Why invest in trackers when you can beat the market yourself?

By Dr. Mike Tubbs Oct 08, 2009

Mike Tubbs

Comments (7) Print this article

Graphs on a computer screen © Jason Alden/Bloomberg News

Track the market yourself for better returns

I just don't understand why people invest in 'tracker' funds. Why pay someone to merely replicate the performance of the index?

A friend I was talking to the other day was singing the praises of this kind of 'passive' investing. He made the point that you may as well go passive since few active fund managers can beat the index over a sustained period. And that's fair enough.

But to me it misses an even more important point. You don't need to settle for market-tracking returns. It's perfectly possible for individual investors like you and me to beat both passive and active funds by picking suitable stocks.

Let me show you what I mean...

There's little doubt that index, or passive funds are a much better bet than actively managed funds. John Bogle, who founded the well-regarded Vanguard Group of index tracking funds in the US, has done a detailed comparison. The arguments in favour of index funds over actively managed funds are convincing.

Most actively managed funds don't beat the market in the long run

For example, he followed all 355 equity funds existing in 1970 over the period from 1970 to 2005. Of these, 223 did not survive to 2005. Only 24 of the remaining 132 beat the market by at least 1% per year. Just nine of those 24 beat the market by at least 2% per year and two beat it by 3% or more.

Choosing one of the few outperforming funds also proved to be difficult. Bogle looked at the 20 top performing funds in each year from 1995 to 2005. He found that the average rank of these top 20 funds in each following year was 619! In other words, if you bought one of the best funds one year, it often ended up being among the worst funds the following year.

One of the reasons the funds did so badly is their high costs, which are compounded over the years. Another reason is that funds advertise most heavily when the markets are reaching a peak. That means most investors invest more when shares are expensive rather than cheap.

Finally, large funds find it hard to invest in the stocks that are most likely to show the best share price growth. This is one area where smart individual investors have a serious advantage over funds managers. Here's why. Let's assume that a fund manager has 50 stocks in a £1bn fund. That is £20m per company on average. Now the manager will probably not want to own too large a percentage of any one company's shares. This means that, for a 3% share worth £20m in a company, he is limited to companies with market cap over £660m. This figure will be even higher for a larger fund.

Special FREE report from MoneyWeek magazine: When will house prices bottom out - and how will you know?

  • Why UK property prices are going to fall 50%
  • When it will be time to get back in and buy up half price property

This means the fund must concentrate mainly on larger companies – the FTSE 100 if it is a UK fund. Indeed, many so-called active funds are just 'closet' trackers but with charges much higher than those of any tracker.

Every investor looking to beat the market consistently should avoid these funds - they can be a dangerous trap.

The best way to consistently beat the market

So we can agree that index trackers are a smarter play than actively managed funds. However, there's no need for you to settle for simply tracking the market. Because you have several advantages over the average fund manager that should enable you to beat the market. These advantages include the freedom to pick stocks from any sector and any market, right down to the smallest micro-cap. And you do not charge yourself any initial or annual fund charges.

You also have an advantage over the index fund because you can decide how much you invest in any single company. The index fund has to invest in proportion to the company's market cap.

But of course, these advantages only give you better performance if you pick stocks wisely. There are a few simple rules to follow that will help in this. Of course, a company's valuation needs to be reasonable to start with. But there are other important things to consider.

The first rule is to select companies with financial strength – look at the balance sheet and cash carefully. Secondly, make sure the company is growing profitably and has a leading market position in its niche. And thirdly, make sure that it is doing well in overseas markets as well as the UK – there is much more risk if a company is limited to the UK market.

But perhaps most importantly, the company also needs to have a sustainable edge in its market. This usually means it re-invests in its own future. Put another way, it is sufficiently profitable to be able to invest a sizeable chunk of its revenues in new products and services coming out of research and development. This kind of re-investment can have a dramatic positive impact on the share price down the line.

In my Research Investments newsletter, I chose Immunodiagnostic Systems (LSE: IDH) in February based on these criteria. It's risen by around 200% since then. Alterian (LSE: ALN) is another which is up by around 100% from its recommended price in April.

What's the common factor for these and many of the other successful shares I've recommended? It's that these companies invest in their own research, expertise and development.

They invest in their future and the future of their investors. And as a result they will do far better on the stock market than companies that don't.

Editor's note: You can read all about Mike's Research Investments newsletter here.

Please note: Past performance is not a reliable indicator of future results. Your capital is at risk when you invest in shares. Please seek independent financial advice if necessary.

