The Myth of the Unbeatable Index

One of the pervasive beliefs amongst private investors is that it is very difficult, if not impossible, to consistently beat the index. People are heard quoting 'research' which 'proves' that most investors – and, indeed, even most fund managers – are unable to outperform 'the market' (meaning the index) over time. Just look at how few unit trusts, these people say, ever beat the All Share Index.

When you think about indices, it's hard to understand why this belief is so entrenched. An index is, essentially, an average of stock prices. It follows that, at any point in time, half the shares making up the index performed better than average (and the other half, therefore, worse than average). Even if shares were chosen randomly, you would expect half of any group of portfolios to outperform the index 'on average' over any particular measurement period.

The Performance of Unit Trusts

The performance of unit trusts is a good way to evaluate this myth.

At the time of writing there are 69 funds in the general equity sector. For the five years ending 5 December 2011 the JSE All Share Index was up 55.9% (all figures assume reinvestment of dividends). The average return of funds in the sector was 45.5% – clearly a minority of funds outperformed the index. In fact, only 14 of the 69 funds did better than the All Share, which seems to support the myth. There is a catch, however. The unit trust performance figures are net of management costs, which are typically 1.5% per annum. Growth of 56% over

Now, if nearly half of unit trust managers can outperform the index (before costs), it should be fairly easy for private investors. Why do we say this? Well, fund managers face a few important challenges. The first is what we call benchmark pressure. The second is short-term performance pressure. The third is diversification pressure. And the fourth are impact costs. Let's look at these in more detail.

1. Benchmark pressure is one of those weird circular things that asset managers face. Their performance is judged in relation to a benchmark. The loss of face for underperformance is greater than the kudos for out-performance. The best way not to underperform is to replicate the index (clearly, if you 'own' the index you're going to perform in line with it). Which is why so many funds hold the same shares that make up the benchmark index, and why so many actively managed funds look a lot like tracker funds.
2. In addition to benchmark pressure, fund managers face the demands of short-term performance measurement – official portfolio growth is reported quarterly or monthly in fund fact sheets and asset management houses like to present a picture of steady, reliable growth. If there are reverses, these should be in line with a fund's peer group. Again, the safest strategy for a fund manager is to follow the herd, which is to invest predominantly in the large, popular shares that absorb a large chunk of industry assets – this way the fund manager is never going to deviate too far from the sector average.
3. Which brings us to diversification. Fund managers are expected to be 'properly' diversified, which in asset management terms means having exposure to most market sectors. When it comes to large institutional portfolios, most fund managers maintain holdings across all major industries. At best, portfolios will be tweaked by being 'overweight' favoured industries and 'underweight' out of favour ones. 'Overweight', in this context, means having slightly more exposure to a particular stock or sector than the industry or the peer average – clearly, one doesn't achieve dramatic results by having, say, 15% of a portfolio in financials instead of 12%.
4. Finally, we have the issue of impact costs. 'Impact costs' refer to the problem of prices being pushed up by demand – buying pressure is exactly what makes share prices rise. Here's an example. The manager of a R10 billion fund identifies a mid-cap stock he thinks is a great investment at the current price. He would like to invest 1% of the fund's assets in the share, which means he has to invest R100 million (anything less means the position is too small to make any meaningful impression on the portfolio). Then he discovers that turnover in the company's shares is around R8 million a week, which means it will take him three months to establish the position if he outbids all other buyers and takes up all the shares typically on offer. But the process of outbidding other buyers, naturally, pushes up prices. The fund manager's average purchase price will therefore end up being considerably higher than the current price, which makes the investment less attractive. It also occurs to the fund manager that if he wants to sell out of the position it will also take three months (at least) and the flood of shares as he sells will push prices down. At this point the fund manager decides to shop elsewhere. The problem of impact costs, in short, tends to steer the managers of unit trusts and other large, institutionalised investment funds into the big cap stocks that can absorb big trades.

Being your own fund manager

Let's turn these limitations on their head and consider what you can do as your own fund manager.

First off, you're going to save that 1.5% per annum. Even if you do no better than the market average, this will have quite an impact over time. Consider this: if you invest R250 a month for 30 years, the difference between an average return of 10% per annum (compounded monthly) and 11.5% per annum is nearly 40%. In other words, at 11.5% per annum you will have nearly 40% more capital at the end of the 30-year period. That's an extra R200 000 on R500 000 – not to be sneezed at.

Secondly, without the pressures and limitations faced by fund managers, you have huge advantages when it comes to stock-picking and diversification.

Let's deal with diversification first. Make no mistake, diversification is a good idea. You don't want to have all your eggs in one basket. But too much diversification is obviously a problem – it's impossible to beat the market if your portfolio is the same as 'the market'. Statistically, you only need five to 10 shares to achieve most of the risk-reduction benefits of diversification (provided, of course, they are in different sectors). On the plus side, with a portfolio of five shares, it's much easier to have one or two stellar performers that help you outperform the market.

A small portfolio of carefully selected shares achieves two things at once – it manages your downside risk through diversification and it gives you a fighting change of being above average.

Which brings us to stock-picking. Unless you a very well-heeled private investor, you are not going to have impact cost problems with stocks that trade R8 million a week (or even R2 million a week) – this immediately gives you a broader investment universe than the average fund manager. In fact, the whole problem of impact costs gives you an additional advantage because a lot of the smaller stocks are simply ignored by the asset management industry. This means fertile ground for independent research. Identifying a largely ignored mid-cap, which is on its way to becoming a large-cap stock, is often a key to picking a ten-bagger .

ShareMagic™ – the above-average advantage

Good stock pickers can and do beat the market consistently. Over a period of more than 30 years, legendary investor Peter Lynch beat the market by over 13% per year. Warren Buffet, over almost 50 years, has maintained annual returns of around 20%, significantly better than the market average. And calendar 2011 was the 39th year that Buffet beat the performance of the S&P500.

Incredibly, these returns were achieved by people running enormous funds. Buffet and Lynch, therefore, achieved these results in spite of the obstacles faced by managers of very large portfolios. Private investors, with their greater agility and larger range of opportunities, can consistently beat the market with ease if they are able to pick the right stocks.

ShareMagic™ provides the information and tools needed for astute stock-picking – from price data to company fact sheets, from financials to stock market news – all in one easy-to-use package. With its intuitive interface and full integration, ShareMagic™ allows you to find those above-average shares that beat the indices. Put yourself in line for above-average returns – pick up the phone today and speak to one of our friendly consultants.

Be above average – call +27 11 728-5510 today

PS  ETFs (Exchange Traded Funds) and Tracker Funds are sold on the premise that it's better to be average than below average. This is true, of course, if you believe that you can't be above-average. To find out how ShareMagic™ can help you to construct and maintain an above-average portfolio,
call +27 11 728-5510.