Index investing has met its match.
Don’t flip out, index investors. The strategy of buying exchange-traded funds and mutual funds that track major stock and bond indexes is both sound and sensible. But the 27-year experience of the Two-Minute Portfolio shows that it is indeed possible to beat the index on a consistent basis in the Canadian market.
The Two-Minute Portfolio was introduced in this space many years back as an experiment in quick and easy portfolio building. All you do is invest equal amounts in the two largest dividend-paying stocks in each of the 10 sectors of the S&P/TSX composite index at the beginning of the year. Size is measured by market capitalization, which is the number of shares outstanding multiplied by share price.
Data for the TMP is processed by Morningstar Canada senior consultant Craig McGee, who reports an 8.9-per-cent total return (dividends plus share price gains) for 2012, compared to a gain of 7.2 per cent for the S&P/TSX composite total return index. Back-testing to the beginning of 1986 shows an annualized total return of 10.3 per cent, compared to 8.2 per cent for the index.
Truth be told, the Two-Minute Portfolio is similar to traditional indexing in that it avoids the guesswork of individual stock and sector selection. But the TMP uses an equal weighting approach for sectors and stocks, while a traditional index takes the market however it comes.
Almost 42 per cent of the S&P/TSX composite index is accounted for by the energy and materials sectors, both of which were pooches last year. Consumer staples and consumer discretionary stocks, two of the hottest sectors of the past 12 months, account for 2.7 and 4.5 per cent of the index, respectively. The TMP offers more diversification by assigning a 10-per-cent weighting to each of the 10 market sectors, and a 5-per-cent weighting to each stock. The index-beating record of the TMP suggests there’s definitely something to this equal weighting approach.
Blue-chip dividend stocks dominate the TMP in any given year, but the quirks of the Canadian stock market mean that some smaller dividend payers are included as well. Take the information technology sector as an example. While there are plenty of big, dividend-paying tech stocks in the U.S. market, we have none. That’s why small players like Constellation Software and MacDonald Dettwiler are in the TMP.
Health care is another sector where the TMP, by necessity, veers away from blue chips. The two stocks in this sector last year were CML HealthCare and Nordion Inc., both down a little more than 20 per cent. With its rigid 10-per-cent weight in each stock, the TMP was able to offset the hit from these and other losers with strong returns from stocks like Constellation and Canadian Pacific Railway.
One area where the TMP and traditional indexing are similar is in their skew toward stocks that have performed well and thus are not bargain priced. How do you get to be a market cap leader, and thus included in the TMP? Being a big company with lots of shares outstanding is part of it, but so is a comparatively strong share price.
Similarly, the traditional stock index is market-cap weighted. In other words, the companies with the biggest presence in the index tend to be those that are big and have shares that have done well. In truth, the TMP is even more focused on rising stocks than the index. The TMP annually evicts stocks that have faltered as market cap leaders (usually because of a falling or lagging share price), while the index keeps them around, albeit with less influence.
Investors are constantly advised not to chase stocks and funds that have already posted big gains. And yet, the TMP’s results suggest there’s a case to be made for riding winning stocks.
In addition to delivering better returns than the index over the long term, the TMP has also been less nerve-racking to own. You can see this clearly in the fact that it has posted just three losing years since 1986, while the index has fallen eight times. A commonly used risk measure called beta also signals less risk for the TMP. The S&P/TSX composite has a beta of 1.0, while the TMP is significantly lower at 0.71 per cent.
Another perspective on risk: The maximum loss over any time frame for the TMP was the 30.5-per-cent drop between October, 2007, and February, 2009. The index dropped 43.4 per cent from May, 2008, to February, 2009.