It’s the holy grail of investing. No, I’m not talking about lunch with Warren Buffett, although that would be pretty cool. I’m talking about being able to beat the stock market.

Also, this joke:

Millions of collective hours get spent trying to beat the stock market. People come up with all kinds of strategies to do so. Some of these are even smart, like buying dividend-growth stocks or deep-value stocks or even focusing on buying beaten-up sectors. There’s also something to be said about buying out of favor ETFs that track the world’s cheapest stock markets.

Other beat the stock market strategies aren’t so smart. I once tried to beat the dividend aristocrats by just blindly picking the highest yielding ones. I got an email once from a guy who’s 100% into marijuana stocks. And we all know people who have gone all-in with Toronto or Vancouver real estate.

It turns out that these people are doing it all wrong. It turns out there’s a very easy way to consistently beat the S&P 500. And you can do so with a very minimum of effort.

Enough teasing. Here’s the strategy.

It’s super easy. I told you

All you need to do is buy the Russel 2000 ETF, and then call it a day. I hear golf is a fun way to pass the time.

Don’t believe me? Here’s the iShares Russell 2000 ETF (NYSE:IWM) versus the S&P 500 ETF (NYSE:SPY). First, here’s the one year comparison:

IWM vs. SPY 1 year

And the five year comparison:

IWM vs SPY 5 yr

Yeah, I know. The S&P 500 won. But it’s basically a rounding error.

And now the ten year comparison:

IWM vs SPY 10 yr

A 14% outperformance over 10 years is the equivalent of 1% a year. I know people who would strangle a hobo to beat the market by 1% a year.

And now the piece de resistance, the 16.5(ish) year chart, which goes all the way back to the year 2000.

IWM vs SPY 16 yr

Shazam! It’s not even close, either. The Russell 2000 Index has consistently beat the stock market over both the short and long-term.

It gets better. From 1979 to 2014, the Russell 2000 went up 11.85% annually, excluding dividends. The S&P 500 also did pretty well, but only went up 8.78% before paying dividends. Yes, the S&P 500 would have paid a higher yield, but not enough to make up for a 3% difference.

How is it so easy?

There’s one simple reason why this works, and should continue to work. Small-cap stocks tend to return more than large-cap stocks.

There are a couple reasons for this. First of all, smaller companies have greater growth potential. Some fizzle out, others get acquired. But as a group, they do have a better chance than growing versus the average S&P 500 constituent.

In fact, studies have shown that a stock that gets booted out of the S&P 500 tends to outperform the year after it gets ticked out.

The other reason why the Russell 2000 index of small-caps should continue to outperform is something I’ve been saying forever. Nobody likes small-cap stocks. The biggest Russell 2000 ETF has a market cap of $38 billion. There are three S&P 500 ETFs that are larger.

If small-cap stocks don’t get any attention, then an index that tracks a whole bunch of them is bound to be underfollowed too. And that’s exactly what happens.

Can we replicate this in Canada?

This is all fine and good, but what about use who invest in Canada? Can we do this.

Yes, provided you want to invest directly in the Russell 2000. BlackRock has a Canadian ETF that tracks the Russell 2000 which is even hedged back to Canadian Dollars. The ticker symbol is TSX:XSU, and it’s even a decent size. It trades nearly 60,000 shares a day and has a market cap of $263 million.

There’s also a iShares Small-Cap Index ETF (TSX:XCS). Keep in mind that it has lagged the TSX Composite over the last five and ten years, but it is kicking the main index’s ass over the last year.

Wrapping it up

There’s no indication that the relative outperformance of the Russell 2000 ETF will continue, but I’d be far more inclined to add it to an ETF portfolio rather than more exposure to large-caps.

It takes a little individual thought to beat the market, which is why most people won’t ever do it. Being the 1,392,027th person to buy a S&P 500 ETF won’t get you ahead.

Feel free to blindly accept the market return. But with a couple of easy tweaks you can practically guarantee outperformance. You’d rather have more money, yes?

 

Tell everyone, yo!