Passive index investing may have lost some of its luster during the bear market of 2008. It seems proponents may have focused too much on relative returns and not enough on volatility and absolute returns.
One way to get a smoother ride besides having a higher allocation to bonds (like the One-Minute Portfolio) may be touse sector indexes as building blocks instead of market indexes. With sector indexes, an investor can bring the risk-reduction process of rebalancing and lowering correlations down to a finer level of detail.
Consider a passive index investor just starting out. They can buy and hold the oldest and most liquid of exchange-traded funds (ETFs): the S&P 500 SPDR ( SPY). Compared to other major indexes, the S&P 500 has better diversification and lower volatility. But it would have been even better to have owned an equal-weighted portfolio of ETFs tracking the nine sectors making up the S&P 500:
Materials SPDR ( XLB) Energy SPDR ( XLE) Financials SPDR ( XLF) Industrials SPDR ( XLI) Consumer Staples SPDR ( XLP) Utilities SPDR ( XLU) Technology SPDR ( XLK) Consumer Discretionary SPDR ( XLY) Health Care SPDR ( XLV)
The investor would have enjoyed lower volatility/higher returns, as Tristan Yates illustrates in Enhanced Indexing Strategies (John Wiley & Sons, November 2008), a book reviewed in my last column. His table on page 49 shows SPY earned 3.9% annually with 14.1% annualized volatility from 1999 to 2006 while the portfolio of sector ETFs earned 7.2% annually with 13.5% annualized volatility (Yates’ figures are dividend adjusted).This result occurs because of rebalancing, i.e. keeping sector proportions equal over the years — as I understand Yates to say.
Yet, the nine-sector portfolio is not optimal in the sense the ETFs were selected so as to minimize volatility and correlations amongst each other. If only sector ETFs with low volatility/correlations are included, that leaves four: Consumer Staples SPDR, Energy SPDR, Financials SPDR and Utilities SPDR. This basket returned 8.8% per year with volatility of 12.7%, on average. The results show that its better to build [your own indexed portfolio] than to buy [an off-the -shelf package], writes Yates.
Taking Yates line of thought further, someone with a high aversion to volatility might conceivably index the equity component of their portfolio to a basket of non-cyclical ETFs, notably Consumer Staples, Healthcare, and Utilities. Over the five years to Jan. 9, they individually outperformed SPY. Two of them show a positive return for the period and the third a smaller loss than the S&P 500, which was down over 15%.