Undoubtedly, every investor would like to beat the market, just like every man would like to have above-average wealth, looks or intelligence. Unfortunately, although some of us at FWU have these attributes, on the whole this is by its very nature not possible. However, while active managers as a group will have considerable trouble beating their benchmark, this is not to say it is impossible. The good news in all of this is that certain investment strategies can be employed to use and beat the herd!

The first point to make here is that to even have a chance of beating the market, an investor must be truly active, which cannot be said for most active managers out there. Indeed, according some recent research, of all mutual funds in the United States, only 20% are truly ‘active’ versus the benchmark. In other words, the bulk of ‘active’ managers are benchmark huggers and cannot therefore be classified as active.
If an active manager is truly active, what are the strategies to use to beat the market? There are a few market inefficiencies that can be exploited, such as in smaller companies and Emerging Markets, but the one that quant managers tend to opt for, us included, is ‘momentum’. What we mean by momentum is that the past performance of a stock has predictive power for future returns. We see, for example, that over very short horizons, stocks exhibit a mean reversal pattern. This means stocks that do very well in the past month, tend to revert to the mean in the following month, i.e. they ‘fall back’. Looking at longer horizons, however, something interesting happens – we see stocks that have done well over the past 12 months continue to do well over the coming year as well. There is, in other words, a ‘continuation effect’ at work, which is a market inefficiency that can be exploited.

What explains this effect? It is heavily debated, but in our view three factors are crucial. Firstly, given that the bulk of money being managed worldwide is in the hands of very large institutional investors, it takes a while for these investors to build positions; they are like large tankers turning around – a process that takes some time and is not immediate. Secondly, and as can be seen by the market reaction to earnings reports, information is not perfect. If a company, for example, produces stellar numbers, it of course initially attracts many investors, but as other hear about it too, more money is attracted, and the stock can continue going up. In connection, and this is important to stress and ties into what we say above, there is a clear behavioural bias at work – investors exhibit a herd-like mentality and ‘crowd’ into trades, which further underpins the momentum phenomenon.  

To conclude, yes, it is true that not all active managers can beat the market, but those who take active risks and skilfully exploit the momentum phenomenon stand a very good chance of doing so.