You can beat the market. It’s an evocative phrase and the well-worn trope of salesmen and spruikers.
It usually generates two polarised responses. Some say it’s impossible, that no one can beat the market. Others point to famous investors like Warren Buffet as proof that beating the market is possible and can be taught.
But it’s more subtle than those black and white responses imply.
It certainly is possible to ‘beat the market’ – but, luck aside, it involves considerable skill and often taking on a higher level of risk. There are two main risks – the risk of capital loss or underperformance and the risk of a shortfall in income.
The term most often used for investments that outperform is ‘alpha’. Alpha has its origins in Harry Markowitz’s 1950s Nobel-prize winning mathematical framework that measures risk and return in investing. Economics professors Harry Roberts and Eugene Fama (also a Nobel prize winner) developed a contrasting hypothesis known as the Efficient Market Hypothesis that theorised that investors could not make returns above the average of the market on a consistent basis. But we will park the latter theory for another article.
Alpha measures the relative return of an asset compared to a benchmark, after accounting for its volatility. (Alpha’s counterpart, beta, measures the volatility). So, generally, a share that returns 5 per cent when its index returns 3 per cent can be said to have an alpha of 2.
At its essence, generating alpha means consciously taking positions different to the broad market Volatility has a role to play in that decision. If you have a long-term horizon, short-term volatility may not matter so long as you ultimately get capital and/or income growth. But if you need your investments to fund your lifestyle in the short to medium term, volatility poses a real risk of being left without enough money.
Assuming you’re willing to take on the risk, seeking market-beating returns, or alpha, means taking an active approach to investing.
So what should you look out for when implementing an active investing strategy?
First, make sure your base fees are low. There are few more misleading statements than having to spend money to make money.
Research shows higher cost funds generally underperform lower cost funds. In fact, a fund’s expense ratio is the single best (although far from perfect) predictor of its future performance1.
True, passive index investments are often cheaper than actively managed investments. But that doesn’t mean that all active investments are high-cost – there are inexpensive actively managed investments available.
Vanguard itself is famous for being a low-cost index manager, but it has a long and proud history of active fund management dating as far back at the founding of the firm in 1975. In fact, more than a quarter of Vanguard’s global funds under management are in active management2.
Second, make sure you’re investing with talented active managers with a strong track record and honourable business practices.
And finally, make sure you’re willing to take your time.
Time is often the most underrated factor when it comes to investment performance. Investors that are willing to be patient – that understand markets have cycles, managers have up and down years and both highs and lows need to be ridden out – are likely to enjoy investing success.
In the end, active vs passive is not an either/or question – it can be both, depending on your desire for alpha and appetite for risk.
Reproduced with permission of Vanguard Investments Australia Ltd
Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.
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