"Beating" the Market

So far, our analysis suggests that you should study short-term price movements and stock market ratios (over a twelve­month period, say) complemented by qualitative information in the public domain. Without giving too much away, a successful strategy adopted by the author is to invest in stocks that have exhibited the highest growth rate in the last six months. Hold for a year, and then sell. As always, the key is to time your trade, buying when prices are low and selling high. However, even in a reasonably efficient market this is easier said than done, particularly when stocks rise very little, since all trades entail a cost that can wipe out your dividend or capital gain.

(a) Dealing Fees

In the UK, a typical one-off dealing fee is £25.00 over the phone, although this can drop by as much as 50 percent if you conduct more than 100 trades in a three-month period. It is also cheaper if you deal on-line. A typical internet fee of £18.00 falls to £7.50 if you trade more than 100 times. But beware the administrative costs. Many stockbrokers impose annual standing charges of £60.00, although these may be waived for frequent trades. Brokers also levy a range of extra charges on top of dealing and administration fees. For example, they often charge about £10.00 a stock if you want to close your account.

(b) Buy Everything

Of course, if you want to avoid the costs of managing your own share portfolio, the alternative is to let the professionals do it for you. The simplest and least risky strategy for playing the market and minimising management fees is not to build up a portfolio of individual shareholdings, but to diversify across the entire spectrum through unit trust funds. One type of fund is termed an index tracker, which represents a proportionate investment in every company that comprises the fund's chosen market index. All trackers (global, USA, UK or Japan, say) assume that no combination of shares (or their derivatives), other than the weighted market portfolio, can provide a higher return for the same risk. The fund is also passive, rather than active, based on a policy of "buy and hold" for all the shares in the index, rather than "trading" its constituents at the whim of management. The fund manager is essentially a computer program fed with data to allow for new entrants, or sales when a share is dropped from the index.

Advocates of trackers claim superior performance over any three to five year period than the most actively managed funds because the portfolio is independent of human ingenuity and judgment when selecting which stocks to buy, hold or sell. Long-term you should also turn a profit (the period from the early Eighties until the 2007 banking crisis is usually cited). The rationale is that tracker funds perform well when their chosen market rises. Moreover, if the market collapses, as it did in 1987 and 2000, the fund can only fall as far as its index. Proponents of actively traded portfolios may cite impressive gains, based on the fund manager's perception of rising world markets, but an actively traded portfolio can also plumb the depths. During periods of uncertainty, for example since 2007 with markets repeatedly forecast to maintain little momentum or fall significantly (so the argument goes) an index tracker fund offers downside protection, whilst also retaining exposure to any potential recovery.

However, recalling our observation from the previous Chapter that markets always revert to their long-run average price (valued by CAPE) trackers attract legitimate criticism. Unlike their active competitors, they aspire to an impossible goal, since the only way "to beat the market" is by short-term speculation or access to "insider "information, neither of which represents a realistic basis for long term risk-return management.

In theory, a portfolio strategy of "buy and hold" should work best on the few occasions when markets are stable and values are determined by rational behaviour, leaving little room for maneuver. Between times, in the presence of bull and bear markets or volatility, it cannot predict what proportion of traders operates on fundamental news, as opposed to rumor or speculation. In contrast, funds that actively trade their portfolios based on qualitative judgments can respond quickly to market sentiment fuelled by adaptive expectations, as well as changing intrinsic values in response to fundamental news.

Unfortunately, in a market interspersed by volatile peaks and troughs, historical support for active fund management does not stack up either, unless you select the time period carefully. One explanation is that with so much information floating around it is difficult for a fund manager to spot trends that many others have not already seen. Moreover, aggressive trading not only presupposes that the fund knows what to buy and when, but also which portfolio constituents to sell before events rapidly unfold. For example, if you had bought and held the "best" stocks cheaply in the early Nineties you would have still made money after the techno-bubble burst. But if an active fund had bought in late 1999 it would have made huge losses. Active funds also tend to be caught out when markets rally, trailing a market index following its upswing. On the other hand, tracker funds capture all of the market's returns, minus any charges.

