Beating the Index

January 23, 2007

I just dumped $100K in various broad market index funds. Evidence suggests that most active fund managers will underperform the indexes over the long-term. However, the long-term annualized returns for the indexes hide an important fact: the index is mostly slow growth with a few big spikes and plunges. If you miss a big spike, your returns are fairly low. If you miss a big plunge, your returns are much better. Since you can’t predict when the market will soar or crash, the conventional advice is to stick your money in indexes and pray.

I’m hoping to avoid at least one big stock market plunge. The idea is to buy long range, deeply out-of-the-money put options on a broad index. For example, SPY(Spyders), which match the S&P 500, are currently at 142. A 10% fall would bring it down to approx. 125. A 125 put option that expires in Dec. 2009 is 5.75. It cost 4% to hedge the market for a 10% fall for 3 years, which is a 1.3% cost per year. Better yet, it’s 1.75 for a 125 put expiring on Dec. 2007: 1.3% again. That’s what an active fund charges in expense fees. If the market plummets, the put option will protect you from losses. If the market goes up, you lose your 1.3% insurance premiumin the form of a put option. This strategy is now practical because ETrade and others are charging a mere 0.09% expense fee and no transaction fee on their S&P 500 index funds. I haven’t backtested this idea yet, but I can’t think of any obvious problems. Worst case: the index rises and you waste 1.3%/year, which is just like an active fund. Best case: the index drops one year and you protect yourself, thus your portfolio doesn’t lose much money while others lose 10%. Once I figure out how to use Excel, I’ll backtest it and post some figures.

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