Ben Warwick funding mantras: Ben Warwick’s suggestions for gaining an funding benefit for returns consistent with the market
Ace investor Ben Warwick says that to achieve exceptional investment performance, investors need to achieve above-average returns, which is only possible if they have an investment advantage.
He says this “edge” can be defined as “alpha,” which is the portion of a mutual fund’s return that is generated entirely by the skills of the portfolio manager.
“Investors, traders, and speculators alike have been looking for a reliable source of alpha since the financial markets began,” he says in his book Searching for Alpha – The Quest for Exceptional Investment Performance.
Ben Warwick has been in the investment industry since 1990 and is the founder of Quantitative Equity Strategies (QES), a Colorado, US-based quantitative investment management firm that developed indices for the mutual fund industry in 1999.
Warwick was previously a founding shareholder and CIO of Sovereign Wealth Management, a multi-family wealth management company acquired by United Capital Financial Advisers in 2011. He was also the head of quantitative trading at Exis Capital, a New York-based hedge fund.
Warwick holds a BS in chemical engineering from the University of Florida and an MBA from the University of North Carolina, and has authored several books on finance and investing, including the investment classic Searching for Alpha: The Quest for Exceptional Investment Performance.
He is also a Market View columnist for the financial website worldyinvestor.com.
Why most funds can’t beat the market
Warwick says winning the investment game is difficult because only a small number of mutual funds are able to generate above-the-market returns.
But he does believe that there are some elite investment professionals out there who manage to produce exceptional returns year after year because of an investment advantage.
Warwick says that generating exceptional returns and generating alpha depend on managers being able to find and exploit mispricing and other market inconsistencies.
“Many active portfolio managers make a living convincing investors that rigorous analysis of a myriad of mysterious factors can give them the edge that will allow them to beat the market. The fact that 70% of the total invested funds are actively managed market-wide shows that professional and private investors alike support this approach, ”he says.
Warwick says more than half of actively managed mutual funds have failed to outperform the S&P500 over the years, and many of the funds that beat the index one year will fail the next.
Anyone looking to invest in actively managed mutual funds should keep in mind that past performance is not necessarily an indicator of future performance.
Warwick believes that the fact that most funds can’t beat the broader stock market shouldn’t come as a surprise given that most of the money invested in the stock market comes from mutual funds and institutional funds.
“Since these funds make up the bulk of the market, they can’t all outperform the market. However, there will always be funds that deliver exceptional performance, ”he says.
Warwick says most actively managed mutual funds attract investors with the promise of superior market performance in exchange for higher fees (compared to index funds). However, there are a variety of obstacles preventing these funds from delivering on their promises.
One of the barriers to achieving superior fund performance is fund size. “The bigger a mutual fund gets, the more difficult it becomes to achieve exceptional performance. A large fund must invest more broadly and must invest in companies with larger market capitalizations. Large companies will be watched more closely, and their stock prices will usually accurately reflect their value (e.g. there will be fewer bargains). Fund managers also have to work harder to avoid their trades having an impact on the market. For example, if you buy a large block of stocks that the fund manager believes are undervalued, there may be market effects that would drive the stock price up and reduce profits, ”he says.
Warwick says that while fund size is counter to alpha generation, fund managers have strong motivation to grow the fund as big as possible, as most actively managed mutual funds charge a fee based on asset size. The bigger the fund, the more money the fund managers make.
How can investors generate “alpha”?
Warwick believes that actively managed funds can “generate alpha” by trading frequently. He also believes that stock options can be used to secure profits and avoid losses, but many funds don’t use this strategy.
Warwick says there is a common belief that mutual funds are conservative, which in theory limits their potential losses and makes them more suitable for the average investor. This in turn limits the mutual funds’ ability to “generate alpha”.
Warwick says one of the “alpha generation” techniques that funds can use is arbitrage, in that it buys an asset in one market and sells it or a related asset in another market.
