To track or chase returns

 
Philip Salter
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WHETHER investors should aim for alpha (beating the benchmark) or beta (tracking the benchmark) is a debate that divides investors. Here a defender of tracking beta and an advocate of chasing alpha put their respective cases.

WORLDTRACK
ANTHONY CHRISTODOULOU

Should investors chase Alpha? In a word: no. Evidence shows that it is futile attempting to outperform markets with odds heavily stacked against investors. This has been shown to be true both in rising and falling markets and over short and long periods. Most studies estimate that, over one and three year periods, fewer than 20 per cent and 5 per cent of fund managers respectively beat the market. Investors do have an alternative.

Investing in public markets involves operating in a market with millions of other participants. When investors chase alpha they believe they can outwit the majority of them. Common sense alone should dictate that unless an investor has exceptional advantages – for example, superior knowledge or technology – then he cannot expect to outperform. On the contrary, he should expect to achieve the market average return, less fees and charges. These costs vary widely, but can range from 1 to 3 per cent per annum taking into account implicit charges, which are often not disclosed to investors.

When market returns are high, the costs of accessing, transacting and advising might not appear significant to many investors. However, with lower returns, costs become proportionately greater and crucially significant. Perhaps more alarming: if markets remain highly volatile, chasing alpha is likely to result in excessive levels of turnover further increasing costs.

The “animal spirit” of investing will always encourage some degree of chasing alpha. However, a new way of investing is now available. The innovation of exchange-traded funds (ETFs) means that investors can simply buy entire markets, or sub-markets (including all dividends), with much lower costs and greater flexibility than before. These costs tend to range from 0.25 to 0.50 per cent per annum. Rather than trying to generate alpha, investors can access markets with precision and allocate cheaply using personalised objectives. In the words of Jack Bogle: “Don’t look for the needle in the haystack. Just buy the haystack.”

Anthony Christodoulou is the founder of Worldtrack, an independent specialist ETF investment business providing exclusive solutions to private clients and family offices in the UK: www.world-trackers.com

It’s hardly surprising, with repeated investment studies showing that the majority of professional fund managers fail to beat the markets, that many investors come to the conclusion if you can’t beat it, then track it cheaply. However, I believe it’s possible to outperform the market. For those who would like to try, I would recommend three strategies.

BARCLAYS STOCKBROKERS
JOHN COTTER

Many studies have confirmed the importance of reinvested dividends when it comes to the long-term performance of shares. Over a lifetime of investment (65 years) in the UK market it represents over 90 per cent of the overall return – an amazing figure by any standards. The higher the dividend the more significant its contribution – which explains why the dogs of the Dow theory still remains popular. This simple, but effective, strategy outperformed the market from 1972 to 2007 and although it all went badly wrong in recent years, so did most things. I think in a world of record low interest rates and gilts, which offer negative real returns, the dogs will have their day again fairly soon.

Another strategy that will lead to market outperformance is following directors’ deals. Actions always speak louder than words and when directors buy their own company shares you should listen. The outperformance of these shares was confirmed by research carried out over a four-year period by directorsdeals.com. This showed shares bought by directors went up by an average 23.5 per cent in the year following the transaction and shares that were sold fell by 15.5 per cent. Watch out for deals at the full market price in small companies carried out by more than one director.

Finally, use the Garp theory to discover undervalued shares. This was introduced by the American investor Peter Lynch and works on the premise that fair value exists when the price-to-earnings ratio (P/E) of a stock equals its growth rate. Pegs of less than one are the ones to look out for. There is a big difference between a stock that is cheap and one that is undervalued. The P/E will tell you whether it’s cheap, but a peg of less than one tells you it’s undervalued.

John Cotter is vice president of Barclays Stockbrokers and author of Cotter On Investing, Taking the bull out of the markets. Published by Harriman House.