of your money in the S&P 500 and the tech SPDR, and you told them that we would have a bear market during the next quarter, they would surely think that the SPDR would be riskier and a lot riskier probably.
After all, these tech stocks have run up so much more than the market has over the last few years and everyone knows that tech stocks go down more than regular stocks, so they might even think this idea would be certifiably crazy with a bear just around the corner.
We haven’t had a whole lot of opportunity over the last decade to see what happens with bear markets, other than that mini-bear we had to end 2018, but we sure got one lately. This provides additional opportunities for investors who think conventionally to be shown the error of their ways.
As much as we over-diversify, a little diversity, not too much but enough, can be a good thing. Our sector fund does provide some, as this is a fund, not a stock, and covers stock risk that way. People see some tech stocks a little too volatile for their tastes and then look to paint the whole bunch red though.
They might think that we are asking them to decide between putting all of their money in Apple when they do this, but they might not want to just assume too much and have a look at how this sector fund and the big index actually stack up.
It’s a given that the tech sector tends to well outperform the average stock, the big index in other words, and no one gets concerned about the risk of making more money. They do get scared about losing money, and that’s very understandable, but you would think that they would look first before they jump to this conclusion about the tech SPDR being riskier at all.
We aren’t bringing this all up just to tell you that they are right and this sector SPDR is actually riskier, especially standing by it when it gets attacked by a bear, and all you had to do is look at the beta of this fund prior to all this, which is ready accessible. The sector fund’s beta is less than 1, meaning that it is less risky than the S&P 500 which is given a 1, in spite of what the common view may be.
This can only be explained as people not bothering to look, and this isn’t just the last couple of years, this sector fund isn’t as risky period. We can even look back to the 2008 crash and the S&P lost more than it did, and they both lost the same 20% from the 2018 drop.
This is what beta measures though, drawdown risk, even though drawdown risk isn’t really that significant anyway and especially not for investors. When investors consider risk, they need to look at the real risks, not holding something that is down on paper for a little while from the swat of a bear’s paw that they aren’t going to be selling for years anyway.
There’s a much bigger reason than you’re not selling now though that makes drawdown risk not very significant for investors, and this is because better returns themselves proportionately reduce drawdown risk. For instance, if you achieved a 50% better performance, when things take a dive, you’ve earned 50% more room until you even get to real drawdowns, where the move down would even take you to where the index was before the fall.
If you are at 150 and the market has 100 after a given amount of time, and you lose 30% of that while the market loses 20%, you still are at 105 while the market has dropped to 80. Your better returns have gained you all this extra room, which does need to be accounted for, although we rarely account for this.
No matter though, our SPDR tech fund just doesn’t go down as much as the big index anyway, and we know this to be true just from looking at the beta. This was worked out prior to our being asked to walk on coals with it though, so let’s see what happened.
The S&P 500 famously lost 35% from top to bottom with this move, and even fell below its 2018 low, 5% below it in fact. From the rebound since, the index now sits 15% off its lows. The tech SPDR fund fell 30% instead of 35%, stayed 21% over its 2018 lows instead of being below by 5%, demonstrated how it grows more over time, and is only 11% off its high now instead of 15%.
We don’t want to forget about all that added upside though, even though everyone knows how well this sector has performed. Over the last 5 years for instance, the S&P 500 has gained 38% while the tech SPDR has moved up by 105%. Who wouldn’t want to make an extra 13.4% per year when you can do at least as safely, and in this case, considerably more so when you use net drawdowns? This is actually pretty representative when we look at other timeframes as well.
Even into a bear market, our SPDR would have been the better choice in every regard. When you take on even less risk and do a whole lot better on the upside, there should not be anything to think about here as far as which is the sensible choice.
As much as we like to do the bare minimum when it comes to investing, the bare minimum cannot include not bothering to even look around much and not even wondering what else there may be out there. This is the starting point for any conception of good investing, but we need to get there first.
Editor, MarketReview.com
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.
Contact Robert: robert@marketreview.com
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