He says another area where mutual fund investors can get “alpha” is in funds that invest in small-cap companies or small-cap stocks.
“Many market analysts don’t track small businesses. This means that there can be unrecognized bargains. An actively managed fund with good research staff and a talented fund manager can potentially build a portfolio of small-cap stocks that can beat the market. However, small companies are more sensitive to economic downturns, and small-cap stocks can fall faster than big company stocks during a recession, ”he says.
In his book, Warwick discusses some techniques for creating an investment advantage that can help achieve superior investment returns. Let’s look at some of these tips –
Warwick says the secret to outperforming the market is not in portfolio concentration, but in holding a little bit of everything and staying overweight in sectors that offer the best opportunities to outperform.
“While famous investors like John Maynard Keynes and Warren Buffett have made fabulous returns from a small number of large positions, they are the exception rather than the rule,” he says.
- Use indexing for difficult sectors
According to Warwick, different sectors differ in how quickly they can respond to information, making it very difficult in some sectors to add value through active strategies. Therefore, he recommends indexing such sectors.
“Largecap stocks, for example, are tracked by many analysts and reflect company fundamentals so quickly that it is almost impossible to add value through active strategies. I recommend indexing such sectors, ”he says.
- Use active strategies in inefficient market sectors
Warwick says that some parts of the market are very efficient, but there are certain sectors like small-cap stocks and high-yield bonds where active management can really come in handy. “For these sectors, use active managers who have a unique and scalable methodology for generating alpha (ie, return above a market index),” he says.
- Use the credit spread to make portfolio changes
Warwick says different types of stocks respond in unique ways to changes in the economic environment. He says small-cap stocks do better during a recession or a downtrend. Largecap stocks, on the other hand, tend to lead the market higher in good times.
He advises investors to look at credit spreads to understand the economic situation and change their portfolios accordingly. “Look at the credit spread – the difference between the yield on government bonds and corporate bonds – to see if an economy is expanding or contracting (a growing economy is associated with a tightening of the spread) and align your portfolio with the market sector from d benefit the most, ”he says.
- Use momentum strategies during the growth phase
Warwick says momentum traders buy stocks that have risen the most, believing they will continue to do so in the future. He says investors should only use momentum strategies during times of economic growth for generous returns. “While there is abundant evidence that market sectors trend-following during expansion phases, a weak economic environment usually prevents such momentum players from generating above-market returns,” he says.
- Consider alternative investments
Warwick says that as the world’s economies become more integrated over the years, the equity and bond markets are globally connected. He therefore advises people to also invest in futures to ensure that their portfolios are diversified in value, as these can be a source of steady returns.
“Prudent investors should consider skill-based investing in the futures markets and through market-neutral hedge funds (unregulated investment pools that make profits through an arbitrage approach) in order to add value to their portfolios. Steady returns on these investments can go a long way in generating market-leading returns, ”he says.
- Find ways to minimize taxes
Warwick says taxes are mostly the biggest expense investors face, even more than both commissions and investment management fees. He says tax profits are primarily the result of efforts by asset managers trying to add value to the investment process by buying and selling securities. He says taxes can be minimized by indexing the hard sectors and keeping all actively managed funds in a tax-privileged account.
- Choose your investment manager wisely
Warwick says investment managers shouldn’t be hired based solely on past performance. “When considering investing in a mutual fund, there are more important things to consider than the fund manager’s past returns. Take into account transaction costs, fees, and the fund’s research budget. These three criteria are much better indicators of what might happen in the future, ”he says.
- Regularly rebalance your portfolio
Warwick says the market tends to have mean revert in the long run; That is, winners become losers and losers become winners. Therefore, it is important that investors regularly rebalance their portfolios by taking money from investments that have done well over the past few months and reallocating it to those who have suffered losses.
This could ensure that they can both increase their returns and reduce their reliance on some bets that have grown significantly in value.
(Disclaimer: This article is based on Ben Warwick’s book Searching for Alpha – The Quest for Exceptional Investment Performance.)