The Design of Our “God” StudyStarting on 1/1/1927 we compute the 5-year “look ahead” return for all common stocks for the 500 largest NYSE/NASDAQ/AMEX firms. For simplicity, we eliminate any firms that do not have returns for a full 60 months. 2 We look at gross returns and all returns are total returns including dividends. Next, we create decile portfolios based on the forward five-year compound annual growth rate (CAGR).
We rebalance the names in the portfolio on January 1st of every fifth year. The first portfolio formation is January 1, 1927 and is held until December 31, 1931. The second portfolio is formed on January 1, 1932 and held until December 31, 1936. This pattern repeats every fifth year. To be clear, this is a non-investable portfolio that would require one to know with 100% certainty the performance of the top 500 stocks over the next 5 years.
We are explicitly engaging in look-ahead bias.Returns are analyzed from 1/1/1927 to 12/31/2016. Portfolios are value-weighted returns for month t are weighted using the market capitalization at the end of month t-1. All returns are gross of transaction costs, taxes, and fees.
Performance of the Decile PortfoliosWe first look at the decile portfolios rebalanced every 5 years. These portfolios highlight what perfect foresight can achieve. The Decile 10 portfolios represent value-weighted portfolios sorted on future top 5-year performers and the Decile 1 represent value-weighted portfolios sorted on future bottom 5-year performers. The compound annual growth rates for the 10 decile look-ahead portfolios are mapped below: As expected, a portfolio formed on the names that have the best 5 -year performance, have the best 5-year performance. Duh. God would compound at nearly 29% a year, in theory. In practice, he would run into capacity constraints and own the entire market (see here for details). We know God would knock it out of the park, but the details are interesting…
Summary StatisticsHere we investigate some statistics and charts on the performance of the 5-year look ahead portfolio.
- God_Best = Top decile 5-year winner portfolio
- God_Worst = Bottom decile 5-year loser portfolio
- SP500 = S&P 500 Total Return Index
|Sharpe Ratio (RF=T-Bills)||1.12||-0.53||0.42|
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. In fact, these returns are EXPLICITLY IMPOSSIBLE TO ACHIEVE. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Note: these results were updated on 6/14/2017.The 29% CAGR is obviously awesome for the look-ahead portfolio. Expected. The volatility is high on the God_Best portfolio — higher than the market. Interesting. The Sharpe Ratio is above 1, but not by much. A far cry from the 2+ Sharpe Ratios touted by some hedge funds. Interesting. But how about them drawdowns! The perfect foresight portfolio eats a devastating 76% drawdown (Aug 1929 to May 1932). But the pain doesn’t end there, here is a chart of the drawdowns on the portfolio over time: And here are some details on the drawdowns:
|Drawdown Rank||Drawdown||Date of Prior Peak||Date of Low||Date of Recovery||Peak to Low (days)||Low to Recovery (days)||Peak to Peak (days)|
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. In fact, these returns are EXPLICITLY IMPOSSIBLE TO ACHIEVE. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Note: these results were updated on 6/14/2017.Clearly, even a “perfect” long portfolio can bring a long-only investor a ton of pain.
How About We Create A Hedge Fund Managed by God?In the analysis above we highlight that God’s long portfolio can endure enormous drawdowns and enhanced volatility. But perhaps we can leverage God’s perfect foresight and go long the known winners and short the known losers. Slam dunk, right? Let’s investigate… God’s long/short portfolio is constructed as follows:
- Long God_Best and short God_Worst, rebalanced monthly.
- God L/S = Long 5-year decile winners; short 5-year decile losers
- SP500 = S&P 500 Total Return index
Summary StatisticsHere are the high-level stats:
|Summary Statistics*||God L/S||SP500|
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. In fact, these returns are EXPLICITLY IMPOSSIBLE TO ACHIEVE. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Note: these results were updated on 6/14/2017.Yowza! Clearly, the ultimate hedge fund does amazingly well — 46% CAGRs would have you owning the world’s stock market in short order. Obviously, this sort of return is not possible over a long period — even if someone had perfect “Biff-like” foresight. Yet, check out the worst drawdown on the PERFECT hedge fund — 47%+. Incredible. And it gets better… Here is the time series of drawdowns over time for the God L/S portfolio. Certainly not a cake walk!
ConclusionsThe famous quote attributed (wrongly?) to Keynes is spot-on:
Markets can remain irrational longer than you can remain solvent!This study also highlights a truism for all active investors:
Active investors MUST have a long-horizon!Good luck out there… 3
- We mean no offense by the use of the term and this could be construed as a single deity, multiple deities, or whatever fulfills your definition of an entity or concept that is all powerful and all knowing. ↩
- Results are similar with or without this assumption. ↩
- h.t., Arturo B. . An old Chicago PhD (1980) we met at the Nantucket Project, who suggested we explore this research question… ↩