How to measure a bubble in the market


Stock market investors are always worried that they are committing fresh money to the market during a bubble when valuations are high, after all the m
[See the full post at: How to measure a bubble in the market]


Describing beta as volatility can lead to confusion. Volatility has more than one meaning in the context of share and fund prices. A stock with low beta can have high volatility when ‘volatility’ means comparing the price against its own historic returns, i.e. standard deviation.

For instance. Using 3-year data from Morningstar (as at market close on 7th November 2014), and using HSBC’s FTSE 100 Index OEIC as a proxy for said index gives a 3-year standard deviation (a.k.a. ‘volatility’) of 10.91 and a beta of 1.03 (1.00 being the beta of the index).

Compare those data against a some if the index’s components:

Tesco has a beta of 1.14 and a standard deviation of 23.00 - higher beta, therefore higher volatily? Now look at a peer…

Sainsbury’s has a beta of 0.78, yet its standard devation is 19.38. So a beta that is 20% less than the market, yet the share price volatility compared with its own price trend is twice as high, and not much less than that for the higher-beta Tesco.

RSA has a beta of 0.53, around half that of the market. But its standard deviation is 19.95, around twice that of the market.

Admiral Group has a beta of 0.98, implying that its share price movements have tended to track the market. But to in doing so the share price has been almost three times as volatile as the market: the standard deviation has been 27.2.

The annualised return for the index over three years is shown as 10.06%. For the companies above they are: -17.74%, -24.96%, +2.24%, +7.65% respectively. Doesn’t appear to be much correlation between beta, standard deviation or returns in those figures.


The article contains quite a fundamental error in stating that the FTSE 100 makes up 90% of the All Share index. It doesn’t - it makes up just under 82% of the All Share. Therefore, the size of pool of companies outside the top 100 is 80% larger than is implied by the article. A significant difference.

Further, the article states that for active managers to outperform their competitors then they must ‘…go overweight in small or medium cap stocks that subsequently rise’. Not necessarily.

When ranked by by market capitalisation, the top ten companies in the All Share index represent one third of that index (around twenty companies make account for half of the index). The remaining 90% of FTSE 100 companies are not the usual definition of ‘small or medium cap stocks’, yet by underweighting just ten stocks - out of over six hundred and forty five (as at 31st October) - the active manager can achieve a significant difference to the index by allocating more to those other 90 stocks in the FTSE 100 at the expense of the top ten. Which is riskier - having concentrated investments over ten stocks or a more diversified holding selected from six hundred and thirty five? The answer to that will likely depend upon which type of risk is being discussed.

Not that it is easy for funds overweight those top ten stocks. At least, not easy for open-ended funds - entirely due to the regulations in place that restrict the amount that this type of fund can allocate to individual stocks. Not so much of a problem for closed-end funds, however.


"The explanation does appear to be that active funds do indeed hold a lot more smaller companies than the index weight suggests they should"
Except that active funds aren't supposed to weight their holdings according to the weightings within their benchmark index, are they?

A frequent whinge from both providers of passive funds and sections of the journalists’ profession is that too many ‘active’ funds are just expensive ‘closet trackers’ and bound to underperform their benchmark index because of their charges. The article comment is now complaining that too many active funds have the temerity to actually be active by deviating from their benchmark index and outperforming in the process. A case of doing what it says on the tin…? How presumptuous of them.

The risk-on/off effect induced by QE has meant that asset allocations have tended to be indiscriminate, leading to company share-price movements being largely synchronised with company fundamentals being ignored; a scenario that has favoured trackers over active management for a number of years because altering company weightings within a fund has been unable to affect the returns to a great degree. Certainly, an observation made by a few of the journos over at the Financial Times. Therefore, the unwinding of (or un-increasing(?!!)) QE ought to increase active managers’ ability to outperform rather than the reverse.

I’ll leave the ‘capital is less important to returns than dividends’ until another time.


I completely agree with @arkwelder. I was going to make some of the same points though he raised more than I was aware off.

my thrupence hapny is they are active managers and shouldn’t be investing like they’re trackers.

