Our Secret Sauce

Our Secret Sauce

We have been asked to explain our secret sauce in simpler ways. How do we beat the S&P 500? When two Indexing methodologies compete, there can not be anything secret about it, as Indexing is an open idea. However, if the market capitalization weighting methodology used by S&P 500 works with a linear set of rules (A*B=C) while our Exceptional & Rich 3N methodology is based on mechanism thinking, the comparison between the two ain’t easy.?

Simplicity to Popularity

Copernicus was motivated by the desire for simplicity and elegance in his model of the solar system. He believed that the heliocentric model was more elegant and simpler than the geocentric model, which required complex explanations for the apparent retrograde motion of the planets. Sometimes elegance and simplicity do not make things right.

MCAP (Market Capitalization) method’s elegance and simplicity are deceptive because of its inbuilt bias towards large size. MCAP is the simplest way to inflate the value of an investing basket. This is why the popularity. Think about it, if you had a basket of components and you were given the choice to value it the way you want. What would you do? On the day of the valuation, you will see, which are the most expensive things and you would give them the most value. If you had to program this process, the easiest way would be to give more weightage over time to every positive change in price. There is no simpler way to inflate the value of an Index (basket or a portfolio) but to give it winner’s bias. Hence simplicity and elegance do not translate always to intelligent design.

Popularity to Risk

The MCAP methodology used by the S&P 500 is also popular because it is convenient to calculate. This popularity drives its success with ETF manufacturers, which consequently makes its way into the majority of investors’ pension funds. However, the same popularity has a flip side. The concentration risk percolates from the Index to every investor.?

Let’s imagine a scenario where first; Google's stock price goes sideways like Microsoft from 2003 till 2007 when it returned 38% over 5 years, compared to S&P 500 which delivered 69% for the same period. ChatGPT becomes an ad revenue killer. Second; Apple’s $100 billion cash wasn't spent on buybacks and dividends but was accidentally sitting in fixed-income bonds, with large mark-to-market losses because of the fast rise in interest rates. Third;?Amazon witnesses a drop in revenue because discretionary consumption falls off the cliff.

When a popular index is concentrated in a few stocks, a stagnation in those few stocks can put the S&P 500 into a performance drag. And it won’t take much to reincarnate the specter of 2000-2012 sideways action. Popularity is a double-edged sword that can propagate the risk of a poor concentrated design marketwide.?

Historical Legacy

Both historical legacy and scientific debate are important in evaluating the efficacy of the MCAP methodology of S&P500. The methodology has a long history and has had a significant impact on investment strategies and market trends. Historical legacy provides valuable context for understanding the evolution of the methodology and how it has been used over time. Scientific debate is important in evaluating the efficacy of the methodology and determining whether it is the best approach for measuring market performance. Both perspectives can help us to develop a more comprehensive and nuanced understanding of this important aspect of the financial world.

Touch Points

The MCAP method that is used in S&P 500 is believed to be passive. There are ways to understand passiveness but one simple way is to look at touch points. How many touchpoints does the incumbent method have with the price? MCAP methodology touches the price with every tick change (the smallest change). Every time the price changes, the methodology recalculates the component weight in the Index value. There is no other way to touch the price more than what the MCAP method does. Can something that is pegged to a price change be considered passive? And even if we assume MCAP is passive, can a strategy with fewer touch points be more passive??

A methodology that has less frequent touch points and an average weight readjustment of a component at 24 months is likely to be more passive than the MCAP methodology of the S&P 500, which has frequent touch points and ongoing weight adjustments based on market capitalization. Even if the actual turnover ratio is less, more touch points create more weight changes and such weight obsessiveness of the methodology conflicts with what should be understood as Passive. A methodology that adjusts weights once on average 24 months is more long-term focussed and does not inflate the value of winners and hence does not amplify concentration and related risk.

