The search for alpha
Investment experts often talk about alpha and beta, but what do these terms mean?
While it may sound like Greek to you, and it is, it’s not as complicated as you might think. Beta is simply what any particular market or index does – it’s the benchmark. And alpha is the measure of how a managed fund can outperform the index.
In essence, if you are seeking alpha, then your aim is to get better returns than the market average. The way to achieve this is by choosing an actively managed fund over a passive (index) fund.
The management fees are lower for index funds than for active funds as they merely match a particular benchmark. That means they buy and sell less frequently, which reduces transaction costs. But there are still fees, so you will never fully receive 100 per cent of the returns from the market.
Those who support index funds over active funds argue that the market is efficient and therefore, over time, an active fund is unlikely to beat the benchmark.
Top funds outperform
If your actively managed fund performs in the top third of all funds, then the chances are it is beating the benchmark and more than compensating for higher fees.
The SPIVA Australia Scorecard, conducted by S&P on the performance of actively managed Australian mutual funds versus their benchmarks, found that in a one year period 68 per cent of active funds outperformed the ASX200 index. While, this figure reduced to 37 per cent over a three-year period and 30 per cent over a five-year period, it still means that if your fund performs at the top end then you are ahead.i
Much of the performance of a fund comes down to the skills of the fund manager. With close to 400 managed funds investing in general Australian equities alone,ii local investors are spoiled for choice.
Another important factor in the active versus index debate is the efficiency of the respective markets. The theory goes that the less efficient the market, the greater the potential for a skilled investor to make a profit.
If you are looking at smaller listed companies, for instance, the market for these stocks is significantly less efficient than the ASX200 which is made up of the top 200 stocks. That’s because fewer analysts research small companies and therefore investors are less informed. And that provides an opportunity for specialist fund managers who are prepared to do the research.
According to the SPIVA figures, the majority of active Australian small cap funds outperformed the ASX Small Ordinaries index consistently. In 2013, only 5.4 per cent of active managers failed to meet the benchmark.iii
Growth vs value
Investors need to be aware that not all active funds are the same. Some active fund managers favour growth stocks while others favour value stocks.
Growth fund managers believe in the future potential of stocks to grow their earnings and hence their share price. So they would tend to choose companies in growth or developing industries.
Value fund managers, meanwhile, focus on out-of-favour stocks that appear to be under-priced by the market.
Given that the greater your diversification the wider you spread your risk, it can be argued that you should have exposure not only to both growth and value managers but maybe also to index funds.
Working out what is the best investment mix for you takes knowledge and experience. Make a time to speak with your financial adviser in regards to what works best for your individual risk profile.
i. http://us.spindices.com/search/?query=asx&Search=GO&Search=GO Click on SPIVA Australia Year End 2013 and go to page 6 for table.
ii. http://us.spindices.com/search/?query=asx&Search=GO&Search=GO Click on SPIVA Australia Year End 2013 and go to page 6 for table.
iii. http://us.spindices.com/search/?query=asx&Search=GO&Search=GO Click on SPIVA Australia Year End 2013 and go to summary.