The Evidence-Based Investor

Should we use professional money managers?

Posted by Robin Powell on December 12, 2016

One of the first questions investors need to ask themselves is this:

Do I have an edge over the market?

We recently published an extract from Lars Kroijer’s book Investing Demystified in which he explained that even if they think they do, the vast majority of people do not have an edge. We should think of the market as a giant super-computer, collating the opinions of millions of people all over the world. Every time they trade, they express an opinion as to how much a particular security is worth at that precise moment in time.

What most ordinary investors tend to forget is that the vast majority of trading is now done by professional investors, with more skill and expertise, and with far better resources at their disposal, than the rest of us. It’s extremely difficult for a professional investor to outperform; the chances of a non-professional doing so on a regular basis are tiny.

So, assuming you’ve established that you don’t have an edge, here’s the next question to ask yourself:

Shall I give my money to a professional asset manager to invest as he or she sees fit?

That question is the subject of this second extract from Lars Kroijer’s book.

 

Should we give our money to professional asset managers?

The following is an extract from Investing Demystified by Lars Kroijer. its is serialised here with the kind permission of the author and FT Publishing.

The fund management industry is continuously developing mutual funds for everything you can imagine. There are funds for industrials, defensive stocks (and defence sector stocks for that matter), gold stocks, oil stocks, telecoms, financials, and technology. Many investors have become ‘fund pickers’ instead of ‘stock pickers’. Even today, years after the benefits of index tracking have become clear to many investors there is perhaps $80 invested with managers that try to outperform the index (so-called ‘active’ managers) for every $20 invested in index trackers.

When investors pick from the smorgasbord of tempting-looking funds how do they know which ones are going to outperform in future?

 

Is it because you have a feeling that whatever sub-sector of the market a fund specializes in will outperform the wider markets?

If so, you are effectively claiming an edge by suggesting that you can pick sub-sets of the market that will outperform the wider markets? Consistently picking outperforming sectors would be an amazing skill.

 

Is it because you think that someone with your fund manager’s impressive background will find a way to outperform the market?

If so, you are essentially saying that you know someone who has an edge, which is really another form of edge. This is the kind of edge many hedge fund investors claim. Funds will say, for example, ‘through our painstaking research process we select the few outstanding managers who consistently outperform’. Maybe so, but that is also an edge.

 

Is it because your financial adviser considers it a sound choice?

First figure out if the adviser has a financial incentive, like a cut of the fees, in giving you the advice. The world is moving towards greater clarity about how advisers get paid, making it easier to understand if there is a financial incentive in recommending some products. Keep in mind that comparison sites also get a cut of the often hefty active manager fees. Now consider if your adviser really has the edge required to make this active choice. Unless he has a long history of getting these calls right I would question whether he has the special edge that eludes most (and would he really share this incredibly unique insight if he had it?).

 

They have done so well in the past

Countless studies confirm that past performance is a poor predictor of future performance. If life was only so easy — just pick the winners and away you go.

We are often driven by the urge to do something proactive to better our investment returns instead of passively standing by. And what better than investing with a strong performing manager from a reputable firm in a hot sector we have researched?

Mutual fund/ unit trust charges vary greatly. Some charge up-front fees (though less frequently than in the past), but all charge an annual management fee and expenses (for things like audit, legal, etc.), in addition to the cost of making the investments. All-in costs span a wide range, but if you assume a total of 2.5% a year that is probably not too far out. So if someone manages $100 for you, the all-in costs of doing this will amount to approximately $2.5 a year come rain or shine.

If markets are steaming ahead and are up 20% or more every year, paying one-tenth to the well-known steward of your money may seem a fair deal. The trouble is that no markets are up 20% a year every year. We can perhaps expect equity markets to be on average up 4–5% a year above inflation. So you need to pick a mutual fund that will outperform the markets by 2%, before your costs, in order to be no worse off than if you had picked the index tracking exchange traded fund (ETF), assuming ETF fees and expenses of 0.5% a year.

 

You need to pick the best mutual fund out of 10 for it to make sense!

The fund industry goes to great lengths to show their data in the brightest light, but a convincing number of studies show that the average professional investor does not beat the market over time, but in fact underperforms by approximately the fee amount.

There is of course the possibility that you are somehow able to pick only the best-performing funds. Suppose you had $100 to invest in either an index tracker, or a mutual fund that had a cost disadvantage of 2% a year compared to the tracker. Suppose also that the market made a return of 7% a year for the next 10 years. Finally assume that the standard deviation of each mutual fund’s performance relative to the average mutual fund performance was 5% (the mutual funds predominantly own the same stocks as the index and their performance will be fairly similar as a result).

Comparing an actively managed portfolio to an index tracker is unfortunately not as simple as subtracting 2% from the index tracker to get to the actively managed return. The returns will vary from year to year, and in some years the actively managed fund will outperform the index it is tracking. Some funds will even outperform the index over the 10-year period. If you can pick the outperforming fund consistently, you have an edge. If you can’t, you should buy the index.

In approximately 90% of the cases in the 10-year example above, the index tracker would outperform the actively managed mutual fund, which is roughly in line with what historical studies suggest. So in order for it to make sense to pick a mutual fund over the index tracker you have to be able to pick the 10% best-performing mutual funds. That would be pretty impressive.

If you did not have an edge and blindly picked a mutual fund instead of the index tracker you would, on average, be about $30 worse off on your $100 investment after 10 years because of the higher costs. Had it been a $100,000 investment the difference would be enough to buy you a car.

You can bet your bottom dollar that the 10% of mutual funds that outperformed the index would trumpet their special skills in advertisements. Historical performance is however not only a poor predictor of future returns, but it can be very hard to distinguish between what has been chance (luck) and skill (edge). Just as one out of 1,024 coin flippers would come up heads 10 flips in a row, some managers would do better simply because of luck. In reality the odds are much worse in the financial markets as fees and costs eat into the returns. However, ask the manager who has outperformed five years in a row (every 50th coin flipper …) and she will disagree with the argument that she was just lucky, even as some invariably are. Likewise some managers underperform the market several years in a row simply due to bad luck, but those disappear from the scene and thus introduce a selection bias as only the winners remain. This sometimes makes the industry appear more successful than it has been.

 

Outside stock markets

The discussion of edge is not exclusive to stock markets. You can have an investment edge in many areas other than the stock market and profit greatly from that edge. For example:

  • Will Greece default on its loans?
  • Will the price of oil increase further?
  • Will the USD/GBP exchange rate reach 2 again?
  • Will the property market increase/decrease?

The list goes on.

 

Being rational

For someone to accept that they don’t have an edge is a key ‘eureka’ moment in their investing lives, and perhaps without knowing it at first, they will be much better off as a result. At this point you are at least hopefully considering a couple of things:

1 An edge is hard to achieve and it’s important to be realistic about whether or not you have it.

2 Conceding that you don’t have an edge is a sensible and very liberating conclusion for most investors. It makes life a lot easier (and you much wealthier) if you acknowledge that you can’t better the aggregate knowledge of the market.

 

Related post:

Do you really have an edge?

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Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector. Regis Media.

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