Static vs. Dynamic

To be better than the MCAP method, a contender Indexing methodology has to be measurable, knowable, and specified in advance. And since Indexing mathematics is as old as coins and coinage, indexing innovation needs more than a linear calculation of A*B=C. To move from a linear to a non-linear approach, a methodology needs to rely on a non-linear mechanism that allows for change of initial conditions and hence the opportunity for re-weighting, recalibration of probabilities, move beyond components into other informational contexts, and make other readjustments. MCAP method is static in a true sense as its dynamism is driven by a change in price and not by an underlying mechanism.

Resilience vs. Rigidity

At the heart of a great indexing methodology is a great recovery ratio. Markets may always go up and down, but a methodology that can dynamically asset allocate while retaining a long-term weight readjustment and fall less in a negative environment and rise more in a positive environment (compared to the benchmark) can make a huge difference in the outcomes. The fact that MCAP is so heavily weighted at one end of the size, sometimes the recovery can take forever. E.g. the Japanese Nikkei, which is still below its 1980 peak, or STOXX 50 which is below its 2000 high, or even S&P 500 moved sideways between 2000-2012. Indexing methodologies should be extensively tested for their resilience measured by recovery ratios i.e. number of days taken by the S&P 500 to come back to previous highs divided by the days taken to be the contender.

Concentration vs. Diversification

MCAP method is concentrated and not-diversified. Fiduciary duty is a legal obligation that requires an individual or entity to act in the best interest of another party. In the context of investing, fiduciaries have a duty, to prudently manage the assets under their control and make investment decisions that are consistent with the best interests of their clients or beneficiaries. Diversification is often considered a part of the fiduciary duty for investment managers and trustees because it helps to mitigate risk and improve the overall risk-adjusted return of a portfolio. By diversifying across different asset classes, geographies, and investment strategies, fiduciaries can help protect their clients or beneficiaries from the impact of market volatility and other risks. Therefore, fiduciaries are generally expected to adhere to a prudent diversification strategy that aligns with the specific investment objectives and risk tolerance of their clients or beneficiaries.

Several codes of conduct and industry standards specifically refer to diversification as a key component of sound investment management like Global Investment Performance Standards (GIPS), CFA Institute's Code of Ethics and Standards of Professional Conduct, and even the SEC, which requires written policies and procedures that are reasonably designed to ensure that portfolios are adequately diversified. Overall, diversification is a fundamental principle of sound investment management and is reflected in many codes of conduct and industry standards. Hence a better methodology has to address diversification as the first tenet of indexing construction.

Sounds Too Good To Be True

An average annualized excess return of 400-500 basis points on a risk-weighted basis claim to beat the S&P 500 is not a prominent claim. But it can evoke the sound of too good to be true (TGTBT). Early technologies suffer from this risk and this is why the trade-off for early adopters who can benefit from competitive advantage, cost savings, innovation leadership, and learning opportunities. Disruptive technologies can build a significant moat in no time. What early adopters need to overcome the TGTBT is due diligence. What is the methodology? What is the technology? How does it use AI? What’s mathematical innovation? How can it be tested? What are the cost benefits? Is the methodology replicable? Is it a general purpose in nature? If it works, how can it change the business landscape??

The Radar Chart

In this radar chart, we looked at concentration, large-size bias, touchpoints, dynamism, recovery, and diversification. MCAP scored a 10 when it came to concentrations, large size bias, and touch points, while the 3N method scored a 5, 5 and 3 for the respective variables as it was not concentrated, assumed other biases outside large size bias, and had fewer touch points.?

MCAP scored a low 1 for dynamism, and 1 for diversification as it relied on price for dynamism and did not offer diversification. We gave the 3N method a high 8 for both dynamism and diversification, expecting further improvements. Recovery ratios for the 3N method were on average 1.5 times faster than their respective MCAP benchmarks across all simulations. If MCAP scored a 4 on resilience, the 3N method was a 6, as resilience capability could improve in future versions.

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Bibliography

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