Can you beat the market through passive investing?
In our article on stock investing tips, we suggested that investors who are unwilling to invest much time and effort in analysing stocks might be better off adopting a passive investing strategy such as buying a low cost index ETF using the dollar cost averaging method. In this article, we shall illustrate how such a strategy can be put into practice and if indeed an investor can achieve satisfactory returns or even outperform the market through it.
Dollar Cost Averaging explained
Dollar Cost Averaging ("DCA"), also known as Constant Dollar Plan, is basically investing in a financial instrument such as equities in equal amounts at regular intervals. The concept behind DCA is straightforward and intuitive: by investing money in equal amounts regardless of the then prevailing price, the self correcting mechanism ensures that more units are bought at lower prices and less at higher prices thereby minimising risks associated with market timing.
However, DCA also has its fair share of detractors with some going as far as deriding it as a "marketing trick to convince people to hand over money regularly, ensuring trading commissions". So does DCA really deserve its bad reputation or can the strategy really be used to produce satisfactory gains?
To find out, we backtested the strategy on the SPDR STI ETF, an exchange traded index fund tracking Singapore’s benchmark Straits Times Index ("STI"), over 3-, 5- and 7-year periods. SPDR STI ETF was chosen over a similar instrument, the Nikko AM STI ETF, as it was incepted much earlier and thus has more data available for our backtesting.
Tracking error
Before we applied the DCA strategy to it, we measured SPDR STI ETF's (the "ETF") performance against the STI Index to assess its adequacy as an index tracker over a 7-year period dating back to 2 January 2008[i].
Using publicly available price data and tabulating the price performance of STI and the ETF over the 7-year period in Figure 1, we see that the ETF underperformed STI slightly over this period. The underperformance reflects the price tracking error of the ETF due largely to expenses related to the operations of the fund (the fund has an expense ratio of 0.3%) as well as market pricing inefficiencies. It should be noted that this is different from the tracking error defined by SPDR which compares the Net Asset Value (NAV) of the ETF against STI instead of actual market transacted prices, which we think is more relevant for a publicly traded fund. You can read more about tracking errors from this wall street journal article.
Dollar Cost Averaging explained
Dollar Cost Averaging ("DCA"), also known as Constant Dollar Plan, is basically investing in a financial instrument such as equities in equal amounts at regular intervals. The concept behind DCA is straightforward and intuitive: by investing money in equal amounts regardless of the then prevailing price, the self correcting mechanism ensures that more units are bought at lower prices and less at higher prices thereby minimising risks associated with market timing.
However, DCA also has its fair share of detractors with some going as far as deriding it as a "marketing trick to convince people to hand over money regularly, ensuring trading commissions". So does DCA really deserve its bad reputation or can the strategy really be used to produce satisfactory gains?
To find out, we backtested the strategy on the SPDR STI ETF, an exchange traded index fund tracking Singapore’s benchmark Straits Times Index ("STI"), over 3-, 5- and 7-year periods. SPDR STI ETF was chosen over a similar instrument, the Nikko AM STI ETF, as it was incepted much earlier and thus has more data available for our backtesting.
Tracking error
Before we applied the DCA strategy to it, we measured SPDR STI ETF's (the "ETF") performance against the STI Index to assess its adequacy as an index tracker over a 7-year period dating back to 2 January 2008[i].
Using publicly available price data and tabulating the price performance of STI and the ETF over the 7-year period in Figure 1, we see that the ETF underperformed STI slightly over this period. The underperformance reflects the price tracking error of the ETF due largely to expenses related to the operations of the fund (the fund has an expense ratio of 0.3%) as well as market pricing inefficiencies. It should be noted that this is different from the tracking error defined by SPDR which compares the Net Asset Value (NAV) of the ETF against STI instead of actual market transacted prices, which we think is more relevant for a publicly traded fund. You can read more about tracking errors from this wall street journal article.
