Investing in winners: Why an index is difficult to beat

John Redwood, Charles Stanley's Chief Global Economist, looks at the performance of individual shares and an index.

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A study of the last ninety years of US stock market performance by Hendrik Bessembinder concluded that most shares quoted in the country do not, on average, give you a better return than that on Treasury bills, roughly the same as a short-term deposit account. Indeed, he concluded that the substantial returns over and above Treasury bills which the index recorded came from just 4% of all the shares listed over the long time period. Just ninety shares accounted for half the substantial extra returns. The average share was only listed for 7.5 years, reminding us that plenty of companies get taken over or delist because they are struggling or wish to go private.

Stock indices like the S&P 500 or the Eurostoxx 50 are momentum managers of shares. Any company with a falling share price faces relegation from the list if it ceases to be large enough to qualify, whilst just outside the top 500 or top 50 companies lie aggressive new growing companies jostling to be admitted to the index. Such an index usually removes a share well before the company gets into serious trouble or goes bust, and welcomes in any fast growing company that is going places and meets the required size. More importantly, given the evidence of the research about the importance of the few companies to overall wealth, the Index allows the successful companies to become larger and larger components of its portfolio as the companies grow their profits, revenues and share prices.

This has been a marked characteristic of the long bull market since 2009 in western markets. The positive performance of shares overall has been dominated by the emergence of some very big US technology companies, which have come to represent a bigger and bigger part of the US share indices. In their turn their performance has driven the world share index, with US shares representing more than half the total and often being important drivers of the bull trend.

The performance gap between the US and European indices in favour of the US owes quite a lot to the presence of a much larger and fast growing technology sector in the US. Six of the ten largest companies in the S%P 500 are technology companies on a wide definition, whereas only two out of the top ten are in the European index. A total of 21% of the US index is defined as technology, and 10% communications, compared to less than 10% for technology in the Eurostoxx and less than 6% in communications. Large US companies have grown their profits and revenues in European countries and reported the profits back to their US base and share market.

This phenomenon means that an active share manager with both good judgement and courage can do well, by picking more of the handful of stocks that are going to make a big difference and sitting with them. In practice many active share funds want to diversify. They are also tempted to take profits on the way up as some of their companies are very successful, whilst the Index they are trying to beat does not take profits all the time the shares stay above the minimum threshold of total enterprise value to stay in. As soon as an active fund diversifies too much or takes profits on key companies and sectors that are successful, it has problems beating the Index. It also means buyers of index tracking funds need to be aware of the contents of each index and the powerful industrial and sector trends that will help shape its performance.

Just as technology companies have come to represent a growing proportion of the US Index, so the same phenomenon has been the experience in China as well. The digital revolution is sweeping through all economies, punishing traditional business models and transferring large revenues to the tech challengers. In the West, Amazon and Google, Netflix and Apple advance. In China Tencent and Alibaba make the running. The traditional retailers are undermined by Amazon and the traditional media and advertising are damaged by internet providers which can lead to falls in their share prices. Lower profits and the competition for revenues takes its toll on the less successful of traditional businesses and brands. The index automatically adjusts to the digital challenge daily as values of companies and shares alter.

For more information please get in touch 020 3504 8307 or email us at madeforyou@charles-stanley.co.uk 

John Redwood is Chief Global Strategist at Charles Stanley &Co. Limited, which is authorised and regulated by the Financial Conduct Authority.

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