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There are several ways fund managers and investors can outperform the benchmark stock indexes, according to Bank of America Merrill Lynch.
So far this year, 60 percent of active fund managers are beating their respective market indexes, tracking to the best performance since 2003. But it hasn't always been this easy, particularly with the rush of investor money to so-called passive funds that track indexes.
"One of the biggest challenges for active managers has been a substantial shift to passive investment strategies," Bank of America equity and quantitative strategist Savita Subramanian said in a note to clients on Friday. "The best way to slow or reverse this shift is by generating alpha," another word for outperformance.
Bank of America made a list of seven ways to beat the benchmark, three of which are highlighted here. "The job of an active fund manager is far from simple, and we would be remiss to reduce the complexity of fund management to a series of rules. But our quantitative work reveals a few techniques worth considering to beat the benchmark."
Here are some recommendations that investors can use to outperform.
1. "Pick your battles."
In some sectors, picking the right stock is key. For other sectors that are more influenced by macroeconomic factors, picking the sector is enough. Subramanian noted investors should focus on parts of the market with more return volatility, which provides opportunities for bigger gains.
She recommended technology, health care and consumer sectors as a "stock-picker's paradise." And for those betting on sectors, she recommended financials, real estate, utilities and energy "where being right on macro (rates, oil, GDP, etc.) is likely a more important call."
2. "Take the road less traveled … especially by the sell side."
Investors are more likely to find bargains in areas of the market that are less covered by Wall Street analysts, Subramanian said. Less research means these stocks could get overlooked, and they won't be prone to overcrowded trades by investors chasing hot stocks.
"The more eyeballs on a stock, the less alpha you're likely to harvest," she said. "Another pitfall avoided by steering clear of the sell-side darlings is crowding. Since the crisis, crowding has been a particularly acute issue for investors. In three of the last five years, the most overweighted stocks by active managers have underperformed the most underweighted stocks."
3. "Extend your time horizon."
Subramanian said short-term trading hurts returns because of higher levels of competition.
"Alpha over short time horizons has become increasingly hard to come by," she said. "But with the paucity of resources, investment strategies and eyeballs focused on the longer-term outlooks, the alpha opportunity over a longer time horizon has dramatically increased."
Bank of America Merrill Lynch research showed funds do better if they hold their positions for longer, three-year holding periods.