It's going to be harder to find winning stocks among the household name mega-caps whose prospects have been analysed by every broker and his dog. Photo / Getty Images
Despite the fees they charge, fund managers who consistently outperform the market index are few and far between, and as a result individuals are commonly advised to invest in a diversified range of low-fee index trackers.
But some quirk of human psychology prevents most people from signing up for guaranteed average returns. Who wants to give up on the hope of getting rich in financial markets?
If you're smarter than average, it's tempting to believe you can get above-average returns. Not every investor can of course, as in aggregate, investors hold the total pool of market assets and by definition earn average market returns. But for individual investors, the dream of individual out-performance persists.
Ironically, while modern financial literature is sceptical of the ability of fund managers to add value, it offers plenty of fuel for the hope of out-performance. Research has documented numerous investment ideas (often termed "anomalies") that have outperformed the market historically.
Stocks with certain characteristics do better than average. For instance, small-cap stocks generate higher returns than large-cap stocks on average, and value stocks (with low prices relative to earnings or assets) have returned more than their more expensive counterparts.
Certain strategies have worked too. There seems to be short-term momentum in stock prices, with past winners continuing to outperform, and past losers continuing to sink. Statistical arbitrage is another popular strategy that involves buying one stock and shorting a similar stock (Coke and Pepsi for example) when their prices diverge temporarily.
Finally, there is some evidence that total market returns are (slightly) forecastable by some financial or economic indicators, raising the prospect of active asset allocation strategies adding to portfolio returns over time.
So how do we reconcile the research suggesting a multitude of sources of outperformance, with the evidence that few fund managers consistently add value?
The most sceptical response is that the positive findings arise from excessive data-mining. Search long enough and you're bound to find something that worked in the past, but if the relationship is spurious it will not work in the future. Nevertheless, some of the aforementioned return anomalies have been shown to work outside the time period or market in which they were discovered.
Another possibility is that a strategy used to work, but that the growing amount of money chasing the strategy eventually drives the return on the strategy to zero. Being in on the ground floor is clearly the key here, but that is a difficult task. How does one identify managers with winning strategies but no track record?
Or maybe the incentives in traditional funds management work against outperformance. There is a lot of pressure to not deviate from the pack (minimise "tracking error" in the lingo) and that limits the ability of fund managers to implement non-traditional strategies. While this is seemingly plausible, academic reviews suggest that non-traditional investment entities fare little better. Hedge fund and private equity returns are harder to measure but there is no clear evidence that they outperform equity markets on average.
But if the goal remains for an investor to outperform, what basic principles are worth bearing in mind?
First, be wary of any free lunches. Hanging over these results is the spectre of the efficient market hypothesis (EMH), and the idea that strategies that deliver better than average returns may simply reflect compensation for some extra risk. Small stocks, for example, certainly seem like they may be riskier; it is harder to make the same claim about value stocks.
If we accept some degree of market efficiency, it probably makes sense to search for out-performance in the markets and market sectors where existing information is weakest and market prices are most likely to be "wrong". It's going to be harder to find winning stocks among the household name mega-caps whose prospects have been analysed by every broker and his dog.
Prepare yourself to tolerate lots and lots of "tracking error" - the cost of being different and earning higher returns in the long run is almost certainly going to be a number of years where your portfolio is going to be at the bottom of the heap compared to how the market is doing. If you want different (i.e. better) returns, you'll have to take a different journey.
Liquidity is seemingly another dimension where sacrifices can be made to get higher returns. But the cost here is not being able to get your money back at short notice, and especially not when you need it most. For example, the NZ Super Fund, with its long-term investment horizon, is able to capitalise in this space.
Finally, there may be more "out-performance" to be had in the dimension of volatility than the dimension of returns. Just as diversification across shares reduces volatility without hurting returns, there may be room to dial down the risk in your total portfolio through both long-term and dynamic asset allocation decisions. Sure, this may not change the amount of money in the kitty in the end, but it does make it easier to sleep along the way.
Chris Worthington is a senior economist at Gareth Morgan Investments.