Join our community of smart investors

Ideas Farm: Tap your hidden skills

We may not appreciate the skills we have, or those of active fund managers
Ideas Farm: Tap your hidden skills
  • The average active fund manager has underperformed once again
  • So there’s no such thing as stockpicking skill, right?
  • Actually, very probably wrong
  • What can private investors learn?
  • Loads of new ideas-generating data

It’s that time of year when the finance industry, and especially us media types, love to start to tot stuff up to see how 2021 went. One of the topics often on people’s minds is whether there’s been any reprieve for active fund managers, who, on average, perennially underperform their benchmarks. A recent survey by broker AJ Bell suggests there certainly wasn’t this year. It found only a third of active managers were able to outperform in 2021 (albeit, the year is not quite over yet).

There is a compelling but lazy logic that springs from this observation. It is that if professional fund managers cannot outperform, how can there be such a thing as stockpicking 'skill'? After all, these people are among the best-resourced and most intelligent market operators. What chance do private investors have if even these pros can’t, on average, beat the market?

Such arguments are likely to particularly resonate with private investors who have had their portfolios beaten up during 2021. It is easy to be left feeling defeated and skilless by falling share prices. Stockpicking starts to feel like a fool's game. So maybe there is no such thing as stockpicking skill? Maybe private investors should just throw in the towel?

There are many compelling reasons to put money into the fantastic, low-cost, index-tracking products that are available to investors today. But low on the list should be theories about stockpicking skill being a myth. Indeed, there is a growing body of evidence that fund managers, including those whose funds underperform, actually demonstrate significant amounts of skill. 

Where this skill is found is in managers’ most overweight holdings. When managers find something they really like, they tend to bet big, and they tend to be right. For example, a study by Turing Technology Associates from 2019 found that based only on the high-conviction component of fund portfolios, fund managers outperformed 74 per cent of the time after fees with 2.8 per cent average annual outperformance. Evidence from studies like this, is why the Ideas Farm publishes lists of fund managers’ 'best ideas'. But if fund managers do have stockpicking skill, why do their funds underperform?

The most likely answer is behavioural. Indeed, so-called “career risk” puts most fund managers under huge pressure to never look that bad compared with their benchmark. The significant role of luck in investing outcomes makes this very hard. A way to guard against looking like a fool is to diversify a portfolio with low-conviction bets. The evidence is that these bets destroy value. And they tend to destroy more value than high-conviction bets create. This is compounded by evidence that big-money professional fund buyers tend to have bad timing, They put money into hot strategies that are set for a downturn in performance and pull it from those due for a renaissance.

There is also evidence to suggest that while fund managers tend to be good at buying shares, they tend to be bad at selling them. So a lack of attention to processes for selling shares may be a significant detriment to average fund performance. 

So the easy inference that underperformance means there is no such thing as stockpicking skill looks very much like it could be a false conclusion. But how can private investors try to tap into their 'skill'? 

There are two key, well-documented methods. The first is to direct efforts to a part of the market where there is less competition: smaller companies. Professionals largely avoid small-caps, which leads to more mispricing. This is the one place in the market private investors can genuinely hope to achieve a so-called information advantage. However, it is also a risky part of the market, so many prefer to avoid it. 

The other method is to work on improving one’s investment process. Knowing one’s own behavioural mistakes, stockpicking weaknesses and foibles in portfolio construction and management is the basis of building a strong process and a 'behavioural advantage'. And unlike fund managers who often face the sack for relatively short-term underperformance, private investors have much more freedom to construct and follow well-thought-out, wealth-building rules. 

And for those that don’t have the time or knowledge yet, yes, there are passive ETFs and many of the mainstream options are really rather wonderful.

 

External links:

High conviction bets outperform

Institutional investors back the wrong fund managers

Fund managers are bad at selling