SERIOUS MONEY: Stock index growth of 6% to 8% should not be seen as staid performances, writes Chris Johns.

There is a pretty strong argument against passive investing (indexing) and it is to be found in the dispersion of sector and stock returns. In this regard, 2004 looks as if it has been a typical year.

Anyone looking at the broad macroeconomic climate in Europe throughout this year might be tempted to conclude that stock markets are unlikely to have done well. Growth, while positive, has not surprised on the upside and has shown signs of faltering of late.

Precious little domestic demand growth has been accompanied by some buoyancy in exports, as countries like Germany have been able to piggy-back on the boom in world trade. Only a handful of economies have grown strongly, or better than expected, with Britain and Ireland featuring prominently on this list.

The euro has been unambiguously negative for output and profits and may yet crimp Europe's main source of growth. But inflation has stayed low, as have interest rates. Companies have been able to mitigate to a certain extent the disappointing macro environment via restructuring and cost-cutting.

All of this would seem to point not only to underperforming markets but also ones likely to bore us to death.

On the face of it, these sorts of conclusions certainly hold for the main market indices. The FTSE 100 in Britain, the CAC 40 in France and the DAX in Germany have all seen a capital return of just over 6 per cent for the year so far in local currencies: the UK has done about 8 per cent in euro (yes, sterling has appreciated slightly since the end of last year).

We should not be too hasty to condemn these sorts of numbers as dull. They may not be what we hope for when we invest in stocks, but that is more a comment about unrealistic expectations. When we add in dividends, we push the UK's (euro) return into double digits - which is actually more than we have any right to expect.

Actuaries and company pension funds will - or should - welcome these returns with open arms. They will relieve funding pressure on many schemes: the achieved returns are higher than any sensible actuarial projections, upon which company contributions to pension funds are based. While many schemes will remain in deficit, provided they have been able to match or better the indices (always a tough proviso), they will be in a slightly more secure position than they were this time last year.

Mature stock markets in developed economies like Britain are probably as near as we will ever get to being "efficient" in the finance text book sense. The economy and the quoted companies it contains are analysed by thousands of highly paid professional analysts. The growth of hedge funds has added to an increase in efficiency as these newer types of analyst exist to make money out of the mistakes made by others.

(None of this is to argue that markets are perfectly efficient, or even rational: it is merely to make the point that obvious share price anomalies, when they do occur, are arbitraged away faster than they have ever been.)

Efficient stock markets should return the same as government bonds plus a bit extra for being that much more risky. And that means markets like Britain should return around 8 per cent a year, including dividends - hence the argument that the FTSE has actually done better than it should have. Of course, even if they have become more efficient, markets will not behave in this predictable fashion. But what we conclude from this is that when the FTSE departs from that 8 per cent number in any material way, we should view such returns with deep suspicion, unless something pretty fundamental has changed along the way.

But this is all about aggregate market behaviour. When we dig a little deeper, we find much less evidence of efficiency (or perhaps more evidence of fundamental change) and much more exciting stories.

At the sector level, two broad European industry groups have returned in excess of 30 per cent this year (according to FTSE definitions). Those two sectors are real estate, and aerospace and defence.

Tellingly, both sectors are quite small and the high returns achieved have been driven either by company-specific developments and/or macroeconomic surprises.

Other high achieving sectors have included steel, tobacco and utilities - the first two are also very small and have very different stories attached to them.

The steel sector has been an obvious beneficiary of booming global demand, particularly from China: nobody can remember when steel prices have been so strong. Analysts, more used to falling steel prices, have been continuously surprised by the ongoing strength of metal and commodity prices.

Tobacco is a peculiar sector but one that has, on average, been the best performer for the last three decades. I guess if you harvest leaves and sell them for fancy prices you will always generate lots of cash.

The good performance of utilities has been interesting, driven in part by looming shortages of electricity generation capacity globally, rising natural gas prices and higher than expected price increases allowed by the British water regulator. Utilities may be dull but their rise of 23 per cent this year has been anything but.

At the bottom end of the scale, we find support services (down 16 per cent). The giant sector pharmaceuticals and biotech is also towards the wrong end of the league table (down around 1 per cent).

Other strong performers this year have been leisure and hotels (up 20 per cent) and construction (up around 16 per cent). One of the key features of all these outperformers is that they are at the least sexy end of the stock market - our list does not contain any of the technology, media or telecommunications sectors that still attract most of the headlines. That, I think, is one moral of this story.

Superior investment returns will be achieved by staying away from the glamorous, over-analysed (and often over-hyped) countries, sectors and stocks. In a way, this is a variant on an old refrain: if you want to achieve higher returns, you have to take more risk (but it is tough to argue that buying European utility stocks represented a high-risk bet).

The huge dispersion of returns within relatively dull markets carries a moral for advocates of passive investing: you can guarantee dull index returns but you also guarantee that you stand no chance of achieving superior returns from successful bets on stocks that still, even in relatively efficient markets, rise 30 per cent or more in a year.

The trick, of course, is to be able to pick those winners.