It is the dirty little secret of the investment world: most of the fund managers and stock brokers who are paid handsomely to pick stocks actually fail to beat the simple index. And yet the cult of the “star stock-picker” remains as strong as ever.

Countless studies have cast doubt on the benefits of active management in highly efficient markets, especially US equities, where competition is high and (in theory) prices largely reflect all publically available information.

While the Australian equity market appears similar, the evidence is less compelling but still gives much cause for scepticism.
The most recent SPIVA report from Standard & Poors shows that over the five years to 30 June 2012, 69% of Australian active large cap equity managers failed to beat their benchmark. Similarly 73% of global equity managers failed, 92% of Australian bond managers failed, and 65% of Australian listed property managers failed. In fact, the only category where the active managers did better than the index was in Australian small companies segment where 79% beat the index.

These results are not an anomaly, but rather they are repeated again and again through virtually all meaningful time periods.
So why then is the cult of the star stock picker so strong? This is difficult to answer precisely, but we think it’s because investors “want to believe”. They love a good story and are vulnerable to being seduced by the promise of a better than average return. Investors are even more vulnerable when the promise comes complete with a cleverly packaged set of slogans and themes.

Some of my favourite stock broker sayings include:

• This year is going to be a stock picker’s market.
• We just buy on the dips and sell on the ups. (Ohh… if only it were that easy!)
• If you buy the companies that sell to China you can’t go wrong.

If you actually look at the evidence, there is prescious little to support these slogans.

Historically the investment management community has been split into two styles: the active guys, and the low cost index managers (who simply replicate a market index). More recently however there has come the emergence of a third style, which is widely becoming known as “Smart Beta”.

Smart Beta strategies aim to get the best of both worlds: the low costs of index funds, but with the possibility of alpha (outperformance above the benchmark). There is no single definition of smart beta strategies, but there is one easy way to think about them: If alpha is about outperforming the market and beta is about achieving the market return, smart beta is about improving performance by passively tracking an index that is not based on a traditional market capitalization weighting. In other words, smart beta is an enhanced form of passive investing.

At Minchin Moore, we didn’t set out to become a “Smart Beta Firm”, but our evidence based approach to portfolio construction has lead us to a situation where we largely do fit this description.

Whilst we remain open to all arguments, our philosophy and process mean that we can’t be seduced by something that is little more than “a good story”. No matter how good the story is, there must be empirical, academic evidence to justify the strategy’s inclusion in one of our portfolios.

Some of the core strategies that have passed the test and we employ today include:

• We utilise passive managers in efficient markets (large cap equities and bonds) while using active managers in other parts of the market where there is demonstrable evidence to suggest the chance of generating alpha is high (for example Aussie small caps).
• We tilt equity portfolios toward cheap (or low book to market) companies and smaller companies.
• We utilise momentum strategies to generate virtually pure alpha (that is, virtually zero correlation to traditional asset classes). This in turn can reduce portfolio risk without compromising expected returns.