I don’t think the market is always efficient and – unlike my virtuous co-blogger here on Monevator – I invest some of my money accordingly.

Please note: I’m not suggesting you should try to beat the market at home. I don’t even think I should!

For most, the best results will come through passive index investing. The chances that you or I will follow in Warren Buffett’s footsteps are tiny, whether his returns are down to luck, skill, or cheap money from his insurance operations.

Some people are drawn to active investing for reasons other than greed and delusion, however. There’s intellectual stimulation, an interest in business, the sheer challenge, and an aversion to having fun in the evening.

So if you’re an incurable moth and the market looks like one giant candle, what’s the best way to get burned?

Why I like value investing

When it comes to the quixotic – and for the last time optional and ill-advised – goal of trying beat the market, I think value investing has the edge.

Most of my favourite investors were value investors, from Benjamin Graham and Warren Buffett to Sir John Templeton, Walter Schloss, and even The Motley Fool writer Stephen Bland.

They all backed their judgment that the market isn’t always efficient, and found that a value-based investing method was the best way to root out the truffles from beneath the wood and the trees.

I like value investing because it makes logical sense. Buy the unloved stuff that stinks, and sell it when it doesn’t. If you’re looking for profits in real-life that’s not a bad formula, so it seems a good place to start hunting for profits in the stock market, too.

I also like value investing because I’ve noticed most people can’t do it. Oh they talk about contrarianism and buying cheap, but most of their investments are in companies that have been doing well, and that look fully valued to me. Often in life you can get paid for doing something that others can’t or won’t do.

A final reason I like value investing is because even the high priests of the efficient market have anointed it as a market-beating strategy.

After all, they can hardly refute the data1, which consistently shows that over the long-term, stocks with value-based metrics (such as a low price-to-book value) have outperformed the wider market:

Source: Credit Suisse/London Business School

Of course, efficient market supporters don’t see value as a violation of the efficient market.

They typically either think that value investors are taking on more risk to get higher their rewards, or else they think that there was a genuine anomaly in the market due to ignorance, but now it is being whittled away by everybody knowing about it.

I’m not so sure. I’m more in the emerging camp of behavioural finance, which takes the notion of human beings as rational creatures, and puts them in a silly hat then plonks them on a photocopier to make duplicate asses of themselves at the Christmas party.

Metaphorically speaking, you understand.

People will always be foolish, greedy, scared, and more interested in jam today than Victoria sponge tomorrow. I therefore suspect that value anomalies will persist, too, although whether you or I will profit from them is another matter.

Small companies deliver bigger returns

It’s not only value that beats the wider market, as it happens.

A few famous growth investors have been successful. In the UK, Jim Slater found fame as a stock picker of small, fast-growing companies. Slater did have a value tilt though, in that his metrics centered on the PEG ratio he made famous, which aims to prevent an investor overpaying for growth. Some other growth investors all but dismiss valuation altogether.

Growth has a poor record when statisticians crunch the numbers, tending to underperform value shares over multi-year periods.

In focusing on smaller companies, though, Slater was on the side of another proven market-beating strategy:

Source: Credit Suisse/London Business School

Unlike with value, I can easily believe higher risk is the reason for the higher returns from smaller companies.

Very small companies – which are the ones that have delivered the highest returns – are illiquid and often difficult to trade, which adds to risk in the academic sense, and so to higher returns.

Higher yield, higher returns

In the UK Neil Woodford has soundly beaten the market by investing in dividend-paying stocks, as we never seem to keep hearing these days.

Few other income investors have Woodford’s record. But the performance of equity income investment trusts as a class has been very good compared to the market for as long I’ve been watching, suggesting to me there may be more at play than just a clutch of lucky managers and a fair investing climate for dividends.

Sure enough, professors at the London Business School report that high yielding shares have also beaten low yielding shares over long periods of time:

Source: Credit Suisse/London Business School

The success of high over low yield is to my mind value investing in another guise.

