Our headline feels like an essay question. Before we can even start to answer, we must come up with a definition for ‘alpha’. And then we need to challenge the premise of the question. Is alpha the right thing to be seeking?
For a fund manager, delivering alpha generally means outperforming the benchmark. Our performance is measured by that yardstick, especially when investors have the option of cheap trackers.
We accept this challenge, and over the long term – five and 10 years – our team has succeeded. But, talking to advisers, we know that what clients really want is growth in the purchasing power of their savings over time.
They do not welcome volatility, which undermines confidence and the ability to maximise time ‘in’ the market. So perhaps we should not just be talking about returns.
How risky is the benchmark?
Risk has often been forgotten in the drive for passive investment. Over a period of, say, five to 10 years the risk you take investing in an index can vary significantly. The inability of a passive fund to discern value and avoid inflating bubbles can pose hidden dangers.
By definition, the index contains large holdings of stocks that are in fashion, whether they represent good value or not, and small holdings of unfashionable stocks, however cheap they might be.
The shift from active to passive investing has created a feedback loop that has exacerbated this issue and proven a headwind to active managers underweight in the fashionable stocks (our funds are typically less than 20 per cent aligned with the composition of the MSCI All Country Worldwide Index – or MSCI ACWI).
Take Apple, the world’s biggest company by market capitalisation. It makes up 4.5 per cent of the MSCI ACWI and over 7 per cent of the S&P 500. In the past year Apple shares have risen 5 per cent, defying the weakness in US technology stocks.
Apple is expected to earn $6.46 (£5.71) per share next year, against $6.10 this year (so growth of 5.7 per cent). It now trades on 23.7x earnings, according to Bloomberg – the average price/earnings ratio for the US S&P 500 for the end of next year is just 15.6x.
Is the index a safe proposition if it allocates so much of your savings to one company on that valuation? Other index giants are even more expensive – Amazon (36x) and Tesla (39x), according to Bloomberg.
Lessons from history
If you are worried about the size of individual companies in the index and their valuations, should you also be concerned about the allocation to countries?
In the late 1980s, when at its peak, the Japanese equity market made up more than 40 per cent of global indices. It has underperformed other markets for most of the 35 years since and now represents below six per cent of the index.
In mid-2011, when we launched our global equity unit trust, US equities made up 47 per cent of the global index. Today they account for 62 per cent. Arguably, this weighting says less about the value for money represented by US stocks and more about the US as a haven in a tumultuous investing world.
