How to Invest Differently Than a Mutual Fund

Conventional wisdom holds that buying index (“passive”) mutual funds and exchange-traded funds (ETFs) is an effective way to beat actively managed funds. Index funds tracking broad-based indexes are difficult to beat over extended periods because of their low costs. For many investors, they are a good option but are not the only way to beat the returns of actively managed funds.

A second way would be to not invest like a mutual fund; rather, hold a truly diversified portfolio of stocks. Such a portfolio would not be just different in terms of which stocks it holds, but also different in the types of stocks it holds. It would also differ in size and even turnover.

A simple way to start would be to truly emphasize value; not just value in name but by holding true value stocks. Such stocks have price-to-book (P/B) ratios ranking in the lowest 40%, or even the lowest 20%. These stocks currently trade with price-to-book ratios below 1.5 and 1.0, respectively.

Couldn’t you simply buy a value fund instead? Theoretically, the answer would be yes. In reality, it’s much harder to get exposure to such stocks through a mutual fund. An analysis of 574 value funds found most holding more expensive stocks. The weighted price-to-book ratios were in the top 50% to 80% range for “the bulk” of such funds. (We’ll discuss the study further in the Dispatches section of the February AAII Journal.)

One possible explanation would be a simple lack of reliance on the price-to-book ratio. Fund managers could be looking at a different valuation ratio. Yet, when the researchers looked at the oft-used price-earnings (P/E) ratio, they again found a lack of a deep value focus. Most value funds stayed away from the cheapest 25% of stocks. Instead they held stocks with price-earnings ratios closer to the midpoint for all stocks. (Based on current levels, a price-earnings ratio of 11.4 or less would rank in cheapest 25%. A stock in the 50th percentile would have a price-earnings ratio of 17.1 or lower.)

Even if we assume that the lack of an identifiable value focus is simply due to the use of other means of assessing relative valuation (cash flow measures, yield, etc.), there are other ways to invest differently. Mutual fund portfolios showed no clear preference for stocks possessing traits such as profitability (defined loosely as pretax return on equity), investment (year-over-year change in total assets) or momentum (relative price performance).

Putting it all together, placing a strong emphasis on specific traits (“factors”) will allow you to invest differently than a mutual fund. Seek out stocks with low price-to-book or price-earnings ratios, high levels of profitability, low levels of investment or strong price momentum. Better yet, seek ways to combine two or more of these traits—or even other traits like size and quality. Doing so will not only allow you to take advantage of the academic research about what factors lead to higher returns, it will also lead you to stocks potentially overlooked by mutual fund managers and that may have greater odds of being mispriced.