Also, the FTSE 100 P/E reflects the lower valuations placed upon very large businesses that are out of favour such as banks and cyclicals that make up around 50% of the market. Take them out of the equation and your cheap Footsie isn’t so cheap.


Both interesting posts but neither addresss the question of why passives have underperformed over 5 years?


So is your point that you think the next five years will be good for for tacker funds in the way that the past five years haven’t @robert-davies ?


Who knows, but a consistent feature of financial markets is reversion to the mean.


For me investing in passive funds is complementary my active funds. The passive funds give me the market return in a low cost fashion whilst my carefully chosen active funds (at times) give me the alpha.

I know a lot of people have strongly held views on holding either active or passive - I come down on the side of holding both.

Incidentally, I love the photo used in this article, it’s really beautiful.


I wasn’t attempting to explain the relative returns of active versus passive over five years, I was pointing out some of the errors in the article and how these might lead to incorrect conclusions being made. Also, how beta and volatility are not interchangeable terms due to beta having a specific application, whereas volatility does not.

However, if that is the required subject…

IMA UK All Companies sector (red line) vs. FTSE All-Share Index (blue line) since the trough of the credit crisis (all data being total return).

Compare the same over the past five years:

Neither of the above charts gives a definitive indication that the average fund in the IMA UK All Companies sector has consistently outperformed the All Share. What the second chart does show is that the sector started to outperform the index around eighteen months ago, but definitely not consistently over a full five years.

Looking at the discrete 12-month total return data for the past five years shows that the sector has outperformed in only the 12-24 and 24-36 month periods, but underperformed in the other three discrete periods.

All charts and data sourced from Trustnet.

Of course, what I am comparing is Active versus Market Cap-weighted Passive strategies. There may be other passive strategies with a smart beta approach which have underperformed, and underperformed both market cap-passive and active strategies over five years, but that underperformance is more likely to be down to the particular smart beta methodology being employed. But it would be wrong to infer from this that all passive strategies have underperformed against active ones.


The relative returns of the UK All-Share index and the UK All Co Sector have changed quite a bit in the last month and the gap between them has closed as you say.

Nevertheless, over 5 years there are 15 passive funds in the fourth quartile and another 13 in the third quartile so I do believe you can say passive funds have underperformed active funds over that time period.

It is also interesting to note that one of the passive funds with a value bias is the worst performing passive fund over 5 years. However, over one year another fund that has a different value bias and can be argued is semi-passive is in the fourth quartile.


Societe Generale says:
In the last three years, the MSCI World Index has risen by 38% (11% per annum) whilst reported profits have risen by just 3% (that’s just 1% per annum!). As the events of last month attest, central bank actions–not profits–are driving equities forward.


Well central Bank actions and the fact companies have hoards of cash too eh @robert-davies

If you didn’t put it in the stock market where else would you put it.

My Mum and me Dad used to be scared of investing in anything stock market like but they were were making so little from cash ISAs they changed their mind. They’re not in anything risky like but, mainly big safer income trusts, Fundsmith, Diverse Income and Henderson Diversified Income but they’re well chuffed with the results.

I think a fund like yours if you can keep up the high dividend payout will be something people who are retired might look at for the income.

My parent aren’t retired yet though they’re getting close to it.


But don’t forget equities have short term risks that deposit accounts don’t. They are different asset classes with different risk and return profiles.


Yeah I know that funds are more risky but you leave aside money for everyday living. that’s what I do and it’s what my Mum and Dad do as well and then we invest what we can afford not to use for the next few years.

I’ve been investing seriously since I was 23 and I’ve not touched any of my investments in that time and that’s over 5 years now.


I’ve never made money out of passive funds, I’ve only ever made money out of investing in shares, a bit of premium Bonds but mainly in funds and trusts.

I just think if you choose your fund managers well and you can invest for a good long while you’ll make buckerloads over passives or over bloody cash ISA’s (don’t get me started on them)