3.3.3 To track or not to track?
You’ll now turn to the question of how to invest in the market portfolio.
In practice, investors tend to buy investment products linked to a stock market index, which represents an underlying market, through the medium of index funds. These have become widely used by investors partly due to the implications of the CAPM. Economic and financial theories do matter! These index funds are investment trusts or unit trusts designed to track an index as it moves from day to day. Index fund managers do so either by ‘full replication’, buying shares in proportion to their importance in an index, or by sampling, buying the larger shares and a sample of the smaller ones, to reduce transaction costs while still getting a close replication of the movements of the index. Exchange-traded funds (ETFs) are index funds that are listed on the stock exchange as shares but are essentially funds (note that the word ‘exchange’ here has nothing to do with currency exchange). ETFs allow low-cost investment in market portfolios.
Investing in index funds is a passive investment strategy aiming to track an index rather than outperform it, but what this has meant for traditional fund managers is that they now have a benchmark strategy against which they can be judged. They have to try to outperform the index by following an active investment strategy.
Investors who do not believe the assumptions underlying the CAPM and think that they have superior investment skills can take on specific risk in the hope of achieving positive returns that beat the market. This is called an alpha investment strategy. It is the holy grail for investors seeking to earn superior returns. And this type of investor is called an active investor.
Fund managers who are active investors can try to outperform the market portfolio, or an index, by one of two strategies. One is to take on more specific risk by selecting companies in different proportions to their weighting in the index, so that the portfolio will be overweight in those companies that are expected to do well and underweight in those that have poor prospects. This strategy is called stock selection. You will look at the second strategy in the next section.