The S&P 500 index is a very popular benchmark for U.S. stocks. Even Warren Buffet is a fan. For the fortune he’ll leave behind, he’s requested a 90% allocation in an S&P 500-based fund.
There are many S&P 500 mutual funds. There are also exchange-traded funds (ETFs) like the SPY (SPDR S&P 500). Despite the S&P 500’s popularity, we think there are better choices for non-TSP investing. This is true whether you buy and hold or invest actively (market timing, seasonal strategies, etc.).
Equal weighted instead of cap weighted
One problem with the S&P 500 is that it’s market cap-weighted. This means larger companies get more “weight” in the index. At the time of this article, Apple makes up 3.88% of the index. Some smaller companies have less than a 0.015% weighting.
This has several disadvantages. First, smaller companies usually grow faster. They also perform better than large stocks over the long term (more on that in a minute). In addition, cap weighting hurts diversification. There are 500 stocks in the S&P 500, but 10 companies determine almost 20% of its performance.
Fortunately, there’s a solution. Funds like RSP (Guggenheim S&P 500 Equal Weight ETF) give equal weight to each stock in the index. Since 2004, RSP has an annualized return of 9.25% compared to 8.07% for the SPY.
Smaller stocks = better returns
The S&P 500 is made up of large stocks (“large caps”). Years ago finance academics discovered small-cap stocks outperform large caps. Since 1972, the annualized return of small-caps is 11.84% compared to 10.17% for large caps.
The most popular small-cap index is the Russell 2000. A popular ETF based on the Russell 2000 is IWM (iShares Russell 2000). The IWM has outperformed the S&P 500, but we can improve our results by digging a little deeper.
Mid-cap stocks don’t get as much attention as small caps, but they’ve done even better. Since 1972, their return has been 12.04%. Since ETFs haven’t been around that long, we can only compare the MDY (mid-cap ETF) to the IWM since 2001. In addition to a higher return, the MDY had a slightly smaller drawdown in 2008 and better risk measurements.
If you want to invest in small-caps, we favor the IJR (iShares S&P SmallCap 600 Index Fund) over the IWM. It’s based on an index of 600 small-cap stocks that must pass a financial test. Since 2001, its return has been 9.60% compared to 7.99% for the IWM. Or you can do a 50/50 split between MDY and IJR for better diversification.
Since 2010, annual returns of the U.S. stocks have tripled those of foreign stocks (13.22% vs. 4.39%). This pattern probably won’t continue, though. U.S. stocks and foreign stocks go through periods of outperforming one another. From 2002-2007, foreign stocks more than doubled U.S. stock returns.
A new trend may already be underway. The EFA (iShares MSCI EAFE international ETF) is up 14.43% from January-May 2017. By comparison, the SPY only has an 8.48% gain. Almost all financial measures–such as the price/earnings ratio–suggest international stocks are a better value than U.S. stocks. And emerging markets are even cheaper than developed foreign nations.
The EFA is very similar to the I Fund. Other foreign funds may be more attractive, though. One is the EFAV (iShares Edge MSCI Min Vol EAFE ). The EFAV is similar to the EFA, but invests in lower-volatility foreign stocks. This means their prices fluctuate less. Sine 2012, it’s had a higher return than the EFA while its max drawdown was much lower (8.54% vs. 18.76% for EFA).
Similarly, the EEMV is fund based on lower-volatility emerging market stocks. It’s outperformed the more popular EEM emerging market fund with a lower drawdown.
We also like GVAL (Cambria Global Value ETF). It invests in the least expensive worldwide stock markets. It’s not a low-volatility fund, though. It’s had some large drops and fluctuations. Still, it’s outperformed the EFA and even the S&P 500 since 2015 (GVAL started trading in mid-2014). Very few international funds have done as well in that period.
Finally, there’s DLS (WisdomTree International SmallCap Fund). DLS holds small, dividend-paying stocks in developed international markts. Since it began in 2006, it’s almost tripled the return of the EFA.
For members only
We’re about to post an additional report for TSPKey members. It covers a “quant” mutual fund that’s managed more like a hedge fund. Below you can see its performance vs. the S&P 500. In addition to better returns (13.92% vs. 10.25% annually), it’s had a much better performance when stocks fall–mostly due it’s hedging feature.
There’s usually a $1 million minimum invesment for the fund. However, we found a broker who allows you to invest as little as $2,500 in an IRA. The fund stops accepting new investors afterJune 30 this year, so time is running out.
We’ll also cover a couple of other “quant” funds that have outperformed the S&P 500.
TSPKey does not give personalized investment advice. This is for informational and educational purposes only. Past and/or hypothetical performance is not an indication of future performance. In our non-TSP accounts, we currently have positions in RSP, MDY, EFA, EEMV, GVAL and DLS. Data and charts courtesy of PortfolioVisualizer.com with some modifications.
Before getting to the topic, here’s a brief look at our performance. Our return through the end of April was 6.47%. We remain well ahead of other services tracked by TSPCenter in 2017:
We sometimes get questions from people nearing retirement. They’re usually more risk-averse and wonder if our service is a good fit.
Here’s a typical question: “I’m 4 years from retirement. I currently have 70% in L2040, 20% in G and 10% in F Fund. Should I use TSPKey or stick with my allocation until I retire?” (Note: this isn’t an actual question, but we’ve received similar ones.)
Before addressing this, there are a few things to note. First, we can’t give personalized TSP advice. Second, every situation is different. There’s no one-size-fits-all answer.
Finally, we’ll assume you have a traditional TSP, not a Roth. With a traditional TSP, you can withdraw funds without penalty at age 59 1/2 while employed by the Federal Government or uniformed services.
Here are a few questions for those nearing retirement:
1) Do you need immediate access to your TSP funds when you retire or reach age 59 1/2? If not, how quickly will you withdraw your TSP funds?
2) Are you trying to protect your TSP principal from a market crash? If so, are you still willing to take some risk?
3) If you plan to transfer your TSP to another investment, have you compared the benefits?
Not all risks are the same
Our service is different than buy-and-hold investing. We sometimes have a 100% stock fund allocation, so it certainly isn’t risk-free. However, it’s not the same as permanently buying and holding stocks. We sometimes reduce our stock allocation for two reasons:
1) The stock market’s long-term trend turns negative
2) It’s a part of the year when stocks don’t perform as well historically
We do this to reduce risk. Backtesting shows it kept our losses much smaller than buy-and-hold in 2008. Because of these measures, we never remain 100% invested in stocks for an entire year.
You may not need to change your strategy
If you’d like to preserve your TSP as long as possible, you can take required minimum distributions (RMDs). You can wait until you’re age 70 1/2 before starting RMDs. According to this publication, your first RMD is about 3.65% of your account. When you reach 80, your RMD will be 5.35% of your account.
In normal market conditions, the stock market should outgrow RMDs–at least until your late 80s. The long-term annualized return of the S&P 500 is about 9%.
Of course, there may be down years. The market has bounced back quickly after most corrections, however
But I need to preserve my principal
Let’s say you want access to your TSP in a few years. You also want to preserve most of your account. Since no one knows when a bear market will show up, you want to reduce your exposure to stock funds.
The chart below is a possible solution. Again, it’s not a customized plan for all investors. But it may give you some ideas. Note: TSPKey is always invested either 100%, 50% or 0% in stock funds (C, S and I). That’s why we covered the 100% and 50% scenarios in the table.
To answer the question we started with, those nearing retirement can definitely use our service. If you’re risk-averse, you can tailor our allocations to protect your principal