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Active managing pays off

Even by the standards of the past, the last 12 months has been a remarkable year for the stock market. It is not just that we have seen a classic bubble in one sector of the market, followed by the inevitable bust of dot.com dreams (can it only be a matter of a few months since the online auction house QXL was valued at £3bn?).

Even by the standards of the past, the last 12 months has been a remarkable year for the stock market. It is not just that we have seen a classic bubble in one sector of the market, followed by the inevitable bust of dot.com dreams (can it only be a matter of a few months since the online auction house QXL was valued at £3bn?).

Just as striking has been the speed with which different sectors of the market have swung in and out of favour, a trend which has resulted not only in a record turnover of stocks within the FTSE 100 index, as newcomers have supplanted old established names, but also in a high level of volatility.

This has been bewildering for many investors, but also hugely difficult for fund managers, most of whom are condemned to be judged by their short-term performance, and who have had to learn to live with high levels of market faddism, and a breakdown in many of the old constants that once guided their actions.

At first sight at least, this has been a year when active management has finally come good, after several years of being pounded into the ground by the dull advance of index-tracking funds. The extreme and volatile market conditions of the past year are ones in which you would expect some active managers to do a lot better than the average, and that by and large is what has happened.

The latest survey of UK growth funds by Standard & Poor's Fund Research, which covers the year to 1 August this year, underlines the extent of this recovery. It shows that the average UK growth fund has outperformed the FTSE All-Share index by a significant margin for the first time in five years. The average fund has returned 11.1 per cent against the All-Share's 7.6 per cent. These figures are on a bid-to-bid basis and, because of costs, somewhat overstate the advantage of the funds. But even so there is a real and undeniable disparity in returns. As the graph shows, a fund in the top 10 per cent of funds in its universe, measured by returns, has beaten the market by a factor of over three to one in this period.

This is even more marked if you look at the performance of smaller companies, which is where a lot of the action was during the market boom between October 1999 and March this year, when the technology bandwagon finally ran out of steam. The average small companies fund returned 46.2 per cent in Fund Research's 12-month survey period, the best result for many, many years.

The importance of this small companies effect is illustrated by the fact that more than 90 per cent of specialist small companies funds outperformed the All-Share index during this 12-month period (whereas, true to form, even in this generally good year, barely half the mainstream UK growth-sector funds managed to beat the index).

It has been a period when small really has been beautiful, bearing out the predictions of such wise old heads as Anthony Bolton of Fidelity, who pointed out 18 months ago that the disparity in valuations between small- and large-cap stocks was as wide as at any time he could remember in a career dating back nearly 30 years.

A different way of saying the same thing is to look back at the equivalent survey a year ago, at which point the average specialist small companies fund was trailing the market by a big margin over both three and five years (99.8 per cent against 142.5 per cent, and 48.1 per cent against 84.5 per cent respectively) - a fact worth bearing in mind when you face the inevitable barrage of advertisements over the next few months promoting the merits of small company growth funds. In fact, most of the best performing funds during the past year were languishing right at the bottom of the league tables barely 12 months before, which suggests that the majority of investors never thought of buying them, and hence have missed out on the fun.

The fund managers who are now sitting at the top of the historic performance tables are those who were most successful at catching and riding the technology, media and telecoms wave when it first picked up in earnest last autumn - but who also had the wit and nerve to bank some of their profits before the whole thing started to implode. By definition, anyone who jumped on the TMT bandwagon and kept on buying stocks at what, both historically and in retrospect appeared to be silly prices, was playing the "momentum" game - buying the shares because they expected them to go up as other investors bought them, not because of any belief in the value of the shares themselves.

"The most successful fund managers during the period," in the words of Fund Research "were those that had a healthy disregard for paradigms (new or old), were willing to play the momentum game, but had either the self-discipline, or a group-imposed discipline, in the form of strict stock weighting limits, to top-slice profits regularly and sell sufficiently early to find buyers. When the technology boom came to a shuddering halt on 10 March, all funds exposed to TMT stocks nose-dived, but the more disciplined had sufficient profit booked to take the loss and still remain ahead of the group".

ABN Amro's UK Growth Fund, managed by Nigel Thomas, was one of those who came out smelling of roses on this basis, having gone into the TMT boom with a huge overweight position in the three sectors. His fund is one of a handful who still look good, even on a risk-adjusted basis, since the extent of their gains in this exceptional year more than compensates for the extra risk that their big-bet strategy involves (it is worth noting that the average small companies fund has been almost twice as volatile in the past year as the All-Share index).

Thomas' success is a good argument for keeping an eye out for an experienced fund manager who follows a deliberately distinctive approach to investing his fund's money (as Anthony Bolton has always done too). Once in a while it will come up trumps, though whether you think it is prudent to play the momentum game is a matter for personal choice. Many funds, unfortunately, are simply "me too" funds which mostly follow the market wherever it is leading: their managers feel they cannot afford to be too far out of line with the herd, and if that means adjusting their investment style, many take the view "so be it".

One consequence of the market's recent volatility, as Fund Research also point out, is that "very few pure value managers remain". Anyone who has stuck to fundamental analysis and looked for shares that are undervalued on traditional criteria, such as dividend yield and earnings multiples, has simply been crushed underfoot by the stampeding herd. It is the safest of safe bets that at some point within the next three years, value managers will have their day, just as momentum investors have had theirs.