Why bother picking stocks yourself? Why not entrust the job to fund managers? They have teams of analysts helping them; more time to research stocks; and better access to brokers and other experts than you do.
The answer is that although fund managers have these advantages over you, you have some offsetting edges over them. But you might not all be exploiting these as much as you should.
To see one of these, consider one of the best-performing and most popular funds, Lindsell Train’s Global Equity Fund. It manages £8.7bn invested in 25 stocks. That’s an average position of £350m. Such huge positions, however, mean there are many stocks it cannot buy: £350m is equivalent to over a third of the value of most FTSE 250 companies. Of course, it could take smaller positions, but doing so would make little difference to its returns. If a £50m stake were to rise 50 per cent, it would add less than 0.3 per cent to its total return, which is less than the difference between a good and an average day.
Of course, most funds are smaller than Lindsell Train’s and have more positions. But even so, they face the same problem – that it is hard to build a significant position in smaller or mid-cap stocks and harder still to sell without moving prices against themselves.
Fund managers therefore lack agility. They cannot quickly move from being a value investor to a growth or momentum or defensive investor. Which matters because as MIT’s Andrew Lo has shown, equity strategies “wax and wane”. What works in one period doesn’t work the next. For example, small caps have recently out-performed big stocks and value has outperformed growth, in both cases after months of underperformance.
Because of this lack of agility, David Blake at Cass Business School found in 2015 that there was a “negative relationship between fund size and performance.” Since then some big funds have bucked this trend thanks largely to some big stocks – most notably US tech firms – doing extraordinarily well. Whether this can persist is, however, doubtful.
Retail investors, however, don’t have this problem. We can quickly dump underperformers and get out of waning strategies by using exit strategies such as stop losses or the rule to sell when prices fall below their 10-month average. Funds cannot do this.
They can improve their agility somewhat. But at a cost. The LSE’s Christopher Polk and colleagues have found that even average fund managers have a handful of good stock picks that do beat the market. But the average fund doesn’t out-perform. This, they say, is because they hold far more than a handful of stocks in an effort to maintain some sort of liquidity. In doing so, however, they dilute returns.
Again, retail investors need not do this. We can take concentrated positions and confine ourselves to our best ideas, topping these up with a tracker fund. We don’t need to hold dud stocks merely to diversify.
Some investors, though, don’t do this. Instead, they over-diversify by holding 30 or more stocks. They choose to make the mistake that fund managers are compelled to, and so dilute away returns.
Retail investors have another advantage. The collapse of Woodford’s equity income fund showed that unit trusts cannot hold illiquid assets such as small or unquoted companies because they cannot sell these if investors want to withdraw money from the fund: they could close to withdrawals (as M&G Property did), but this does not win friends.
We retail investors don’t face the danger of unexpected cash calls – or at least we can put cash aside to deal with such emergencies. We can therefore buy illiquid assets more safely.
The natural way to do so is investment trusts that hold property or private equity. These are risky: if they face increased selling their share price falls relative to their net asset value. But if we can tie up our money for a long time we can hold on through such dips. Which could be useful partly because unlisted stocks could well out-perform older listed ones, and partly simply because investors should be rewarded for taking liquidity risk.
We have another advantage. Many fund managers have to be fully invested or nearly so. But we don’t have to be. Which could be a very good thing. Equity investors always face correlation risk – the danger that all shares fall at once. But with interest rates likely to rise in coming years we now face more general correlation risk – that assets such as bonds, equities and gold will fall at the same time. The easiest way to protect ourselves from this is simply to hold cash. Many fund managers don’t have this option.
Remember a basic fact – that most fund managers fail to beat the market consistently. This isn’t because they are incompetent or because the market is more efficient than you think. It’s because they face some big handicaps to investing well. We retail investors don’t have these and so are freer to invest wisely. But do we really make best use of this freedom?