Keeping this in mind, we next look at how using the DCA as an investment strategy on the ETF stacked up against the performance of the STI.
SPDR STI ETF back-test
There are currently 3 available schemes on the market that can facilitate the execution of DCA on equities in Singapore:
Philip Securities’ Share Builders Plan is the longest established of the three and is the only one that offers the option of investing in SPDR STI ETF. Hence, we have adopted terms provided by SBP in modeling our back-test. To provide a more realistic comparison, we have taken into consideration some of the key parameters below:
SPDR STI ETF back-test
There are currently 3 available schemes on the market that can facilitate the execution of DCA on equities in Singapore:
- Share Builders Plan by Philip Securities (SBP)
- Blue Chip Investment Plan by OCBC Bank
- Invest Saver Plan by POSB
Philip Securities’ Share Builders Plan is the longest established of the three and is the only one that offers the option of investing in SPDR STI ETF. Hence, we have adopted terms provided by SBP in modeling our back-test. To provide a more realistic comparison, we have taken into consideration some of the key parameters below:
- Investment amount of $500 monthly (this may vary according to investor's appetite)
- Execution of trades were done on 18th of each month or if it fell on a rest day, the next available market day
- Excess funds not used were rolled over to the following month
- Dividends were reinvested
- Monthly handling fees & dividend charges were applied
- Good & Service tax of 7% on all charges
|
|
Figure 2: Charges incurred for SBP and how investments are executed (Source: Philip Securities)
The results of our study are presented below:
The results of our study are presented below:
Figure 3. Results of using DCA to invest in SPDR STI ETF
Observations
Our views
It seems that using the DCA strategy on an index fund like SPDR STI ETF does have the potential to achieve satisfactory returns and even outperform the market as a whole. But how is it that the performance could be so different over the different periods tested? To answer this question, we need to understand that DCA works best when a market is going through large cycles given its inherent self-correcting mechanism of buying more units at the troughs and lesser at the peaks. It will also perform better than the benchmark in a declining market. However, if the market is on an uptrend, we would expect the opposite to happen.
Observations
- Using DCA under the conditions listed above would have allowed you to achieve annualised returns of 4.9%, 4.9% and 6.7% over the 3-, 5- and 7-year periods respectively if you had invested $500 per month. A lower monthly investment amount leads to lower returns[ii] as the fixed expenses incurred per month will then form a larger percentage of your investments. The reverse is also true up to a certain point when floating charges kick in.
- You would also have significantly outperformed the STI Index over the longer 5- and 7-year periods while underperformed in the shorter 3-year period.
- Even after adjusting the STI Index for the estimated dividend yield of 3.0%[iii], DCA would only underperform the adjusted STI Index slightly over the 5-year period while still outperform it significantly by 2.8% per year over the 7-year period.
Our views
It seems that using the DCA strategy on an index fund like SPDR STI ETF does have the potential to achieve satisfactory returns and even outperform the market as a whole. But how is it that the performance could be so different over the different periods tested? To answer this question, we need to understand that DCA works best when a market is going through large cycles given its inherent self-correcting mechanism of buying more units at the troughs and lesser at the peaks. It will also perform better than the benchmark in a declining market. However, if the market is on an uptrend, we would expect the opposite to happen.
Figure 4. Performance of STI and SPDR STI ETF over a 7-year period
As an illustration, we look at Figure 4 above depicting the performance of STI and SPDR STI ETF over the 7-year period tested. We can see that over the 3- and 5-year periods, both were generally in slight uptrends and the prices at the beginning of the periods were close to the low points recorded during those years. In such a market, DCA is naturally expected to underperform, as buying of the ETF were executed throughout these periods at generally higher prices resulting in a higher overall average unit cost for each period. The full 7-year period, however, included a major downturn through 2008 and 2009 before the market eventually recovered to end up slightly above where it started. This downturn enabled the automated buying under DCA to acquire more units at lower prices leading to a lower average cost per unit and a significant outperformance.
