<s> Beat The Crash Volume 1
Truth About ETF Rotation Fund Your Retirement by Investing in TopExchange Traded Funds in One Hour Per Week
By Jackie Ann Patterson
©2012-2013 Own Mountain Trading CompanyAll rights reserved. No portion of this work may bereproduced in any manner whatsoever without writtenpermission except for brief quotations in critical reviews.Published by:Own Mountain Trading Company dba BackTesting ReportP.O. Box 620427Woodside, CA 94062-0427support@backtestingreport.com+1 650 752 4921www.ownmountain.comwww.backtestingreport.comDespite best efforts to produce a useful and correct report, thisbook may contain errors. Much of the data relies onbacktesting, which is a historical simulation with significantdifferences from real live investing and trading. No claim isbeing made that you will make money from this book, and infact you may lose money from investing. The author is not alicensed financial planner. You must consider carefully whatis right for you and consult professionals as needed.This book is intended for educational purposes and is not arecommendation to buy or sell securities.HYPOTHETICAL OR SIMULATED PERFORMANCERESULTS HAVE CERTAIN LIMITATIONS. UNLIKE ANACTUAL PERFORMANCE RECORD, SIMULATEDRESULTS DO NOT REPRESENT ACTUAL TRADING.ALSO, SINCE THE TRADES HAVE NOT BEENEXECUTED, THE RESULTS MAY HAVE UNDER-OROVER COMPENSATED FOR THE IMPACT, IF ANY, OFCERTAIN MARKET FACTORS, SUCH AS LACK OFLIQUIDITY. SIMULATED TRADING PROGRAMS INGENERAL ARE ALSO SUBJECT TO THE FACT THATTHEY ARE DESIGNED WITH THE BENEFIT OFHINDSIGHT. NO REPRESENTATION IS BEING MADETHAT ANY ACCOUNT WILL OR IS LIKELY TO
ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSESHOWN.
Table Of ContentsDedicationIntroductionMy StoryHow to Compare InvestmentStrategiesHow Index-Makers RuleHow to Create a DiversifiedPortfolioPerformance of Buy-and-Hold ofDiversified PortfoliosWhat Could Be Better ThanDiversified Buy-and-HoldHow To Do An ETF RotationPerformance of Rotation ofReference PortfolioWhat If You Don’t Own a Home?Which Day of the Week toRotate?Bring on the Long Bonds
Shorting the Market with IndexFundsHow About Those Commodities?Everything but the Kitchen SinkRotatingtoCashWhenEverything RotsWhat Happened With StopLosses?Does Active Rebalancing HelpGrab Profits?Double-Checking the Asset MixWhich Strategies Beat the CrashResourcesAcknowledgements
Dedication
For my mother who set an example ofkindness and generosity.