High yield occurs when a company’s price is depressed, perhaps because of uncertainty about its future or the unpopularity of the sector. Sometimes companies are punished just for paying dividends – it’s hard to believe now, but in the 1990s income was barely discussed by most investors and journalists, if not actively looked down upon.

Yet the cash flow suggested by a strong dividend usually indicates there’s at least some money-making going on at the company.

If things don’t turn out as bad as feared – so the dividend is not cut or worse – then high yield shares can keep on paying a high income, and you might see their share price rise in time. Both factors will boost returns.

The trend really is your friend

Hedge funds and others have been able to profit from all sorts of anomalies over the years.

The book More Money Than God offers an excellent history of a succession of hedge fund pioneers spotting inefficiencies and then exploiting them until others join the feast and the easy profits are gone. (The market might not be 100% efficient, but it’s definitely no mug!)

A common thread to many hedge funds’ success is momentum, in which they find and back trends they see in the market.

To over-simplify, momentum means that if prices are rising then they will tend to keep rising, and vice versa. Such trends should not exist according to efficient market theory. Prices should follow an unpredictable random walk.

One of the biggest investing upsets in the past couple of decades though was the discovery that momentum – long derided by both academics and value investors – does in fact exist.

I still feel queasy when someone shows me a rising price chart as the rationale for a share price going up some more. Yet at the market-wide level, the proof is in the data:

Source: Credit Suisse/London Business School

Of all these market-beating metrics, momentum is the biggest challenge to the efficient market hypothesis, in my humble opinion as a blogger as opposed to a Nobel prize-winning economist. It shouldn’t exist.

That said, I should stress for novice investors that there is an immense difference between the amateur stargazing that passes for momentum investing on bulletin boards, and the Phd-heavy supercomputing-powered high frequency stuff done by hedge funds.

Even hedge funds have been failing to match the simplest combination of equity and bond ETFs lately, so perhaps academics will have the last laugh (although hedge fund returns are also crippled by their enormous fees).

Can we exploit these market-beating strategies?

Let’s end by asking the obvious question: Could we use these stock picking methods to beat the market ourselves?

I can’t give you a definitive answer. What has worked in the past might not work in the future. I’m on-board with the idea that at least some anomalies will vanish, if they’ve not already, as the mostly-efficient market ferrets out the inconsistencies.

However I do think it’s not an entirely discreditable aim to try use these proven market beating methods to boost your returns.

One sensible approach might be to tilt your passive portfolio to try to capture some of the potential outperformance, rather going whole hog into one market-humiliating venture or another.

Even some of the passive investing gurus recommend as much, suggesting minor additional allocations towards specialist ETFs or tracker funds tilted towards small companies or those with higher yields.

But here’s a few things to consider before you get carried away.

Firstly, the academic research showing the outperformance I’ve cited looks at market wide data, and typically ignores costs.

We can’t forget about costs as private investors, and in the UK it’s hard to invest across the market based on these themes too, although some outfits such as The Munro Fund have tried to change that.

US investors enjoy access to a wider range of passive vehicles, including ETFs that seek to capture these extra gains. You might consider buying into one of these US-listed ETFs if you’re keen, but remember that introduces currency risk, withholding tax, and other complications.

Secondly – and in semi-contradiction to my earlier paean to value investors – just because some metric has previously worked across tranches of hundreds of shares, that doesn’t mean it’s a sure way to pick a handful of stocks.

• Buying a basket of 250 low price-to-book small cap shares and mechanically shuffling them year-on-year for an academic study is one thing.

• Buying four or five penny shares you fancy because they seem cheap is quite another thing, and likely an explosive and painful one in most hands.

Finally, academics typically crunch their data over very long timescales. You may well find that a measure such as low price-to-book value outs itself through extra returns over shorter periods – or that it does not – but in any event that’s not what I’m claiming here.

I’m just pointing out what academics have found has worked over periods of 60-100 years or so. But that’s beyond even my investing time horizon, however much I skip the booze and hit the gym!

1. This graph and those that follow comes from the London Business School researchers behind the Credit Suisse Global Returns Yearbook 2013, which is a treasure trove of interesting data. [↩]

To all those passive investors who worry about tracking error on their investments: I salute you.

