A Compelling Quant Fund

There is a really strong quant* fund I want to tell you about.

Over the last 10 years it’s outperformed more than 95% of hedge funds and a majority of active equity managers.** 

The fund is broadly diversified across sectors and across hundreds of companies.***

It has been quite adept at changing it’s holdings to capture the zeitgeist of the moment.  In 2009, it’s top 5 holdings were: Exxon Mobil, AT&T, P&G, Microsoft, and Johnson and Johnson - while today’s it’s top 5 holdings are: Microsoft, Apple, Amazon, Facebook, and Google (Alphabet).  

But wait there’s more!

The fund has daily liquidity.

The fund has an expense ratio <10bps.

It’s also very tax efficient.  Turnover is quite low at about 4-5% per year. ****

The fund is not a black box. It’s published its methodology and criteria publicly.*****  

The fund does not short stocks.  At Ahara we really like that because any short stock position has infinite downside.

Ok you either are very intrigued or you’ve already guessed the answer.  The fund is VFIAX, which is the Vanguard 500 Index Fund Admiral Shares.  It replicates the S&P 500 and has an expense ratio of .04% (there are many other funds that do the same thing at similar cost).  And it’s really damn hard to beat.

The question is: Why?!

Why does this passive, rules based index, keep embarrassing investment and asset managers?   

Well let’s first look at the rules, straight from Standard & Poors.

Weighting; Float adjusted market cap.

Rebalancing: Quarterly

Eligibility:  US domicile.  Plurality of revenue/earnings from the US.  Files a 10K.  Is listed on a set of recognized US exchanges.  

It’s so simple!  It doesn’t seem to shed any light on why it’s so hard to beat.

Except, that first line: “Float adjusted market cap” means that the S&P 500 is long fat tails in stock returns.  What happens when the market cap of it’s largest holdings go up? It increases their weight!  It does the opposite of profit taking.  It leans into winners, and losers get smaller.  

It goes against everything most of us have been taught about prudent portfolio management.  We are supposed to trim our winners - while the S&P 500 is letting them grow to the sky.  

Consider  Exxon Mobil and Microsoft over the last 5 years. As the price of Exxon went down, its weight dropped in the S&P 500, and it went from the top holding at 5% in 2009 to the 32nd holding at .7%.  At the same time as Microsoft outperformed Exxon (and the broader market), its weight in the S&P 500 has grown to be the second largest holding today.

And this approach has been more successful than most other approaches.  As a reminder, the S&P 500 has outperformed 95% of hedge fund managers even before accounting for real world costs like taxes and illiquidity. 

The empirical truth, which is not well known, is that most stocks (58%) underperform cash, and that all gains in stocks as a whole are concentrated in a small minority of companies.******  An index like the S&P 500 is set up to benefit from this truth, by leaning into winners.

We think the only way to outperform the S&P 500, or other indices like it, is to take what the S&P 500 does well (ie, concentrate into winners), and do a better job of it (have a portfolio more concentrated in winners, and less concentrated in the drags on the portfolio).  That’s our philosophy at Ahara.  

References & Notes:

* We refer to quant funds here to refer to funds managed by a quantitative investment process - not a discretionary investment process. Quant funds can be invested in as ETFs, mutual funds, or hedge funds. Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest. Hedge Funds are unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are NOT subject to the same regulatory requirements as mutual funds, including mutual fund requirements to provide certain periodic and standardized pricing and valuation information to investors. Hedge Funds represent speculative investments and involve a high degree of risk. An investor could lose all or a substantial portion of his/her investment. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment. Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments are often sold by prospectus that discloses all risks, fees, and expenses.  They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain and should not be deemed a complete investment program. The value of the investment may fall as well as rise and investors may get back less than they invested.

** Cambridge Associates: Q4 2019 US Manager Universe Statistics

*** Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk

**** https://www.exchangecapital.com/blog/why-the-sp-500-isnt-what-you-think-it-is#:~:text=Although%20the%20S%26P%20500%20overseers,approximately%2022%20changes%20each%20year.

***** https://www.spglobal.com/spdji/en/documents/methodologies/methodology-sp-us-indices.pdf?force_download=true

****** Bessembinder, Hendrik (Hank), Do Stocks Outperform Treasury Bills? (May 28, 2018). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2900447 or http://dx.doi.org/10.2139/ssrn.2900447