IntroductionYou can retire in comfort and security. Your investments canprovide for your living expenses and free you to live the goodlife. It is not that hard, but it will require you to master a fewtechniques to monitor the markets, keep your mind alert, andmaintain the personal discipline to act decisively on occasion.Even if your life savings was devastated by the last decade,this book can give you the tools to help re-build it and get yourretirement back on track.As I write this, the world economy has been on life-support foryears. Stimulus programs are a regular and familiar crutch.Interest rates wallow at all-time lows. The real estate markettook a tumble and loans are not so readily available to fund acash-flow empire based on rental property. Looking back overthe last decade in the stock market, we’ve experiencedtremendous gains and harrowing downdrafts. The only groupthat has done exceedingly well is bond investors, and that maywell be escalating into the next big bubble.Are the days gone when individuals like you and I could hopeto support ourselves without depleting an account’s principalin the process? Admittedly, it looks bleak. But what if youcould sense when to approach the stock market aggressivelyand when to shift to a more conservative stance?This is exactly what large money managers are doing withwhat they call “risk-on / risk-off” strategies. The idea is thatwhen they perceive conditions are favorable to taking risk,they jump in the market full-force. As conditions shift to takeon a dangerous tone, the risk-off orders go out, and themarkets drop as the money takes flight to safety.The trouble is that these money managers don’t alert us, thegeneral public, to their risk assessments. Instead they quietlypull out, selling the assets they believe are on the brink ofdisaster to an unwary public. After all, someone needs to holdthe bag.If you’d rather not be one of their stooges who buys at the topof the market only to learn about the big players getting out oreven selling short, then the Beat the CrashTM series of books is
for you. My goal is to lay out a set of data and indicators thatyou can reference to make your own call on when and how toparticipate in the market. Use the tools described in the pagesthat follow to help understand when it’s a prime time to be inthe market, and when a more conservative asset allocation ismore likely to be rewarded.The indicators and techniques chosen for the Beat the Crashseries run the gamut from fundamental to technical tosentiment. Their common attributes are:
Robust track recordApply to the broad market or economy as a wholeObjectiveRelatively simpleThis first book in the Beat The Crash series serves twopurposes. As the title “Truth About ETF Rotation” suggests,the main idea is to show you how to put together a strategythat rotates among top Exchange Traded Funds (ETFs).Before diving into ETF Rotation, this first book in the Beat theCrash series defines the standards we will use to evaluatewhether an indicator or method can help us understand themarket. It establishes a baseline for comparison – a referencepoint to see how well the strategies are working. To do that,we will look at simple ways to manage a diversified portfolioand decide where to invest funds when the game is on.Clearly, I’m not advocating a buy-and-hold strategy, nor is ithigh-frequency trading either.Buy-and-hold leaves usvulnerable to large losses that take years to recover. Inpractice, it’s a rare individual who actually carries out buyand-hold. Instead, many people who set out to buy-and-holdlose their resolve after a market plunge, only to find they’vesold at, or near, the bottom. Or, they make my friend’sfavorite mistake: buy a promising stock and hold throughstellar gains, but end up selling for a small loss once it comesback to earth.
Just because we’re not married to a stock or market outlookdoes not mean that we need to spend our days and dollarstrading in and out frequently. That style of trading presentsmany challenges, both technical and psychological. It isincreasingly dominated by automated high-frequency tradingtaking place in computer centers co-located with the stockexchanges.Individuals have limited resources to compete in the highfrequency trading game. Besides, I have no inclination tospend my retirement years staring at a computer screen! I’dwholeheartedly recommend that you balance your life beyondthe markets as well. Remember, money management is ameans to an end, not the end to itself.If your end goal is indeed a better retirement, you may findyou do better to practice these strategies in a retirementaccount. A self-directed IRA at a discount broker will do justfine. If your funds are stuck in a 401k with limited choices,you may have to adapt some strategies to the mutual fundsprovided and consider the 401k’s restrictions on tradingcarefully before each move.If, instead, you are investing in a regular brokerage account,you may be liable for taxes when moving money betweenasset classes. But even paying taxes is better than all-outlosing your savings!These strategies are meant to protect your nest egg as much asgrow it. They attempt to point out promising times to riskmoney in the stock market and take defensive action when thegoing gets tough. No doubt we will sometimes experiencelosses using the tools set out in the Beat the Crash series ofbooks. We have only the assurance that we’ve done our bestto learn from history rather than blindly repeat it.The companion website for the Beat the Crash series of booksis beathecrash.com. For this book in particular, you’ll find thecompanion site at truthaboutetfrotation.com. Follow the linkswithin this e-book to access figures and detailed backtestingdata.