Tracking error is a critical measure of index tracker performance. It’s poorly defined, however, and most private investors don’t know where to look for good tools that can provide a ready reckoning.

But I think I’ve found the answer. I’ve been on a quest for some time to find a service that enables passive investors to compare virtually any tracker they own against its index, as well as against rival tracker funds.

And I now think Bloomberg is the way to go.

If you want to compare trackers versus the FTSE 100 or S&P 500 then you’re spoiled for choice. Yahoo Finance, Google Finance, Reuters, Trustnet, and MorningStar all offer partial remedies1.

But if you track the emerging markets or global property or a high dividend index, then turn to Bloomberg to stick that index on a chart and see which funds mimic it like a lyre bird, and which are more like a poor man’s Bobby Davro.

Step 1: Choose your index tracker

Bloomberg’s chart tool dials up data via Bloomberg codes. We need to know the correct code for each fund and index we want to track.

First, choose your tracker. If you’re lucky then the fund factsheet or website will list its Bloomberg code2. You can stick that straight into Bloomberg’s search box3 and you’re on your way.

If you don’t know the code then it’s time to root around in Bloomberg’s funds bazaar, where the ETFs and mutual funds of many nations rub shoulders.

• I found it easiest to choose funds by location rather than objective or even alphabetical order (there are too many American funds to sieve).

• Most trackers intended for UK investors sit in the UK section.

• However, some funds are categorised by their domicile.

• Vanguard funds based in Ireland are found in the Irish section. iShares funds domiciled in Ireland sit in the UK section. (Hey, why make it easy?)

Begin your search in the UK section but, if you can’t find a fund, then check its domicile on its factsheet and rummage around in that country’s silo on Bloomberg.

Of course you could type your fund’s name into the search box, but you risk choosing the wrong version if you get the name slightly muddled. For that reason, I think it’s best to hunt manually.

Funds are categorised alphabetically by fund provider, as you would expect. In the UK section, you’ll find db X-trackers listed from page 19, HSBC from page 28, iShares from page 34, and Vanguard from p.72 (p.44 in Ireland).

Once you’ve found your fund, click through to its overview page.

It’s a good idea to note the Bloomberg code for your fund (circled in the pic above). I’ve chosen to track the Vanguard Emerging Market Stock Index fund (income, GBP version).

The code here is: VANEMPI:ID.

If I want to track a different fund later then I’ll be able to use this code to pull up the Vanguard fund’s data on another fund’s chart.

Finally, click the chart link (circled in pic above) to pull up a performance chart for your fund.

Step 2: Choose your rivals

Compare rival funds by tapping their Bloomberg codes into the ‘add a comparison’ field circled in the pic.

Get the codes as explained above or use the search box if you’re the devil-may-care type.

MorningStar’s quick rank tools are your friend when it comes to finding new funds in the same asset class.

Your chart will now be covered in multi-coloured squiggles as if raced over by genetically modified snails.

Step 3: Add the right index

The final step to checking tracking error is to add its index into the comparison field of your fund chart.

The right index is always the index that the trackers actually track. The fund’s factsheet will tell you which index it follows.

Don’t trust Bloomberg or anyone else to select the benchmark for you. They frequently select an index in the right ballpark but they don’t always worry about an exact fit. A tracking error comparison is meaningless if you’re pitting your fund against the wrong index.

Each index has its own Bloomberg code, just like the funds. Pop the code in the ‘add a comparison field’ to paint the index squiggle on your chart.

You don’t know the Bloomberg code for every index in your collection? Tsk, tsk, it’s like you have a life or something.

The easiest way to get the code, once again, is to rifle through your fund’s website or factsheet for that index’s Bloomberg code.

For example, the Bloomberg code for the MSCI Emerging Markets Index is MXEF:IND.

The :IND component is a suffix that denotes the code is for an index. Make sure to add this bit on if it’s missing from the factsheet.

