Warren Buffet is WRONG about Index Funds?

Warren Buffet is one of the world’s most successful investors. In an interview, he was asked what advice he would give to individual investors. His response was that most people should put their money in an index fund. An index fund is a type of investment fund that tracks a specific market index, such as the S&P 500. Index funds are often seen as a more passive form of investing, as they do not require the same level of research and analysis as other types of investments. However, they can still be quite profitable, and they offer a number of advantages over other types of investments. For example, index funds tend to have lower fees than actively-managed funds, and they are less likely to underperform the market over the long term. As a result, Buffet believes that index funds are the best option for most individual investors.

And Warren Buffet is NOT wrong... (just incase if you missed there is a question mark in the title of this blog post)

Why passive investing with an index fund is a "good option" for most buy-and-hold investors

For the average buy-and-hold investor, passive investing with an index fund is often a good option. Index funds offer several advantages, including low fees, broad diversification, and ease of purchase. Index funds are also generally more tax-efficient than actively managed funds. While index funds do not outperform the market every year, over the long term, they have consistently outperformed actively managed funds. For most investors, then, index funds offer a simple and effective way to build a diversified portfolio that is designed to meet their long-term goals.

... but

Holding through a drawdown periods of like 40-50% requires investors to have a lot of guts.

A max drawdown is the peak-to-trough decline during a specific period for an investment, portfolio, or fund. A max drawdown can be measured for a variety of time periods, but is most commonly calculated on a rolling basis. For example, a 50% max drawdown over a 10-year period means that the investment lost 50% of its value at some point during those 10 years but recovered and eventually regained its original value. The index funds have gone through 40-50% max drawdown periods in market history. While it is reassuring to know that over a long horizon stocks and so the index funds do go up and recover any losses but not everyone is a brave-heart to sit through unperturbed during the periods of their retirement pool getting halved! 

Our backtests have shown that there may be a better way through hedging one's index fund portfolio.

Hedging is a risk management strategy used by investors to protect themselves from losses. By hedging, investors essentially take a "bet" on both the positive and negative outcomes of an event. If the event turns out to be negative, the hedge protects the investor from losses. Conversely, if the event turns out to be positive, the investor still has the potential to make money. In this way, hedging can help to reduce downside risk and protect against losses.

We ran a backtest from 2007-2022 (September) to test out a hypothesis of if we hedge with one negatively correlated asset and one low (almost no) correlated asset with an index fund can it deliver a more 'peace-of-mind' kind of a portfolio that performs decently well and at the same time minimizes the drawdowns.

Performance Comparison of Index Fund Hedging vs Index Fund

Disclaimer: Note that this for educational and entertainment purposes only and is not an investment advice and past performance doesn't guarantee future results.

We used QQQ (Nasdaq 100 ETF), PSQ (1x inverse Nasdaq 100 ETF), and GLD (Gold ETF). PSQ is the negatively correlated asset with QQQ, and GLD is the low correlation asset.  The results indicate that this may be a better way as it delivers a good CAGR with a much-reduced max drawdown. Also higher Sharpe, and Sortino Ratio. And a lower correlation with the market.  

CAGR is short for Compound Annual Growth Rate, and it's a way to measure how an investment grows over time. To calculate CAGR, you take the beginning value of an investment, divide it by the ending value, and then raise that number to a power that equals the number of years in the investment period.

The Sharpe ratio is a risk-adjusted measure of returns developed by economist and Nobel laureate William Sharpe. It tells us how much excess return we're getting for the amount of risk we're taking. In other words, it allows us to compare different investment options regarding the return per unit of risk. To calculate the Sharpe ratio, we first need to calculate the excess return of an investment over the risk-free rate. The excess return is the difference between the investment's return and the risk-free rate. The risk-free rate is the return on a theoretical investment with zero risks; in practice, it's usually the yield on a government bond. Once we have the excess return, we divide it by the standard deviation of returns to get the Sharpe ratio. The higher the Sharpe ratio, the better the risk-adjusted returns.

The Sortino ratio is a risk-adjusted performance measure developed by Dr. Frank Sortino in the early 1990s. The ratio is similar to the Sharpe ratio, but it attempts to isolate the negative (downside) risk of an investment as opposed to the total risk. Essentially, the Sortino ratio measures how much return an investor receives per unit of downside risk. To calculate the Sortino ratio, one first needs to calculate the return over a specific period and then adjust for downside risk. There are two ways to adjust for downside risk: either by using a standard deviation or by using a value at risk (VaR) measure. Standard deviation is a statistical measure of dispersion that captures all types of risk, while VaR only captures market risk. Once the return has been adjusted for downside risk, it is divided by the downside risk. The result is the Sortino ratio. A higher Sortino ratio indicates better performance, and a lower Sortino ratio indicates worse performance.

How to use relative strength to identify individual stock opportunities within the index fund

While hedged index fund may be a good buy-and-hold kind of portfolio opportunity but there are also a number of drawbacks from the perspective of active or semi-active investor and trader. One of the biggest problems with index funds is that they often hold a large number of stocks that are not performing well relative to the rest of the market. As a result, investors and traders in these funds may miss out on potential opportunities.

One way to overcome this problem is to use relative strength to identify individual stock opportunities within the index fund. Relative strength is a measure of how a stock is performing relative to the overall market. Typically Relative Strength (RS) is expressed as a percentile rank of the stocks based on their relative performance to an index or the market i.e. it shows what percentage of stocks have performed below a given stock. For example, RS of 95 means that 95 percent of stocks performed below the given stock.

Top 4 Percentile Relative Strength Scan for constituents in the S&P 500 Index on Researchfin.ai

Disclaimer: Note that this for educational and entertainment purposes only and is not an investment advice and past performance doesn't guarantee future results.


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If you are interested in learning more about a systematic way to trade, the foundational book on Systematic Trading written by Ruban Phukan our Co-Founder & CEO, provides a great introduction into this world and gets you familiarize with the concepts.