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two cents’ worth – Smart investors scout for the best place to park their money

SPORTS teams consider intelligent scouting vital to their long-term success. The same applies to financial investments.

Before deciding where to park their money, investors should scout around for the best bargain; that is, they need to gather and sift through information about the money managers they are considering and the strategies these managers employ.

Depending on their financial objectives, investors can invest with either active managers or index funds. For example, an investor seeking exposure to large-capitalisation stocks can place money with a large-cap active manager or an index fund that mirrors the S&P 500.

How do active managers fare against indexes? Not well. Over a recent five-year period, the indexes outperformed over 40 per cent of all the active managers; over 10 years, more than half of the active funds underperformed the benchmark. This type of result has been consistent over time.

Given how well the indexes have fared, investors can learn a thing or two from how these indexes choose the best candidates for investment, that is, for index inclusion.

The most widely used benchmark for equity fund performance is the S&P 500. The S&P Index Committee uses various criteria when looking for index candidates:

  • Liquidity: The stock must have sufficient liquidity and float.

  • Fundamental analysis: The company must have put in four quarters of positive net income on an operating basis.

  • Market capitalisation: The figure must exceed US$4 billion (S$5.8 billion).

  • Sector representation: The committee tries to keep the weight of each sector in line with the sector weightings of the universe (of all eligible companies). It typically does so by adding stocks in underweight sectors, not by removing stocks in overweight ones.

Excerpted from Michael Mauboussin’s More Than You Know, published by Columbia University Press.

 

Source: The Sunday Times 11 Nov 07

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