Ace investor Ben Warwick says in order to achieve exceptional investment performance, investors need to generate market-beating returns, which is possible only if they have an investing ‘edge’.
He says this ‘edge’ can be defined as ‘alpha’ that depicts the part of an investment fund’s return generated entirely by the skills of the portfolio manager.
“Investors, traders and speculators alike have searched for a dependable source of alpha for as long as there have been financial markets,” he says in his book Searching for Alpha-The Quest for Exceptional Investment Performance.
Ben Warwick has been in the investment industry since 1990 and is the founder of Quantitative Equity Strategies (QES), a Colorado, US-based quantitative investment management firm that developed indices for the mutual fund industry in 1999.
Warwick was previously a founding shareholder and CIO of Sovereign Wealth Management, a multi-family wealth management firm, which was later purchased by United Capital Financial Advisers in 2011. He also served as Head of quantitative trading at Exis Capital, a New York-based hedge fund.
Warwick holds his BS in Chemical Engineering from the University of Florida and an MBA from the University of North Carolina, and has authored several books on finance and investing that include an investment classic, Searching for Alpha: The Quest for Exceptional Investment Performance.
Why most funds fail to beat market
Warwick says it is difficult to win in the game of investing considering only a small number of mutual funds are able to produce market-beating returns.
But he feels there are a few elite investment professionals, who manage to produce extraordinary returns year after year because they have an investing ‘edge’.
Warwick says producing exceptional returns and generating alpha depend on managers being able to find and exploit mis-pricings and other market inconsistencies.
“Many active portfolio managers earn their living by convincing investors that rigorous analysis of myriad arcane factors gives them an edge that allows them to beat the market. The fact that 70% of total invested funds market wide are under active management proves that professional and individual investors support this approach,” he says.
According to Warwick, over the years more than half of the actively managed mutual funds have failed to beat the S&P500 and many of the funds that beat the index one year fail to do so in the next.
He says people who wish to invest in actively managed mutual funds should keep in mind that past performance is not necessarily an indicator of future performance.
Warwick believes the fact that most funds are not able to beat the broader stock market should not be surprising as the majority of money invested in the stock market comes from mutual funds and institutional funds.
“Since these funds make up most of the market, they all can’t outperform the market. However, there will always be funds that yield exceptional performance,” he says.
Warwick says most actively managed mutual funds lure investors on the promise of delivering superior market performance in exchange of higher fees (relative to index funds). But there are a host of barriers that prevent these funds from delivering on their promises.
One of the barriers in achieving superior fund performance is fund size. “The larger a mutual fund gets, the more difficult it becomes to deliver exceptional performance. A large fund must invest more broadly and must invest in companies with a larger market capitalisation. Large companies are more closely followed and their stock prices tend to accurately reflect their value (e.g., there will be fewer bargains). Fund managers must also work harder to avoid having their trading impact the market. For example, by buying a large block of a stock that the fund manager believes is under-priced, there may be a market impact that would drives the stock’s price up, reducing profit,” he says.
Warwick says although fund size runs counter to alpha generation, fund managers have a strong motivation to let the fund grow as big as possible, as most actively-managed mutual funds charge a fee based on asset size. The bigger the fund gets, the more money the fund managers make.
How can investors generate ‘alpha’
Warwick feels one way actively managed funds ‘generate alpha’ is by trading frequently. Also, he believes stock options can be used to lock in profits and avoid losses, but many funds fail to take advantage of this strategy.
Warwick says it is a common perception that mutual funds are conservative, which in theory limits their potential losses and makes them more fitting for the average investor. But this in turn limits the mutual funds’ ability to ‘generate alpha’.
Warwick says one of the techniques for ‘alpha generation’ that funds can use is arbitrage, as it involves buying an asset in one market and selling it or a related asset in another market.
He says another area where mutual fund investors may be able to gain ‘alpha’ is in funds that invest in companies with small market capitalisations or smallcap stocks.
