When we’re doing our due diligence on an Alternative Investment, one of the first questions we dig into is what are the market environments where the program struggles to find returns. And once we get into when they’re likely to do poorly, we then analyze just what that poor performance looks like. In essence – how bad is it when it’s bad?

Does everyone/anyone who tracks the stock market with low cost index tracking ETFs does the same? With stocks all but flat since mid-way through 2014, some investors are starting to question where the returns are, rightly so. But the stock indices aren’t human. We can’t tell them to try a little harder. Or go for a moonshot. Or shake off the rust and get back into the game. No, the stock indices are a rule based investment model.

So while pundits and economists are grasping at straws to identify the problem, we’re more apt to ask the manager of the investment model “Why is the current market making it difficult for your trading model to find returns?”

We’ve said this before, but it bears repeating, stock indices like the S&P 500 are a trading system; or if you prefer a set of investment rules or stock picking model. Look no further than Winton Capital’s CEO on the matter. We really couldn’t have said it better.

Harding: “The S&P 500 is a trading system. The S&P 500 is a set of rules for buying and selling stocks. And by the way… not a very good one!

Think about this for a second. If you took the S&P 500’s monthly returns and put them under some sophisticated sounding hedge fund name, everyone would tell you the drawdowns are too large and last too long, while the annualized volatility is too high for the performance it generates. There would be a Bloomberg article demonizing the system for large drawdowns and for tricking investors.

And what’s worse, this model is a one trick pony. It’s solely focused on one asset class, and only makes money when that asset class goes up. Of course, it does have the Fed doing everything in its power to avoid a 20% drawdown in the markets at the cost of creating a future bubble. Not to mention buybacks are preventing real growth while 3 companies make up 10% of the market’s capitalization.

Put that all together and the S&P 500 is nothing more than an investment model that is high reward-high risk. We dare say, it’s a very basic equity focused hedge fund, choosing which stocks to “own” and which to avoid. To paraphrase Captain Barbossa, “You better start believing in hedge funds Ms. Turner – you’re in one!

 

Barbossa Ghost StoriesThere’s bouts of volatility, drawdowns, and low risk-adjusted returns. But that doesn’t make the most beloved system in the world a bad investment. By all means, take a look at it. There’s a lot to like. Chief among them is probably choosing to align yourself with the majority of investors out there; the government and a huge industry hell-bent on seeing it go up year after year.

The S&P 500 isn’t a bad investment, it’s just not a good one. It will test your nerve, and then test it some more. As a recent post by Reformed Broker noted:

Just because it’s cheap and easy to get exposure to stocks these days, that doesn’t mean it’ll be mentally cheap and easy to stick with them.