Excess Returns
There are several ways to generate excess returns—some widely known, and others more nuanced. One such method is to increase your beta. If you accept more risk you can earn more reward but simply increasing risk has the potential downside of increased downside volatility. Most investors, however, have little stomach for significant downside volatility.
Another approach that can generate excess returns is to deviate from index weighting. For example if your portfolio is weighted exactly as the S&P 500 is weighted, your portfolio will move like the S&P and you will have no excess returns or under-performance. But if you change your portfolio weights but still own the S&P constituents you change how your portfolio performs versus the S&P even if you hold all the same companies. This is what my current strategy does.
Did you know that only 8 out of the 500 companies in the S&P 500 have a weighting above 2% as of writing? A little less than 2% of all of the S&P is weighted above 2%. With my strategy, the smallest starting weight upon re-balance is 2%. What this means is that if I own for example SNDK, and it outperforms and rises by 100%. Assuming an initial starting value of $200, I will see a gain of $400. Now assume it starts at a weight of 0.10% in the S&P but the same starting portfolio value of $10,000 is spread throughout the S&P holdings. SNDK would get a capital allocation of just $10 and produce a gain of $10 when it doubled. Because I over weighted SNDK in this instance I earned a 2% return on my capital compared with the S&Ps 0.10% return generating an excess of 1.90%.
Now, naturally, this allocation difference can work against you too. The reverse is also true. But don't confuse this with simply increasing beta. Yes sometimes this will mean you increase beta, but not always. You can overweight something that has lower volatility and less risk and that asset can also outperform the benchmark giving you excess return. You didn't increase your beta but you still earned an excess return. That's why we try to pick companies that exhibit relative strength, companies the market is buying for one reason or another.
Just look at this quarter's portfolio. I added quite a few energy companies to the portfolio and they have acted as a significant drag on performance. Is there a way to prevent this? I am still thinking about it but every change to the system has an opportunity cost.
Anyway, I just had this thought while I was driving and felt I should write a letter about it. Let me know what you think on X!