In the previous two installments of this series on active management, we’ve covered a fair amount of ground. As such, a short recap is in order. We’ve established: 1) The stock market provides a positive return over long-term periods following a random walk around an upward drift. We showed this using the Russell 3000 index going back several decades. 2) The stock market can be subdivided along “factor” dimensions including size (Large and Small Cap) and style (Growth and Value). Dividing the market in this way reveals distinct performance differentials between sub indexes that can result in large performance deltas where there is zero stock selection skill involved. 3) We cautioned that looking at such sub-indexes can lead to chasing behavior and other things that can damage long term returns. 4) We also cautioned that when evaluating money managers (mutual funds or ETFs) it is easy to get fooled by strategies that simply follow one of the sub-indexes. We can confuse habitat for skill and can wrongly conclude a manager is either good or bad based on their preferred habitat when their skill (good or bad) has a much smaller impact than habitat.

With that as a backdrop, let’s turn to the rotations we see in the annual calendar years between Large Cap Growth, Large Cap Value, Small Cap Growth, and Small Cap value. Remember, these returns are all encapsulated inside the Russell 3000 Index. If you don’t parse the data, you’d never see it. The chart below plots each year, beginning in 1995, along the four dimensions. The first year, 1995, is plotted in red. It looks like this:

In a video we will release in a few days, we will walk through all years starting in 1995 to demonstrate how random the movement is from year to year as one steps through this chart, one year at a time. The point is this is random and it is consequently extremely difficult to consistently pick the winning quadrant in advance. To demonstrate this challenge, we are going to conduct an experiment in which we follow one of two simple rules: 1) We will create one time series that is built by investing in last years’ winning quadrant, and 2) We will create a second time series that buys the opposite quadrant from the winning quadrant. We will see how these strategies compare to simply buying the broad Russell 300 index or any of its subindexes.

But before we show you the results, we’d like you to choose a strategy in advance. You can choose to: 1) Own one of the Russell Indexes over the entire period. This would be one of the following five: Russell 3000, Russell 1000 Growth, Russell 1000 Value, Russell 2000 Growth, or Russell 2000 Value. 2) A trend following strategy that buys the prior years’ winning index, or 3) a mean reversion strategy that buys the laggard index from the prior year. Give it some thought and pick your index or naïve strategy. Now, the chart shows the results below.

It turns out that the winning strategy since 1995 would be buying the Russell 1000 Growth Index. This index produced a 4.45x return over nearly 30 years. Really this is a function of that index’s massive outperformance since 2016. The second-best strategy would be the mean reverting strategy (buying the prior years’ losing strategy.) This produced a 4x return over the period. Next up is the trend following strategy (buying last year’s winner.) This strategy produced a 3.85x return over the period. The Russell 1000 Value returned 3.65x the initial investment followed by the Russell 3000 Index, returning 3.53x. The laggards were the Russell 2000 Growth and Russell 2000 Value Indexes, returning 3.45x and 3.26x, respectively.

The real question for the investor is what would you choose for your go forward investment strategy and why? What about the Fama French research showing small cap and value should outperform based on risk premium theory? Do you want to load up on small cap value hoping it mean reverts over the next couple decades? Do you want to tilt to it or small cap in general hoping small cap mean reverts? Or is it dead? Do you want to load up on large cap growth because it is going to be great forever (does ANYONE really believe Large Growth can repeat its dominance for 30 more years?) Do you want to adhere to one of the two naïve timing strategies of either buying last years’ winners or buying the prior losers? Or do you want to dismiss all of this in favor of the simple “set it and forget it” Russell 3000 Index exposure? The reality is that choosing an active strategy is a craps shoot.

Our approach at WealthPlan has always been to help you identify what you want and need from the capital markets (returns, risk tolerance, income needs, etc.) and then to invest in a portfolio that has the highest probability of helping you hit your target over the long term. Engaging in a strategy to try to get more return from the markets by engaging in the exercise outlined above or something like it, most often results in performance chasing and, ultimately, frustration and bad outcomes. For most people, it is simply not worth the attention, frustration, and anxiety that comes from trying.

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DISCLOSURES

The Russell 3000 Index is a capitalization-weighted stock market index, maintained by FTSE Russell, that seeks to be a benchmark of the entire U.S stock market. It measures the performance of the 3,000 largest publicly held companies incorporated in America as measured by total market capitalization and is approximately 98% of the American public equity market. The index, which was launched on January 1, 1984, is maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group.

The Russell 1000 index is a United States market index that tracks the 1000 largest companies. The Russell 1000 index is an important gauge for how US Large Cap stocks are doing. This index is very closely correlated to the S&P 500 since they both cover large cap US stocks. Additionally, the Russell 1000 has had its largest drawdowns during the Tech Bubble in 2002, and the housing crisis leading to a recession in 2009.

The Russell 2000 tracks the roughly 2000 securities that are considered to be US small cap companies. The Russell 2000 serves as an important benchmark when investors want to track their small cap performances versus other sized companies. The Russell 2000 tends to have a larger standard deviation in comparison to the S&P 500.

The Russell 3000 Value Index covers United States securities with a focus on value from a fundamental perspective. This index can be important for investors that would like to benchmark for a value or conservative portfolio. Historically, the Russell 3000 Value index tends to have smaller drawdowns during pullbacks in the market, but also lower returns when the overall market is trending higher because of the characteristics of the underlying holdings.

The Russell 3000 Growth Index covers United States securities with a focus on higher growth rates overall. This index can be important for investors that would like to benchmark for a growth or aggressive portfolio. Historically, the Russell Growth index tends to have larger drawdowns during pullbacks in the market, but also higher returns when the overall market is trending higher because of the characteristics of the underlying holdings.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed.

No investment strategy can assure success or completely protect against loss, given the volatility of all securities markets. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future. All performance referenced is historical and is no guarantee of future results. Securities investing involves risk, including loss of principal. An investor cannot invest directly in an index.

The information in this communication applies solely to the intended audience and in no way amends, revokes, or otherwise alters the existing agreements and relationships between WPIM and its clients.  This communication is not a binding offer, expressed or implied.  WPIM undertakes no obligation to update or revise the information herein or in any referenced third-party resource due to new information, future events or circumstances, or otherwise.

WealthPlan Investment Management (“WPIM”) uses data compiled and/or prepared by third parties (“Third Party Data”) in the delivery of Licensed Research and Data. Third Party Data is not owned by WPIM and user may be required to obtain permission directly from third parties for further use of Third-Party Data and may be required to pay a fee depending on the use contemplated by the user.