jebmo’s posthaven

In basketball, 15 out of 18 is a pretty good free throw percentage. I promise readers that know that I enjoy both basketball and investing that this is not another missive on Carmelo Anthony and market efficiency. In the NBA, the best basketball players in the world are shooting on average 76.6%. Lebron James, perhaps the best player in the world, is shooting 77.8%. This article is going to describe a strategy that has beat the market in 15 of the last 18 years (83.3%). Beating the market is more like a 50/50 proposition. In the universe of investors that comprise the stock market, roughly half are going to outperform on a given year and roughly have are going to underperform. Beating the market consistently is harder than standing unguarded fifteen feet from the basket and hitting a shot, but understanding this strategy can offer tips to consistently turn investing into something more closely resembling a lay-up.

In a recent series of articles, I highlighted five strategies for buy-and-hold investors that have historically beat the market. The fourth and fifth parts of this series are factor tilts that when combined have outperformed the S&P 500 (SPY), a commonly referenced market benchmark, with striking regularity.

The Dividend Aristocrats, S&P 500 constituents which have paid increasing levels of dividends for at least 25 consecutive years, have produced a return profile exceeding the broader market by 2.3% per annum over the past nearly three decades while exhibiting only four-fifths of the return volatility. The ProShares S&P 500 Dividend Aristocrats ETF (NYSEARCA:NOBL) closely replicates the Dividend Aristocrats.

The S&P 500 Equal Weight Index is a version of the S&P 500 where the constituents are equal weighted as opposed to the traditional market capitalization weighting of the benchmark gauge. The Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP) replicates this alternative weight index. When the equal-weighted version of the index is rebalanced quarterly to return to equal weights, constituents which have underperformed are purchased and constituents which have outperformed are reduced, a contrarian strategy that has produced excess returns relative to the capitalization-weighted S&P 500 index over long time intervals.

Equal-weighting also gives an investor a greater average exposure to smaller capitalization stocks, a risk factor for which investors have historically been compensated with higher average returns. Over a long time series dating back to the 1990, equal-weighting has beat the capitalization-weighted benchmark by 2.5% per year. In an even longer data series that stretches back to the 1920s, equal-weighting the U.S. stock market constituents has bested capitalization-weighting by 2.8% per year.

Index total returns, including reinvested dividends, for the Dividend Aristocrats and the Equal Weight Index are detailed below. I compare a 50-50 weight of the two indices versus the total return of the S&P 500 (NYSEARCA:SPY).

The Dividend Aristocrats produced a disproportionate amount of their relative excess return versus the S&P 500 in falling markets (see 2002, 2008), and the equal-weighted index produced its relative excess returns in rising markets (see 2003, 2009), combining their return profiles produces a risk profile that exceeds the broader market with less variability of returns.

Combining these two strategies in equal proportions has bested the S&P 500 in 15 of the past 18 years. Singularly, the Dividend Aristocrats have beat the S&P 500 in 11 of the past 18 years, and the Equal Weighted Index has beat the S&P 500 in 13 of 18 years, but combining the two passive strategies in equal proportions has led to even more consistent outperformance.

How good has the outperformance of this strategy been? Any active fund manager beating the market for 15 of the last 18 years would have made himself a lot of money. The geometric average return of this strategy (+10%) soundly beat the S&P 500 (+5.4%) by nearly 5% per year while exhibiting lower return variability.

Over this historically weak period for stock returns that featured two large drawdowns (tech bubble, Global Financial Crisis), a dollar invested in this strategy in 2000 would be worth $5.51 today while a dollar invested in the S&P 500 would be worth less than half that figure, just $2.58, even with the S&P 500 near all-time highs.

In each of the years that the S&P 500 produced negative returns in this sample period, the Dividend Aristocrats outperformed. The worst performance for the Dividend Aristocrats relative to the market has been in 1998, 1999, and 2007 - years that preceded down years for the market. Combining the Dividend Aristocrats with the equal-weighted index, which tends to outperform the market when it is sharply rising, provides a diversification benefit.

The 50/50 strategy's underperformance in both 2015 and 2017 was likely a function of the outperformance of the high-flying tech stocks. Amazon (AMZN), Alphabet (GOOG), and Facebook (FB) were all top ten contributor's to the S&P 500's rise in both years. Since none of these stocks were even in existence for the full 25-year time horizon needed for inclusion in the Dividend Aristocrats, none were included in that half of this strategy. They obviously have a much lower weight (0.2%) in the equal-weight strategy than the capitalization-weighted strategy where they are top holdings.

While there can be periods of underperformance like 2017, I am pretty confident in saying that over the next 18 years, a combination of the Dividend Aristocrats and the Equal Weighted Index will have lower variability of returns than the broader market. Because the Dividend Aristocrats Index is populated by companies that are able to return increasing levels of cash to shareholders through both the peaks and valleys of the business cycle, this index has lower drawdowns in weak markets.

If we believe that this strategy will have lower relative risk to the broad market, will this strategy continue to generate excess returns? I believe that the Dividend Aristocrats will produce excess returns when adjusted for their lower risk over long time intervals. This strategy effectively overweights these high quality companies, capturing the Low Volatility Anomaly, and missing S&P 500 constituents that go out of business. I am sure that some astute readers will note that the Dividend Aristocrats have outperformed the combination with the Equal Weighted Index over the entire dataset. Adding the Equal Weighted Index enhances returns in bullish market environments, allowing the combination to be more consistent together.

While their risk-adjusted performance will remain strong, I do not expect that low volatility stocks, like the Dividend Aristocrats, will necessarily continue to outperform the broader market on an absolute basis. As long-time readers know, I believe that there are structural and behavioral reasons that Low Volatility strategies have generated structural alpha. I am very confident in future risk-adjusted outperformance, but less confident on absolute outperformance of these strategies prospectively as the interest rate environment eventually normalizes.

As I have written before, equal weighting the S&P 500 constituents is an alpha-generative contrarian strategy that also more effectively captures the "small(er) cap premium" than the capitalization weighted S&P 500, and I think that this part of this 50/50 strategy will be an increasing component of its outperformance prospectively.

For passive investors who want broad market exposure, understanding that changing your index weightings to a combination that overweights dividend growth stocks and equal weights the broad market benchmark has historically produced higher average returns with lower variability of returns. I hope this article helps readers to better understand how to combine factor tilts to improve portfolio performance. That's the alpha we are seeking.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long RSP,NOBL,SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.