My StoryLet me tell you my story. I am not a natural born investor ortrader. Rarely graced with the intuition to do the right thing atthe right time, almost everything I learned came through oneof two ways: a series of hard knocks or exhaustive computersimulations. Even once I saw that money could be made in thestock market, I stumbled forward in the dark until certainevents forced me to shed a little light on what I was doing.My purpose in writing this book is to help illuminate your pathto greater success in the markets.The truth is that I didn’t set out to forge a career backtestingthe stock market. In fact, I didn’t even set out to trade themarket. I am a computer engineer by training. What withstock options and living in Silicon Valley for the tech bubblein the late 1990’s I couldn’t help but notice that money camefrom the stock market.I started out very conservative, figuring that I had very little soI better not lose it. I selected the most conservative choice formy 401k funds. Some so-called Guaranteed Fund, somethingabout investment-grade insurance blah-blah-blah — I didn’tlook that closely but “Guaranteed” sounded good.Ha! The Executive Life insurance industry debacle taught methat even the most conservative-sounding choices can blowup. It is important to understand what really underlies themarketing names. All was not lost though. Eventually moneytrickled out of the bankruptcy settlement. A few years ago Ireceived a back payment from the Guaranteed Fund. Nice, butit’s much less useful to be made whole 20 years later!Working at a software company as the internet took off, Itraded just for kicks. It seemed all my colleagues had theirown little formula. The Altera rep to Cisco bought more stockin both companies each time he received a sales bonus, whichwas often. A marketing manager bought shares of whateverelectronic company would try out his leading edge designproduct and he profited. I tried my hand at finding dot.cominitial placements (IPOs) and flipping them as they caught onfire.
But I didn’t make as much as I could. Being anxious thatdot.com mania was too good to be true, I tried to make a moreconservative allocation of funds. That’s how I came to havemy account balance once again slashed by holding a bondfund in a rising interest rate environment. I got around tofixing that just before the tech wreck induced a flight to safetyof treasury bonds. I was yet to see that the choice ofconservative versus aggressive allocation had more to do withthe market state than my age, risk tolerance, and goals.Like most adult Americans, I know exactly what I was doingon September 11, 2001. On a business trip to Boston, I had alittle time in my room before my first meeting and was sellingstock on my laptop. I’m not kidding, I was trying to place asell order and NASDAQ was not responding. The roomservice waiter told me a plane had hit the WTC. My sell orderwas lost among the unfolding drama on television and myweek-long adventure traveling home after Boston’s Loganairport closed.When the markets re-opened several days later, I opened thebrokerage window on my laptop once again. Not selling butbuying. Not because I knew anything about bottoms orvolatility or sentiment extremes but because I thought itpatriotic to support the market with whatever I could muster.Meanwhile, after more than a dozen years in industry the workfelt like drudgery punctuated by corporate battles. I started totake financial independence more seriously. I’d learned earlyon not to trust financial advisors. I’ve lost enough being “putin” funds– thank you. I hate being “put in” funds. I decidedto make time to seriously learn to manage my own money.When I sold my house in Saratoga, CA in late 2002, I hadmore ready cash, and thought, “Now I can really give trading awhirl!” With what now, in hindsight, seems like amazinglylittle research, I plunked the proceeds of the sale into a couplestocks. Right there in the office, I just casually put my lifesavings on the line and went off to a meeting.Right. I was quietly freaking out. Back in my office glued tomy screen, I watched as every little tick of the stock pricesdrove my account balance wild. When it was up, visions of
