Take the middle way

Passive funds are cheap and dumb, active managers less dumb but very expensive. There is a middle way, says David C Stevenson.

I apologise in advance for the jargon I'm about to use, such as smart beta' and risk-adjusted returns'. It's all in the name of helping you make bigger gains from a rising stock market assuming you think that markets will carry on rising from here! And that means taking a bit of a delve into the world of academia and of institutional investors.

Institutional investors are rightly cynical about the claims of fund managers. Any half-articulate manager can string together a few words to suggest why their fund should do well in rising stock markets. But what do the hard numbers say? Data on past returns (which is all we have to go on) tells us that most managers struggle to beat the market consistently over the long run. This is down to several factors, not least the fees they charge.

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This scepticism has powered the rise of exchange-traded funds (ETFs), which offer passive' exposure to an underlying market at low cost. But some annoying idiosyncrasies keep cropping up. Scrutinise the returns data enough, and you find that some managers do in fact perform well for prolonged periods. And some though not many also have a better track record of balancing risk and return. Genuine talents such as Neil Woodford or Richard Buxton have attracted countless billions into their funds because they have a better-than-average record of working out what's risky, and thus to be avoided, and what's worth the risk to get some return.

The three investment anomalies'

At first, such analysis revealed three anomalies: the value effect (it pays to buy good quality, cheap shares, where the company has a decent balance sheet); the smaller company effect (smaller companies produce better returns over the long term, although they are very volatile); and the power of momentum (where trends emerge for certain periods, and popular stocks continue to outperform the market).

Certain managers have skills in one, or maybe a combination of these. But none works all the time. Sometimes value stocks work best, but then underperform as momentum takes over.

Yet with further examination, another interesting fact emerges. A basic tenet of investing is that if you take more risk, your potential returns are much greater. But in fact, this is not always true. If you remove the most volatile stocks from a portfolio (volatility is simply the ups and downs of a share price), the risk-adjusted' returns actually improve. Many managers had already worked this out before the academics: tracking the FTSE 100 is all very well, except that in reality you are focusing on big banks and oil stocks. How can that be sensible in volatile markets?

The rise of smart beta'

passive investing

Say you think the FTSE 100 could rise from here, but are wary of buying every stock in the index. A classic passive ETF might leave you cold. While cheap, it leaves you open to the risks of buying dirty, volatile resources stocks. An active manager who emphasises a particular style (value or income maybe), is another option, but you'll pay an extra 100 basis points a year for the privilege. Cue the middle way smart beta ETFs.

Two smart beta ETFs to buy now

Risk-Weighted Enhanced Commodity Ex-Grains TR UCITS ETF (LSE: LCRW)

French upstart Ossiam specialises in smart beta. It has taken a core insight that minimising, or even excluding, volatile elements from an index can deliver improved returns and applied this to commodity trackers. It effectively weights all the futures contracts in a basket of commodities, then gives more prominence to the less volatile bits (grains have been left out for moral reasons).

This simple but effective idea is echoed in a Lyxor ETF Lyxor ETF MSCI World Risk Weighted (LSE: WDRL). This more mainstream product tracks the large-cap equity stocks in the MSCI World index, but attaches a risk weighting based on volatility (ie it's weighted towards less volatile stocks). MSCI also seeks to reduce risk by building a better-diversified index, which has a larger proportion of smaller companies by market capitalisation in it (we'll discuss this subject more next time).

What it means in practice is that you'll see fewer US stocks in the index, more Japanese and Canadian giants, and a general shift towards more defensive stocks. These stocks may underperform in a raging bull market, but past analysis of this index by MSCI suggests you would have achieved at least a 1%2% annual outperformance over its own conventional World index, over the last ten to 20 years.