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 market has doubled since 2009. The subsequent falls in value can be very discouraging even though history shows us that the longer investments are held the less important capital is to returns than dividends.

Although there are lots of ways of measuring the market, such as yield, price to earnings (PE) ratios, price to book ratios and CAPE (cyclically adjusted price earnings ratio) they all take time to work out and may require access to data that is not commonly available.

However, there is an easier way to determine if a bubble exists and how it can be measured.

When investors look at publicly available data to assess fund returns the commonly used reference point is not an index but the average return of the sector. This is the actual performance of all the funds that are listed in the sector, and the largest and most relevant for UK investors is the UK All Companies Sector.

And that difference between index and sector has two important features.

One is that sector returns are net of all costs so they should be lower than the index. The second difference is that the majority of these retail funds, about 210 out of the 240 in the UK All Company sector, are actively managed. Although active managers usually state that their objective is to beat the index in fact their real goal is to beat other fund managers and secure a place at the top of the sector league table. They can do this in two ways. They can either invest outside their asset class or take more risk. The simplest way to take more risk is to buy smaller capitalisation stocks or those with high beta (volatility), i.e. those that move more than the index either because of the nature of their business, their debt levels or both.

An active manager finds it difficult to dramatically outperform by having a bigger holding in a blue chip than others funds, or than the index. However, they can do well if they go overweight in small or medium cap stocks that subsequently rise. Most active managers play this game so the…

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