private jets flew before my eyes. When it was down, mywhole insides just shriveled in fear – I couldn’t even seestraight.Sometimes fear is the appropriate emotion. That was just toobig, too reckless and I am too anxious to be doing that. Iliquidated to cash, ran out of my office, and went for a blazingwalk around the park thinking, “I’m sure glad I don’t have todo THAT for a living!”So back I came to “make a difference” in the corporate worldwith renewed vigor. My career enthusiasm didn’t last long.Surviving something scary can be exhilarating and soon I wasback looking for more exciting market adventures. Besides Iwasn’t so sure my current middle management position wasreally making much difference in the world anyway. On top ofthat my father had passed and I needed more time to help myelderly mother who came to live near me.So I took classes, read dozens of books, and put together atrading plan that promised to set me free. I worked at it until Ihad a quarter where my profits matched my “day job”. Then Iset out on my own.Ah the good life! I rafted the Grand Canyon, snorkeledHawaii, took a trading class in Cyprus, another in Florida, anda third in Arizona. Every day, my laptop came out and Imanaged my trades before going back to my fun. I competedin the Spike Group trading contest, earning two silver medalsfor quarterly performance and growing confident.Things started to change – gradually at first. Gradually as inthat scene from the movie Jaws where the lady is treadingwater and first experiences a surprising little tug on her leg.Okay, that’s too dramatic. You can see where I get anxious.Really what happened is more subtle. While traveling inEurope, trading the US market is an after-dinner activity. Onenight, I got on the wrong side of a trade and couldn’t let it go.Unfortunately, I stubbornly tried to tell the market what to do— an expensive tantrum.Next day, I thought it prudent to eat a little extra from thebreakfast buffet and enjoy a light, inexpensive dinner. By
Portugal, I was packing away boiled eggs from the breakfastbuffet because that was going to be dinner as my trading lossesgrew.No job and losing money in the market. How frightening isthat?I’d like to think I have other prospects. But I hear a youngerwoman sits in my office now. My secret fantasy working atREI with all the cool outdoor products doesn’t include sorefeet and embarrassment of waiting on my former colleagues.Anyway, the credit crisis and subsequent retail contractiontook care of that.No choice but to make money from the markets! Except that’sway too much pressure to trade. With more computer skillsthan market savvy, I decided to sell my backtesting research tofund my ongoing studies of the market. Now I offer reports,videos, software and an alerts service to the public. Also, I doconsulting on strategies for trading and investment.The really great thing about starting this business turns outNOT to be the money. First off, it rekindled my love ofcomputers, software and even customer support. But the bestthing is really the amazing things I’ve learned from my clients.One of my biggest clients, Fidelity Investments, asked me towrite an article on sector rotation1. I saw the potential oftrading a rotation strategy but needed to work out a few issuesraised in the article.Well, “working out a few issues” amounted to developing myown portfolio simulation software, acquiring historical data,running endless tests — basically starting over from scratch toresearch ETF rotation in the context of diversified portfoliomanagement. This book is the summary of my new research.One other important comment:I’m not a registeredinvestment advisor. The quantitative results and discussion inthis report are meant for educational purposes only – notspecific investment advice. You are in charge of determiningwhat fits your needs and temperament. All trading andinvestment comes with risk of loss and is not for everyone.
How to Compare Investment StrategiesThis section discusses metrics to compare investment andtrading strategies. Yes, it is dry, but the reading will make iteasier to understand the nuances of the backtestingperformance of the various strategies presented later in theBeat The Crash series of books. You may want to skip to thenext chapter (How Index-Makers Rule) if you are alreadyfamiliar with mathematic concepts or simply uninterested indelving deeply into investment return measurements.Everything Is RelativeIs 6% per year a good return? It depends on your perspective.To investors looking to meet specific personal goals, such asproviding for the kids’ college or paying the monthly bills inretirement, the absolute return may be all that counts. If itmeets the need, fine. If not, keep looking.Relative returns, on the other hand, make a comparison to abenchmark because everything’s relative. In a good year, a6% return may seem quiet beside the roar of the market. In acrash however, it’s a smug investor who comes out ahead by6%.What is the Golden Standard for Comparison?The investment world tends to compare returns to one of twodifferent standards.The first is the risk-free return, typically assumed to be theinterest paid by short-term US Treasury bills. This is oftenused in the risk / reward computations such as Sharpe Ratio,which is how its used in this book.Another tactic is to compare returns to the most relevantbenchmark. For example, a stock mutual fund compares to theStandards and Poor’s S&P 500® and a bond mutual fundcompares to a bond index.
