Trading secrets: how fund managers beat the market

There are certain tactics that professional investors use to give them the edge. Graeme Evans reveals some of their best tricks here.

Some of the trading secrets relied on by fund managers to beat the stock market have been revealed by a City bank, including the ways they exploit seasonal and dividend factors.

The tricks-of-the-trade research paper by UBS identifies why small-caps are worth holding in April and also highlights trends around the quarterly reshuffle of FTSE indices.

By understanding these structural and behavioural effects, UBS notes that fund managers benchmarked to the FTSE All-Share have outperformed by 2.75% annually over the past 20 years.

One of the biggest seasonal anomalies in the UK market involvestrading at the end of the tax year, with April outperforming the average monthly return for 17 out of 21 years. On average, UBS finds that the FTSE All-Share outperforms by just over 3% in April.

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This reflects one of two factors, where investors sell stocks towards the end of the old tax year on 6 April so their losses are used to offset capital gains, or where so-called window dressing is desirable to improve the appearance of a fund before it is presented to clients.

The result is that investors sell stocks that have underperformed and buy stocks that have outperformed, further increasing the price of the winners and vice versa for the losers.

The April phenomenon is even more pronounced in small caps, where the median excess return for the past 21 years is just over 4% because they generally see larger share price swings.

Window dressing on its own is typically a factor driving momentum stocks prior to the end of the June, September and December quarters.

Dividends

The dividend run-up effect is another to watch after UBS highlighted excess returns in the 45 days prior to the date when shares trade without the right to the latest dividend.

If investors buy before this cut-off they will often do so at a premium to ensure eligibility for the dividend, causing the stock price to increase leading up to ex-dividend day.

The UBS research indicates it is possible to generate approximately 1.9% a year with a strategy where an investor buys stocks prior to their ex-dividend day and sells them straight after.

It notes that the number of payouts peak in April and September where just over 120 companies in the FTSE All-Share pay dividends.

Another anomaly identified by UBS is the movement in stocks prior to the reshuffle of FTSE indices on the third Friday in each quarter. If a stock falls out of the FTSE 100, it may no longer be included within so-called index trackers (funds that aim to track the performance of a stock market index, in this case the FTSE 100) and this might affect liquidity as well as returns.

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Any changes are announced by FTSE Russell on the Tuesday before the first Friday in each quarter, so approximately 13 business days before the actual rebalance takes place.

UBS said it found that stocks that are included in the FTSE indices start to outperform about 10 days prior to the actual reshuffle day and the performance levels off after the inclusion day.

For stocks being excluded from FTSE indices, they start to underperform 13 days prior to the exclusion day but quickly recover and settle at a higher return than before the exclusion day.