So, what does all this conflicting evidence mean for investors?

(c) Fund Fees

Ask financial advisors and there is no definitive answer. You pay your money and take your choice. Like your local stockbroker, active funds justify higher fees compared to trackers because portfolio constituents are frequently researched and traded, which both entail significant costs. This is why shares in companies with a low market capitalisation experience "institutional neglect". They do not interest large active funds because research still needs to be undertaken but the rewards may be minimal. Active funds with the highest share turnover can rack up charges of at least 1.5 per cent per annum, in addition to a typical management fee of 1.5 percent.

Although trackers simply buy the shares (or derivatives) that make up an index, the author's UK analysis reveals that cost-wise, passive funds should also be selected with care. Many schemes have low charges, because they use computer software, rather than employ expensive fund managers. However, not all are cheap and like their actively managed counterparts, high charges can offset returns. Discrepancies between passive funds can also arise due to different management styles. Some managers might buy every share in an index, but many are less sophisticated and only factor in the top 80 or 60 per cent and just sample the remainder to save time and money.

The cheapest have no initial fee and an annual management charge of 0.3 percent. Others have a competitive initial charge of 0.5 percent and an annual fee of 0.5 percent. The most expensive demand a 5 percent initial charge and a one per cent annual fee.

(d) Choosing a fund manager

To rise above all the conflicting evidence for and against different approaches to fund management, the myriad of fees and their variable performance, an alternative investment strategy (whether you require income or growth) is to seek out active fund managers with a successful track record, rather than a fund itself. Then stick with them, even if they move on. Successful managers who consistently outperform the market over a five year period are regularly reported in the financial press.

If markets take a turn for the worse, consistent management is important because it reveals how individual fund managers have coped relative to their peer group under stress. Even the best managers will have periods when they trail the market, whilst others may have much greater freedom to invest whenever they see value. Most successful managers who outperform the market over a five-year period also remain with their fund.

To track an individual fund manager's performance, rather than a share, go to a research group that assesses managers, rather than funds, such as Citywire ( citywire.co.uk ) or an independent financial advisor like Bestinvest, ( bestinvest.co.uk ). But remember that consistency does not tell you all you need to know before you invest. Active funds that performed well in the past might have done so because the economic climate suited their managerial style. For example, active funds that invested in undervalued companies since the millennium have done well. Like individual shares, however, there is no guarantee that past portfolio performance is a guide to the future. All we know is that poorly performing individual shares and portfolios usually continue to perform badly.

Summary and Conclusions

The theoretical relationship between dividend and earnings valuation models based on the market price of equity explains why a few select statistics published in the financial press encapsulate a company's current stock market performance and provide a guide to future investment. However, we have observed that there is more to buying and selling shares than assimilating price data. Even the most inexperienced investor can sift through press, media and internet information at little cost to validate their decisions. And in the short run they will "win some and lose some". However, without access to insider information, the academic and analytical consensus is that in the very long-term, playing the stock market is a zero-sum game, since one person's loss is another's gain. As the author explains in his bookboon series on the subject, no combination of shares (or their derivatives) can provide a higher return for the same risk as the weighted, global market portfolio.

So, does all this conflicting evidence mean that investors (institutional, corporate or otherwise) should abandon stock market analyses based on conventional financial models that explain changing share prices and their returns? On the contrary, as we shall discover in Part Four:

At even the most strategic level of financial decision-making, there is no complete hypothesis to replace the distillation of corporate performance in the form of dividend yields, cover, P/E ratios and the market capitalisation of equity, or its disciplined framework for analysing the signals sent out by the capital market.

Selected References

1. Hill, R. A., Portfolio Theory and Financial Analyses (2010).

2. Hill, R. A., Portfolio Theory and Investment Analysis (2010).

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