The trouble is that both of these golden standards have beenoff their game in the last decade. Interest rates droppedthrough the floor, tempting conservative investors to take morerisk to get anything back on their money. Since 2000, thesecular bear market shredded the previously glowing stockmarket returns.A Better BaselineWhen deciding on an investment strategy, it’s better to makerelative comparisons between different strategies over thesame time period. However, just comparing to non-existentinterest rates or an erratic bear market is too easy.A better baseline is one that produced decent returns and isalso easy to operate. For the Beat The Crash series of books, adiversified portfolio of assets represented by mutual funds orExchange Traded Funds (ETFs) will form the baseline. Moreon that in the upcoming chapter, How to Create a DiversifiedPortfolio.What Metrics to Compare?Having decided on a baseline for comparison, next comes thechoice of what attributes of each investment strategy tocompare. Read on for an overview of the metrics that will bereported for the baseline diversified portfolio and for eachinvestment strategy in the Beat The Crash series of books.Price Gains alone do not include dividend / interest paymentsso they do not present the whole picture even though they arerelatively easy to come by. Typically, only price gains arepresented in other publications. That is inaccurate and givesstocks an apparent advantage over bonds and other dividendpaying instruments.Total Return is the price of the assets plus its dividendpayments. Dividends do matter, especially when dealing withbond funds. This is also the money that ends up in youraccount! Beat The Crash will rely on total returns includingdividends for both backtesting and reporting.Returns may be expressed in several different ways, each withits own advantages and disadvantages.
Year-by-Year Return gives a feel for how the strategyperformed. It exposes the trade-offs between strategies thatmay have similar average returns and varying volatilities. Forexample, this is where you can most simply see the differencebetween a strategy that plods along earning about the same peryear versus a wild ride that wins big, loses big and averagesout about the same. It is hard to compare lots of strategiesyear-by-year so this level of detail will only be presented inselect situations.Compound Annual Growth Rate (CAGR) is comparable tointerest rates. Applying CAGR each year takes you from theinitial account balance to the ending balance albeit moresmoothly than the real ride. Geometric Mean is the generalconcept behind CAGR. The geometric mean is the metric ofchoice for academics interested in the Optimal GrowthStrategy. Intuitively, it makes sense to make this as large aspossible. Who doesn’t want a fast growing portfolio, if all elseis equal?Average Return is easy to calculate as the arithmetic meaneach period’s return, but simply taking a starting accountbalance and applying the average return each year won’t givethe ending balance like CAGR. Keep in mind that a loss of50% requires 100% gain to recoup!Average return is also the mathematical expectancy, if thesample size is large. The arithmetic mean, along withvariance, is the metric used by Modern Portfolio Theory,which forms the basis of your financial advisors’ mandate todivide assets between stocks and bonds according to your ageand risk preferencesExcess Return Over “Risk-Free” Return shows how thestrategy did compared to keeping the money in the safestknown investment vehicle. The risk-free rate has variedconsiderably over the test period for these financial strategies.Many computations boil down the risk-free rate to one numberto represent the whole test period. Instead, I use the actual rateof 3-month US Treasuries available on each day during the testperiod. I don’t care if my stock holdings beat the average of
risk-free rates, but I want to know if the stock strategies beatthe risk-free rate offered at that time. This is especiallyimportant at the present time when the 3-month rateapproaches zero but was up over 8% in 1990.Risk MetricsImagining the upside of investment strategies is great fun butanyone who has ever put money in the stock market knowsthat it’s not all beauty and grace. As prudent investors, weneed ways to estimate how much the various strategies exposeus to risk and how well they reward us for bearing risks.Drawdown measures equity drops from peak to troughwithout regard to monthly or annual boundaries. It takes thehigh point of an account balance and subtracts the low point totell you how much went missing during a market downturn.Once again, we will rely on total returns because dividendscan soften the blow of drawdowns.While drawdown is relatively easy to visualize, it is harder toplug into the probabilistic functions