Beating the market is what every active fund manager aims to do. If fund managers didn’t think they could beat the market — that is, the benchmark index — investors would be better off putting their money into an index-based ETF.
Sure, it would be a less exciting way to invest — all index investors can ever expect is the market return. But it would save a lot in management fees, and a whole lot of stress.
But as we discussed in last week’s article, outperforming a benchmark index is a lot more difficult than it looks. And it’s why professional fund managers fail to beat it time after time.
The only way we can beat the index is by not replicating it. That means choosing stocks that aren’t in the index. Or, selecting stocks that are in the index, but using different weightings.
It’s all about sectors
An added stumbling block for Australian-based fund managers is the disproportionate weightings of the sectors. 38% of the entire index is weighted towards the financial sector. That is, the banks and stocks like AMP Limited [ASX:AMP].
However, there are five other sectors, including energy, utilities and consumer discretionary, which together make up around only 16% of the index. Even if an active fund manager makes some good calls on stocks within these sectors, it’s unlikely that it will be enough to help them beat the index.
And even if they get some right, it’s barely going to make an impact on overall returns if they get a stock like Commonwealth Bank [ASX:CBA] wrong.
The second biggest sector in the index is materials. That is, the bulk suppliers and processors of raw materials. These are stocks like BHP Billiton [ASX:BHP], Rio Tinto [ASX:RIO] and Fortescue Metals [ASX:FMG]. This sector makes up around 16% of the index.
Put these two sectors together — financial services and materials — and you have over 54% of the entire index weight. Get it wrong in either of these sectors, let alone both, and it’s almost impossible to beat the market.
Two different approaches
Given the scale and liquidity required to accommodate the massive size of their funds, fund managers are limited in where they can place their money. If you’ve got billions to invest, it won’t spread very far among small-cap stocks.
As a result, fund managers need to tinker with weightings to beat the index. These weightings can be managed a couple of ways. First, the weighting of the sector as a whole. And second, individual stock weightings within each sector.
With the index weighted 38% towards financial stocks, a fund manager can use that as a base from which to allocate their own weightings. If they’re particularly bullish on financial services, they might pull funds out of some of the more defensive stocks, like REITs and utilities, and spread the additional funds across stocks in the financial services sector.
And if they’re bearish, they can do the opposite. They’ll go underweight the financial services sector, and park the leftover funds in cash, or defensive stocks that hold up better when the market takes a fall.
The other way to play with weightings is within each sector. Again, noting the only way a fund manager can beat the index is by not copying it, the manager will take the individual weight each stock has in the index as a base, and come up with their own weightings.
Rotating into winners
Fund managers allocate these individual weights purely on their own analysis. As you’d expect, if they thought the numbers looked better for Westpac [ASX:WBC] over CBA, they’d weight their allocations accordingly.
But another way some active managers approach it is by treating it like a match race. They start by taking a stock that commands the greatest weight in each sector. Take the materials sector, for example, where BHP’s $77 billion market-cap is around three times the size of Rio Tinto’s $25 billion.
If the fund manager was bullish on the materials sector, they might reduce their weighting in sector leader BHP, and allocate extra weighting to the smaller-cap RIO or Fortescue. They’d do this because they’d believe that these (relatively) smaller stocks might outperform BHP over the shorter term.
However, if they believed the sector had peaked, they might rotate out of these stocks, leaving their remaining holdings in the stock they believe will hold up the best. These fund managers are trading shorter timeframes on their belief about what stocks will do over the next number of months.
If you want to beat the market, the financial services and materials sector is where you need to start. However, it’s not just a matter of picking the stocks you think are going to be the strongest. You’ve got to pick stocks based on how you think they will perform against the heavyweight stocks that make up the bulk of the index.
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