“Small companies are not followed by many market analysts. This means there may be unrecognised bargains. An actively managed fund with a good research staff and a talented fund manager may be able to build a portfolio of smallcap stocks that can beat the market. However, small companies are more sensitive to economic downturns and smallcap stocks may fall faster than stocks of large companies during a recession,” he says.
In his book, Warwick discusses some techniques to create an investing ‘edge’ that can help achieve superior investment returns. Let’s look at some of these tips-
- Diversify your portfolio
Warwick says the secret to outperforming the market is not portfolio concentration, but to hold a little bit of everything, and stay overweight on sectors that offer the best possibility to excel.
“Although famous investors like John Maynard Keynes and Warren Buffett have produced fabulous returns through a small number of large positions, they are the exception rather than the rule,” he says.
- Use indexing on tough sectors
Warwick says different sectors differ in how swiftly they can respond to information, which is why it is very tough to add value through active strategies in some of the sectors. So, he recommends indexing such sectors.
“Largecap stocks, for example, are followed by many analysts and they reflect company fundamentals so quickly that it is nearly impossible to add value through active strategies. I recommend indexing such sectors,” he says.
- Use active strategies in inefficient market sectors
Warwick says some parts of the market are firmly efficient, but there are certain sectors like smallcap stocks and high yield bonds where active management can really be useful. “For these sectors, use active managers that have a unique and scalable methodology to produce alpha (i.e. return over a market index),” he says.
- Use credit spread to make portfolio changes
Warwick says different types of stocks react to changes in the economic environment in unique ways. He says smallcap stocks do better during recessions or when equities are in a downtrend. On the other hand, largecap stocks tend to lead the market higher during good times.
He advises investors to look at credit spread to identify the economic condition and make changes to their portfolio accordingly. “Look at the credit spread – difference between government yield and that of corporate bonds – to determine whether an economy is expanding or contracting (a growing economy is associated with the narrowing of the spread), and tilt your portfolio towards the market sector that is poised to benefit the most,” he says.
- Use momentum strategies during the growth phase
Warwick says momentum traders buy stocks that have increased the most in the belief that they will continue to do so in the future. He says investors should utilise momentum strategies only during periods of economic growth to amass generous returns. “Although there is a plethora of evidence showing that market sectors exhibit trend-following behaviour during periods of expansion, a weak economic environment usually prevents such momentum players from generating a market-beating returns,” he says.
- Consider alternative investments
Warwick says with increased integration of the world economies over the years, stock and bond markets have become globally linked. So he advises people to invest also in futures to ensure value diversification of their portfolios as they can be a source of steady returns.
“Prudent investors should consider skill-based investments in the futures markets and through market-neutral hedge funds (unregulated investment pools that generate profits through an arbitrage approach) to add value diversification to their portfolios. Steady returns of these investments can go a long way in producing market-beating returns,” says he.
- Find ways to minimise taxes
Warwick says most of the times taxes are the largest expense that investors face, even more than both commissions and investment management fees. He says tax gains are mainly the result of efforts of money managers, who attempt to add value to the investment process by buying and selling securities. He says taxes can be minimised by indexing the hard sectors and by keeping all actively managed funds in a tax-deferred account.
- Pick your investment manager wisely
Warwick says investment managers shouldn’t be employed based only on their past performance. “While considering a mutual fund investment, there are more important things to look at than the fund manager’s past return stream. Consider transaction costs, fees and the fund’s research budget. These three criteria are much better indicators of what may occur in the future,” he says.
- Re-balance your portfolio regularly
Warwick says in the long run, the market tends to mean-revert; which means, winners become losers and losers become winners. So it is important for investors to periodically rebalance their portfolios by taking money away from those investments that have performed well in the past few months and reallocating it to those that have suffered losses.
This, he says, can ensure that they can both increase their returns and reduce their dependence on a few bets that have appreciated significantly.
(Disclaimer: This article is based on Ben Warwick’s book Searching for Alpha-The Quest for Exceptional Investment Performance. )