that allow us to comparerisk-adjusted returns across different horizons and anticipatewhat else might go wrong based on what has historically gonewrong.Volatility expressed as the standard deviation of returns isoften adopted as a measure of risk because it is a way toquantify the possibility of nasty surprises. Computing thestandard deviation allows the math geeks among us to useprobability theory tools to estimate the likelihood of returnswithin a range.Beware that the stock market does not follow all theassumptions that go with the usual probability estimates suchas a normal distribution. Historically, the stock market hasmisbehaved much more often than would be expectedaccording to probability theory. It is said that market returnsexhibit “fat tails” because the occurrence of the unlikely hasn’tdropped to nothing as quickly as the math might indicate.Since most of us don’t think in terms of probabilitydistributions, the Sharpe Ratio is useful as a single metric thatquantifies risk and return. It is defined as the average returns
above a benchmark divided by the volatility or standarddeviation of the returns above the benchmark. It can becalculated on either a monthly or annual basis.A key decision when calculating the Sharpe ratio is what touse for the benchmark return. For simplicity, and since theannual returns are a broad brushstroke, a single number of2.8% is used. That is the average annualized 3-monthTreasury rate for the period of 1990 – 2011. When calculatingthe monthly Sharpe ratio, however, we’re getting down intothe gritty details and then the actual month-by-month 3-monthTreasury rate is used.Unfortunately, most documents and prospectuses do notdisclose the benchmark used for the calculation of the Sharperatio. Also the Sharpe ratio will vary depending on the timeperiod applied. For those reasons, it’s actually dangerous tocompare Sharpe ratios across various publications. Within theBeat the Crash series of books, you can be assured that theSharpe ratio calculations are applied consistently and thususeful for evaluating the relative performance of theinvestment strategies tested.As typically calculated, the professional measures of riskadjusted performance carry us away from the notion thatdrawdown is the bad guy. Anything based on standarddeviation as a measure of volatility penalizes us for upsidegains as well as downside losses which may seem harsh. Thecommon-sense explanation is that if something went upabruptly in good times it has the potential to go down sharplywhen things turn sour. Also, preference is given to strategieswith more consistent returns rather than a few big winnersbecause a consistently growing account balance makesfinancial planning easier.Many other risk metrics exist. For example, the Sortino ratiois very similar to the Sharpe ratio except that it does notpenalize for good returns because is based on the semivariance. To calculate it, only the negative variance from therisk-free return was calculated. The Sortino ratio generallycomes out with a larger number than the Sharpe ratio.
The Beat the Crash series of books will primarily reportmaximum percentage drawdowns, standard deviation, andSharpe ratio to answer the key question: Did hopping in andout of the market actually improve the risk-adjustedperformance for investors?Other Interesting StatisticsOther statistics can be of interest when mulling overstrategies. Highlights are
Number of trades per yearAverage holding time of each tradeWin rate (% of times selling for a profit)TimeframesRepeatedly, I’ve said that you can only compare certainmetrics within the same time period. So what timeframes arewe considering for these experiments in investmentmanagement?The limiting factor is getting good data for the backtesting.US Treasury interest rate data back to 1990 is at our fingertipson the web. However, most of the interesting ETFs weren’tavailable until 2005. Mutual funds pre-dated ETFs, however,passively managed mutual funds that follow market indicesdid not come into vogue until the 1990’s. Yes, Vanguard cameout with a fund that mirrored the S&P 500 in the late 1980’sbut it wasn’t until 1997 that an interesting selection of indexfunds for foreign and domestic markets came out. On top ofthat, we need about a year’s data to look back upon whenmaking the first investment decisions in our strategies.After careful consideration of all the factors, the simulation forthis report will focus primarily on the following time periods:
2005 – 2011 for recent ETF performance