Our recommended article for today

What we can learn from Russian petrol shortages

The story of black market petrol in the Soviet Union illustrates how our current artificially low interest rates could set off a hyperinflation chain reaction, says Paul Tustain.

Comments (7)

Published in How to invest | More articles by Dr. Mike Tubbs

Share with:More

TwitterLinkedInViadeoFacebookYahoo! BuzzredditDiggDelicious

Related articles

Comments

Leave a comment

  • 1. Peter Rogers

    (08 October 2009, 12:03PM)  Complain about this comment

    I would agree that it is much better to pick your own stocks than to own a fund or tracker, i have done this for the past 18 months have have so far outperformed the market, it is however a statistical impossibility for a large number of investors to beat a market average because as returns increase so does the average.
    Also you failed to mention other important products now open to personal investors like ETF's which can offer the chance to speculate or hedge on various commodities, currencies and even indexes.

  • 2. Daron

    (08 October 2009, 12:59PM)  Complain about this comment

    This is poor advise. Picking stocks is a mugs game. Even if you are fully competent at reading balance sheets, you need to design a good strategy that actually works (which you will only be able to analyse retrospectively). You also need to be able to read the future which is impossible.
    Index tracking is easy, cheap, proven, leaving plenty of free time to do something far more interesting than reading accounts!

    "There seems to be some perverse human characteristic that likes to make easy things difficult" – W.Buffet

  • 3. Michael Lewis

    (08 October 2009, 01:39PM)  Complain about this comment

    Asset allocation is probably more important that individual stock picking. Bond ETFs are much better than picking your own bonds, unless you have very deep pockets to spread the credit risk. I would agree with the author though, I'm sure it is, on a small scale, possible to beat and index. To do so consistently is tricky, this where ETFs, sector specific, commodity, currency and the like are likely a much easier way to beat a stock index.

  • 4. DJ

    (09 October 2009, 02:03AM)  Complain about this comment

    Do not forget, Dr Tubbs, will try to sell you his newsletter... And that is fine if you choose to go with individual stocks. This explains his negative comments towards ETF and Mut. Fds.
    ETF and Mut. Fds need to be chosen carefully, just like stocks, watch for their cost/expenses, manager, firm reputation, the beta, taxes (Dr Tubbs forgot taxes!) and so on. But once you have picked the right one, you can go fishing or whatever you want, and check on it only once a quarter. Try that with stocks! Ouch!
    DJ

  • 5. Matt

    (09 October 2009, 10:42AM)  Complain about this comment

    Most disingenouous. This is not an article; it's a thinly-disguised FSP newsletter advertisement.

    I'm rather disappointed with MoneyWeek about this. This is what the Motley Fool do; advertise their paid services under a masquerade of impartial free advice. It erodes trust; particularly where the claims made are contentious (e.g. "Consistently beat the market").

  • 6. Geoff

    (16 October 2009, 12:25PM)  Complain about this comment


    Moneyweek's high-pressure selling of financial tipsheets is hugely detrimental to them (though maybe not financially) - it smacks of the the American-style sales pitch similar to The Street.com, inter alia - not surprising really since the publisher/owner I believe is the American, Bill Bonner. How I wish the print version of Moneyweek arrived in my letterbox without the huge array of absolutely junk inserts!

  • 7. Spanner77

    (18 October 2009, 01:16AM)  Complain about this comment

    I agree with the 'DIY' approach of Dr Tubbs that small private investors can beat the professionals (Champagne Charlies) in ETF's, Hedge Funds and Pension/Finance Industry.

    The main reason is we can pick our stocks, pick our sectors and be highly selective. The weaknesses of all the Pro Fund is that they spread risk and buy up lots of Co shares and in that 'spread' also dial out their potential upside from their good picks by their underperforming picks dragging their average down.

    By spreading your risk over say 4 or 5 select shares yo maximise potential upside. The Pro Funds are hell bent (rule bound) to spread risk and therefore reduce upside.

Leave a comment

This will be the name displayed with your comment.

This helps us verify comments are genuine. It will not be displayed anywhere on the site and is stored confidentially.

Please keep your comment to within 1,000 characters, and relevant to the main topic. Comments not directly on topic will be removed.

captcha To prevent spam-related comments please enter the characters shown in the CAPTCHA box to the left.

By leaving a comment you accept our terms and conditions.


FREE - MoneyWeek's daily investment emailJohn Stepek

Our free daily email, Money Morning, is an informative and enjoyable analysis of what's going on in the markets. Written by our Editor, John Stepek, and guest contributors.
Sign up FREE to Money Morning here.