You can search Bloomberg for indices, although I found this method unreliable. Go to Bloomberg’s index emporium and try searching alphabetically for all those FTSE and MSCI benchmarks.

Remember that there can be three different versions of an index:

• Price return (PR) – Dividends aren’t included in performance figures.

• Total return (TR) – Dividends are included.

• Net return (NR) – Dividends are included but with a deduction for tax.

Make sure you pop the right version of the index on your chart. If Bloomberg will only give you the price return index then make sure you compare it against income / distributing versions of your tracker rather than accumulation varieties.

That way you’re not comparing a fund that’s gorged with dividend returns versus an index that isn’t.

Step 4: Analysis

At last we have our funds pitted against their index.

In the example above, we’ve got the Vanguard Emerging Markets Index fund inc (orange) vs iShares MSCI Emerging Markets ETF (green) vs the MSCI Emerging Markets price return index (light orange).

I’ve annotated the components that are most important to understand in the pic above. Note the numbers in the circle refer to daily changes and are thus irrelevant for our purposes.

We want as long a comparison as possible. Three years is a minimum, five years is OK. Ten years is sadly beyond the capability of the charting tool.

Visually, it’s very difficult to tell which tracker has most closely hugged the index as they bounce around over time.

You can do it though by collecting the opening and closing numbers of the funds and index over the entire timeframe.

In other words, move your cursor to the far left-hand side of the chart and note the values for each tracker and the index (see the upward pointing arrows on the pic) on the first day of the comparison.

Now move your cursor to the far right and scribble down the values for the final day of the comparison.

Pop your numbers in a percentage gain calculator to find out total gain (or loss) made by each fund and the index.

Note: The gulf in the actual prices and index points doesn’t matter here. It’s the percentage change we care about.

Whichever fund’s performance most closely matches the index wins. This is the fund that has suffered the least tracking error (or more accurately tracking difference).

If you want to gauge performance on an annualised basis, stick your numbers into a compound annual growth (CAGR) calculator.

Final tips

If you’re not sure you’ve picked the right version of the fund then compare its current price with the price listed on its website or MorningStar. Double check that the prices are from the same day – the fund providers aren’t always as electric as Bloomberg.

Funds have suffixes that denote their listed location, such as :LN for the UK and :ID for Ireland. Be sure to add these on to the ticker codes when searching for them on Bloomberg.

Go to the chart’s settings > ‘enable tracking’ to read the vertical axis using the cursor.

I can’t vouch for the accuracy of the data provided by any company. It’s a good idea to get a read from a couple of different sources, including the fund provider, before coming to any firm conclusions about tracking error.

The good news is that the EU will soon require all UCITS4 index trackers to provide tracking error predictions from this year.

All the same, those figures will be ‘predictions’. Track record counts when it comes to tracking error.

Take it steady,

The Accumulator

1. Note: There are though some difficulties with using the data from some of these services in certain instances, which we discovered when looking into the tracking error of UK ETFs. [↩]
2. ETFs from iShares do, for instance. [↩]
3. See the part about code suffixes in Final Tips. [↩]
4. That’s pretty much all the ETFs and index funds you’ll find in Europe. [↩]

Good reads from around the Web.

The UK’s FTSE 100 index has yet to surpass its pre-crisis highs. Good news if you’re investing new money – you’re getting in cheaper!

If you’re fully-invested though and you’re becoming frustrated that you didn’t put all your money into Venezuala (the tinpot dictatorship returned more than 300% last year, topping the global league) then you might direct your ire at just a handful of the UK’s behemoths.

This graph from the UK Stock Market Almanac blog reveals how much a 10% swing in any of the UK’s 20 biggest listed companies moves the FTSE 100:

I was pleased, though not surprised, to see so many of the blue chips I think still worth buying for income are on this list.

There are exceptions. Diageo looks expensive, and you can argue that BP and RDSB are properly priced for their dwindling assets. Lloyds currently pays nothing, but I think it will one day become a cash cow.

On the whole though I can think of worse income portfolios than simply buying this lot with an equal weighting. (That is not advice or even a suggestion it’s a good idea – just an observation.)

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