1998 – 2011 the largest period with enough funds tomake ETF rotation interestingStrategy Simulation via BackTestingBacktesting measures the relative performance of a set ofinvestment strategies by simulating the strategies on historicalprice data. Backtesting can be done by hand but is usuallyautomated by computer software these days. The rules forbuying and selling are objectively defined and programmedinto the backtesting engine which proceeds day by day throughthe price data and records the results from all the trades.Since backtesting relies on past data, it makes no guaranteesabout upcoming performance and can’t say whether a strategywill do as well in the future as it did in the past. However, if astrategy didn’t perform in the past, there’s no reason to believeit will suddenly turn into a winner. It pays to avoid strategieswith a losing track record.Although most traders agree that backtesting is useful, manypeople don’t do it because of the time, expense, and expertiserequired. To produce the relatively simple backtesting reportsin this book, I spent nearly $1000 on data and two monthspart-time developing and testing the strategies.Backtesting is not perfect. Although I’ve made the extra effortto include dividends which are typically not considered bycommercially available backtesting engines, I did not modelthe effects of commissions or slippage. This matters more ifyou trade frequently or trade extremely large size.Since most tactics in this book result in rather limited accountactivity, commissions probably do not play a huge role in theperformance of the strategies in this book. In fact, at the timeof this writing Fidelity Investments is offering commissionfree trades on most iShares ETFs which are the instruments ofchoice to implement this rotation strategy. So the effects ofcommissions should be insignificant.Other inaccuracies that may affect the results include my tacticof simulating the execution of buy/sell orders each day at theclose, and assuming we get the closing price. Strictly
speaking, this is peeking because we really can’t know theclosing value until it is too late to trade.In practice, however, many of us check for trading signals at3:30pm eastern time and squeeze in an order just before theclose. Another approach for end-of-day trading is to set alimit order for the next day’s open based on the closing priceon the day of the signal. This can be a leisurely way to avoidslippage – until the market moves quickly and the trader isforced to play catch up.Backtesting is not reality. It is a model of reality – like a flightsimulator. I expect professional pilots to gain experience in aflight simulator, even though all the nuances of aviation arenot modeled exactly. Just because a pilot does well in thesimulator, it’s no guarantee that he/she won’t make an error inthe air. But I really do not want to ride with a pilot thatpersistently crashes the flight simulator!So it is with backtesting. It can tell us strategies to avoid –that’s for sure. A strategy that passes backtesting qualifies forfurther investigation and controlled forward-testing before aprudent investor puts much capital behind it. And even then,it’s wise to expect the completely unexpected and sizeaccordingly.
How Index-Makers RuleSince making relative comparisons is the way to assess marketstrategies, the first thing to do is establish a baseline forcomparison. In the case of absolute returns, the baselinebecomes the “risk-free” interest rate. Unfortunately, that rateapproaches zero at the moment. For those interested inbeating the market, some form of market return is needed forthe baseline.Academics and experts are quick to point out that the odds ofdoing better than average in the markets are slim. Just askanybody that makes their living running index funds thatinvest in the averages.Way back in time, the Dow Jones 30 Industrial Averageseemed to be the favored market proxy. With the rise of indexfunds, the S&P 500 index of large company stocks became theposter-child for the stock market. I recall getting advice in the1990’s to simply invest in a fund that passively mimicked thebehavior of the S&P 500 and call it good. People piled ontothe indexing bandwagon and it seemed to work well. Newfunds sprouted that follow every conceivable index.After the millennial market crash, the S&P 500 index wasslow to get off the mats. Other areas of the market did better,notably small company stocks. The Russell 2000 index is thewell-known benchmark for that segment.Benefits of Following an IndexA key benefit of index funds is that they are diversified acrossmany companies in their designated market segment. TheRussell 2000 spreads the risk of small company ownershipbetween 2000 firms. If any one of them hits the skids – whichhappens, especially early in the fight to establish a market base– the impact on the overall index is limited.If a company should implode altogether, it is removed fromthe index and replaced with a stronger contender. Notimmediately, though. If the company is still able to limp alongit may be given a chance to correct its deficiencies. Also,