Alpha Power Investing Newsletter

October 9, 2013


Each year Standard and Poor's (S&P) issues its SPIVA (Standard and Poor's Indices Versus Active Funds) report. This report compares the relative performance of mutual funds to their benchmark indexes. In other words, large-cap funds are compared to the S&P 500, mid-cap funds to the S&P 400, and small-cap funds to the S&P 600. Standard and Poor's has been doing this for more than a decade and compiled an extensive database for use in the indexing vs. active management debate.

Index funds now hold about 20% of equity mutual fund assets in the U.S. More and more investors have come to realize that actively managed funds that beat the market long-term are extremely difficult to identify due to their scarcity. The SPIVA data confirms this. The table below shows the percentage of funds that were outperformed by their benchmark index for five years ending in 2012.

Naturally, the percentage of funds that continue to underperform their benchmarks over multiple five-year periods is much greater.

This result should not be surprising when you think about it. The mutual fund industry consists of thousands of "experts" competing against one another every day. Since 80% of all common stock in the U.S. is traded by institutions (such as mutual funds) it is almost axiomatic to conclude that they are the market. Throw in high fees for management and trading costs and it is inevitable that the majority of funds will underperform comparable indexes that have no fees and no trading.

Quite clearly, stock picking portfolio management by "experts" is a self-defeating game in the aggregate. The long-term winners in this game are few and far between because they are, by definition, mavericks who think outside the box.

Assuming that you are not such a contrarian maverick, how do you outperform the market using stocks as the investment vehicle?

The answer comes in three steps:
  1. When you're in the market, hold an index fund.
  2. Be in the market only during seasonally favorable periods.
  3. When in the market, hold mid-cap stocks (i.e. the S&P 400).

The first step follows the SPIVA findings. The second step follows from long-term research which shows that the market is most robust from late-October to early-May. This is a global phenomenon which is caused by late in the year "expert" predictions about the upcoming calendar year. These predictions are mostly optimistic and often mistaken. By early-May investors begin to get a realistic picture of calendar-year earnings and adjust accordingly. This explains why, since 1949, the Dow Industrials from November through April have had an average daily appreciation that is 27 times greater than the average daily appreciation the rest of the year.

The third step follows from the fact that small/mid-cap stocks outperform large-cap stocks during bullish phases in the market. Over the past 32 years, mid-cap stocks have had the best risk/reward profile. Since 1981, the S&P MidCap 400 Index has had an annual return of about 13.6%, a 28% annual premium to the S&P 500, with less severe drawdowns.

Our three steps yield an extremely simple long-term investment strategy that is easy to put into action: from November through May, own the S&P MidCap 400 Index, then switch to intermediate treasuries (use an index fund) for the remaining five months. The table below shows the performance of this strategy compared to the S&P 500 since 1981 (the year the S&P MidCap 400 Index was created).

Our simple strategy had one down year (1994: -6.7%) compared to the S&P 500, which was down six times over the period. Most importantly, since 1999, while the S&P 500 suffered through two devastating bear markets, our strategy avoided them because the bulk of the declines occurred between May and November.

Today's investors should keep in mind that we have enjoyed a robust bull market since March of 2009. All that was lost in 2008-09 has been recovered, especially in the small/mid-cap universe. This cycle is not complete until a bear market wrings out the excesses that have accumulated over the past four years. Odds are that this will happen mostly during the seasonally unfavorable periods in the future. The actions of the Federal Reserve have undoubtedly delayed this reckoning, but I doubt that all of the gains since 2009 are durable and "built in".

For a complete description of the Alpha Mid-Cap Power Index Managed Account strategy, go to our website at and click on Programs and Performance.

Sincerely yours,

Jerry Minton, Ph.D.
1-877-229-9400, Ext. 11

Disclosure: Past performance is not a guarantee of future performance.

© 2013 Alpha Investment Management, Inc.
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