In a 2015 paper, S&P Dow Jones Indices showed more than 84% of US active funds underperformed the S&P 500 over a 12-month period. Over a 10-year period, only 2% of active funds outperformed their benchmark.
Similar results also popped up in Europe and the UK.
Its clear institutional investors don’t have all the answers.
Don’t mimic investment professionals
But if professionals can’t beat the market why should you even try?
According to legendary fund manager, Peter Lynch, you have many advantages that fund managers simply don’t. This was the overall message in Peter Lynch’s 1994 national press club speech.
For a little over an hour, Lynch explained ‘good investing’ to the group. And who better to give such a speech. During his 13-years as manager of the Magellan Fund, Lynch achieved a compounded average return of 29.2%!
“I frankly think it’s a tragedy in America that the small investor has been convinced by the media, the print media, the radio and television media, that they don’t have a chance,” Lynch said.
“The big institutions with all their computers and all their degrees and all their money have all the edges. It just isn’t true at all.”
“When this happens (investors believe institutions have all the edges), people act accordingly. They buy stocks for a week. They buy options and they buy the Chile fund this week and next week it’s the Argentina fund. They get results proportionate to that kind of investing. That’s very bothersome. I think the public can do extremely well in the stock market on their own.”
So why then do we try to mimic institutional strategies?
Maybe it’s because they’ve been intrusted with millions, sometimes billions of dollars. They also have decades of market experience. Yet as I mentioned above, the track record of these high flying investors is horrendous.
The truth is most fund managers are like you and me. They get emotional and nervous when their positions go down. They panic when everyone else starts to sell.
Interests Misaligned with Goals
One toxic habit rampant among ‘professional investors’ is this proclivity to trade. Take a look at the graphs below.
Both charts show the relationship between turnover rates and returns for 407 mutual funds. The left chart is over a three year period and the right is over a five year period.
As you can see, funds with the lowest turnover rates performed far better than the rest. The reason why, in my mind, comes down to two factors.
First, holding undervalued stocks for longer periods should theoretically give them more time to appreciate. Second, fund managers who had lower turnover rates – those who traded less – likely made fewer mistakes.
So then why do institutional investors continue to jump in and out of investments? Well, imagine the following hypothetical.
I gave you $50,000 to invest. You could invest in whatever stocks you wanted, domestic or international. You could also choose not to invest at all if you didn’t see any opportunities. But the catch is I would review your returns each quarter. If you didn’t beat your benchmark, the S&P 500, then I would take $10,000 away from you.
With all this information, how would you invest?
Would you try to buy undervalued stocks that might take a year or more to appreciate? Or would you jump in and out of ‘hot’ stocks, trying to capture short-term gains?
You’d probably lean towards the latter right? It seems like the better option to beat your benchmark for the quarter. Well, this is the situation many fund managers are in.
The DOW investment company reasoned that activity is also easier to explain than inactivity, regardless of the end result.
“One cynical, but plausible, explanation is that active trading is the mutual fund manager’s “raison d’être.” If an inactively traded mutual fund does well, it may be concluded that the manager’s services were superfluous; if it does poorly, the manager will be blamed for inaction. On the other hand, if an actively traded fund does well, the manager is a hero; but, if it does poorly, it can be said that the manager at least tried.”
OK so cutting down activity is probably a good thing. But are some other edges you have over fund managers like Lynch?
What do you do for work? You likely work in an industry which has multiple public companies, all of which you have a certain level of knowledge about.
Lynch uses the example of pharmaceutical company, GlaxoSmithKline and their hugely popular ulcer product, Tagamet. He imagines that nurses and druggist were writing prescriptions for Tagamet all day. Had they decided to buy GlaxoSmithKline on the popularity of Tagamet, they would have made six times their money.
“Tagamet was doing an amazing job of curing ulcers and it was a wonderful pill for the company because if you stopped taking it the ulcer came back. It would have been a crummy product if where you took it for a buck it went away.
“But you could have bought it two years after the product was on the market and made five or six times your money. All the druggists all the nurses all the people, millions of people saw this product and their out buying oil companies, or drilling.”
Bigger Isn’t Always Better
OK, what about another edge? Your size.
I’m going to assume you don’t have millions at your disposal to invest. You might have thousands, maybe even hundreds of thousands. And this is the absolute prefect size to take on the big boys.
Let me repeat, having a lot of cash adds absolutely nothing to your returns. In fact, there is a point where too much cash can actually reduce your performance.
A 2002 paper, ‘Does Fund Size Erode Performance?’, decided to look at this very relations – size and returns.
Researchers before them believed there was a negative correlation between size and returns because of transaction costs and liquidity problems. Meaning large funds, which were fully invested, couldn’t put all their money in their best ideas. They had to also invest in so-so ideas to remain fully invested (of course there’s no reason to be fully invested anyway).
However the 2002 paper believed size eroded performance primarily due to liquidity.
“…we find that the effect of fund size on performance is most pronounced for 27 funds that play small cap stocks. This suggests that liquidity is an important reason behind why size erodes performance.”
Again, put yourself in the fund manager’s position. You have hundreds of millions to invest. But because there are only so many stocks with large enough volumes, you are limited to some of the biggest stocks on the market. This leaves plenty of undervalued investments for the savvy individual investors.
Even Mr Buffett acknowledges that his size limits his returns. Buffett said in a 1999 Businessweek interview:
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow.
“You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
So rather than copy institutional investors, why not take advantage. As Lynch explains:
“I think the fact that institutions dominate the market today is a positive for small investors. These institutions push stocks on unusual lows and push them on unusual highs. For someone [small investors], they can sit back and have their own opinion and know something about an industry, this is a positive. It’s not a negative.”