Conclusion
We see that using publicly available schemes to execute DCA on an exchange traded Index fund such as SPDR STI ETF can generate satisfactory returns and outperform the general market as a whole under the right conditions. The strategy works best during times of uncertainty as well as over a longer period and ideally over the course of one or more market cycles, which have been increasingly common in recent years. Investing in Index funds gives investors a diversified exposure to equities and using DCA minimises or eliminates the need to time the markets. DCA is also particularly useful for investors without sufficient capital to make a meaningful one-off lump sum investment. Investors who are unwilling to expend much time and effort into studying and picking stocks should consider adopting such such a passive investing strategy.
(Note: We have no doubt that there will be many investors who might disagree with our suggestion, steadfastly believing in your abilities to time the market, in which case you might want to read this article showing anecdotal evidence to the contrary.)
As an illustration, we look at Figure 4 above depicting the performance of STI and SPDR STI ETF over the 7-year period tested. We can see that over the 3- and 5-year periods, both were generally in slight uptrends and the prices at the beginning of the periods were close to the low points recorded during those years. In such a market, DCA is naturally expected to underperform, as buying of the ETF were executed throughout these periods at generally higher prices resulting in a higher overall average unit cost for each period. The full 7-year period, however, included a major downturn through 2008 and 2009 before the market eventually recovered to end up slightly above where it started. This downturn enabled the automated buying under DCA to acquire more units at lower prices leading to a lower average cost per unit and a significant outperformance.
Conclusion
We see that using publicly available schemes to execute DCA on an exchange traded Index fund such as SPDR STI ETF can generate satisfactory returns and outperform the general market as a whole under the right conditions. The strategy works best during times of uncertainty as well as over a longer period and ideally over the course of one or more market cycles, which have been increasingly common in recent years. Investing in Index funds gives investors a diversified exposure to equities and using DCA minimises or eliminates the need to time the markets. DCA is also particularly useful for investors without sufficient capital to make a meaningful one-off lump sum investment. Investors who are unwilling to expend much time and effort into studying and picking stocks should consider adopting such such a passive investing strategy.
(Note: We have no doubt that there will be many investors who might disagree with our suggestion, steadfastly believing in your abilities to time the market, in which case you might want to read this article showing anecdotal evidence to the contrary.)
Notes
[i] The 7-year period was chosen due to the lack of availability of reliable data beyond this period. Although the SPDR STI ETF was incepted in 2002, historical prices prior to January 2008 were not widely available. Actual closing traded prices of the ETF were used instead of fund NAV which is a more common measure of fund performance because as an exchange traded fund, investors can only transact at market prices and not the fund NAV. Thus, we find it more reasonable to use the former.
[ii] The corresponding returns using an investment amount of $250 are 4.0%, 4.4% and 6.3% respectively for the 3-,5- and 7-year periods. Conversely, an investment amount of $750 per month generates increased returns of 5.1%, 5.1% and 6.8%. The conclusion remains the same in any case.
[iii] STI Index does not publish dividend yields. However, various sources have suggested that the yield to be close to 3.0%.
[i] The 7-year period was chosen due to the lack of availability of reliable data beyond this period. Although the SPDR STI ETF was incepted in 2002, historical prices prior to January 2008 were not widely available. Actual closing traded prices of the ETF were used instead of fund NAV which is a more common measure of fund performance because as an exchange traded fund, investors can only transact at market prices and not the fund NAV. Thus, we find it more reasonable to use the former.
[ii] The corresponding returns using an investment amount of $250 are 4.0%, 4.4% and 6.3% respectively for the 3-,5- and 7-year periods. Conversely, an investment amount of $750 per month generates increased returns of 5.1%, 5.1% and 6.8%. The conclusion remains the same in any case.
[iii] STI Index does not publish dividend yields. However, various sources have suggested that the yield to be close to 3.0%.
|
Like on Facebook or Follow us on Twitter to get the latest updates:
|
|