At Robur, we highlight the importance of making equity investment decisions based on the trends that can be derived from analysing company historical financials. But of course you can‘t analyse every possible aspect, so, once you have defined your company or sector of interest, you need to define your own analytical priorities
The Argument against managing your stock portfolio
The lure of the professional is strong. The old adage is as true as ever: ‘if you act as your own lawyer, you have a fool for a client‘. Doctors, teachers, architects do jobs for which most of us have neither the training, the knowledge, nor the aptitude.
It should therefore make perfect sense that letting a professional manage your money will result in a better return than if you managed your investment portfolio yourself. Indeed, in some investment scenarios, it is not sensible to ‘go it alone‘. For example, some stock markets make dealing hard for individuals resident outside that country; or the share packet sizes are uncomfortably large for a private investor; or there is such a good long-term manager in that restricted market, who knows it backwards and has done nothing else for twenty years, that it would be both silly and arrogant not to entrust your investment for that market to her. In such cases, pooling investment cash with others, by buying into a fund, is the sensible option.
The Argument for managing your stock portfolio
However when you are looking at the easily traded, liquid stocks which are at the heart of most personal investors‘ equity portfolios, it is harder to justify using fund managers. Here are six reasons:
1. Unlike typical professionals, becoming a fund manager does not require a rigorous, multi-year professional training.
2. The managers‘ objectives (good salaries, next career move, and so on) may not be at all aligned with yours (long-term, fairly steady growth, say).
3. The cash problem: very few managers are prepared to go into high levels of cash if they think markets are about to fall; they are measured against benchmarks, so if they go into cash, but markets rise, their “performance” suffers disproportionately; whereas if they stay invested, and markets fall, so do the benchmarks. But a personal investor may well cash up, on a hunch that markets are about to fall.
4. The timing problem: despite meretricious charts which purport to show that it does not matter when you enter the stock market, any seasoned investor knows that both long-term yield and capital appreciation depend heavily on timing. The wise investors do their analysis, make their selections, and wait for a market dip to buy and a rise to sell (the opposite of the way Benjamin Graham‘s wonderful ‘Mr Market‘ behaves). Managers can‘t do that: their job is to get invested.
5. The sheep effect: if you look at the top ten holdings of a group of different funds within the same investment areas, there are often a lot of common stocks; indeed in many cases, the top ten holdings are 90% identical. In other words, the managers have picked the same companies. This has potentially bad pricing effects. When they are buying a company, they are all buying, so the price paid is high. When they are selling, they are all selling, so the prices achieved are low. It may only be a couple of percentage points each way, but over time and over the portfolio‘s life, this is a significant performance problem. Compounding the sheep effect is the unforgiveable habit, of fund managers in the more esoteric areas, of buying other firm‘s funds, thereby subjecting their personal investors to two lots of (mostly hidden) charges for the same stocks.
6. The data advantage: until quite recently, the timely financial and market data needed to make good investment decisions was simply not available, at a sensible price and in a sensible form, for private investors. That has all changed. You have access to just as good basic data about normal stock investments as the fund managers (especially, of course, if you subscribe to our Robur service). You don‘t have roomfuls of quants crunching the cute ratios required for split-second market arbitrage of obscure financial derivatives, but that is not what you do anyway: as a value investor, you just want to build a growing equity portfolio.
Fund Management Costs
‘Shedding light on invisible costs: trading costs and mutual fund performance‘ – a paper published in the Financial Analyst Journal in 2013 – showed that these costs were significantly higher than the funds‘ declared expenses and had a significant negative impact on returns. Fund management fees, stated and hidden (for example, brokerage costs and duties incurred by ‘portfolio churning‘, and initial and exit fees), are typically actually over 2%, often over 3%, per annum, over the life of an individual‘s holding of units in a fund.
‘Portfolio churning‘ is a particular problem, since fundamentals do not change that quickly, and swapping out of one company into another may be based on the feeblest of rationales. But some managers feel they have to be seen to be doing something, and so make many more trades than you, as a private investor, would consider sensible given the costs of buying and selling. In the 1950‘s, the typical mutual fund‘s stock turnover was about 15%; by 2011, this had risen to 100%.
The above table shows 2 portfolios invested in the same stocks, with an initial investment of $10,000, and $1,000 a month added on average thereafter, showing underlying asset growth of 7% compounded annually. Over the course of 25 years, the individually-managed portfolio will outperform the fund manager by 50%, simply because of the fees effect.
Most Funds cannot outperform the Market
This is mathematically inevitable: if the underlying performance of the stocks is average, the fund‘s performance must be below average, because of the salaries, costs and expenses. A recent study found that only 24% of managers outperformed the index after accounting for fees.
This wouldn‘t matter if you could pick the star managers. But that is much harder than picking companies. For example, in the UK alone there are more funds than investable companies. There are roughly 4,600 equity mutual funds worldwide; we would argue that this is probably more than the number of company stocks that are realistically investable for personal investors. But researching funds is much harder than researching companies.
Company financials are freely available and have to follow established rules. Fund financials are anything but transparent, and use confusing ‘performance‘ numbers which, just as one example, typically exclude the effect of taxation, so that reinvested dividends are substantially overstated. So the ‘performance‘ you actually get differs substantially from the ‘performance‘ which will be reported. Finding out which managers are responsible for which bit of performance is seriously hard work, and not always possible at all.
The final difficulty is that successful managers may not be good for longer-term investors. This is the ‘successful manager paradox‘. Success brings inflows of investment money. As a fund grows in size, it has to invest more widely, and the performance is inexorably driven towards the average. For the personal investor, therefore, the trick is spotting star managers before they are known: which is obviously impossible, being a contradiction in terms.
Building your own equity portfolio is normally less work, and more likely to be profitable, than selecting fund managers and handing your money to them. It’s still hard work, mind: that’s investment.
Defining “Investable Companies”
We view “investable companies” to mean:
1. The stocks have sufficient liquidity from “market-makers”, so you can sell when you want, even if not at the price you wan
2. They have sufficiently reliable company reports, without evidence of silly fudging of revenues or income or other numbers
3. You can buy them online without unrealistically large “packet sizes”, or local currency deposit issues, or paperwork, which are beyond the resources of the typical personal investor
4. When you sell, you can get your money out to where you live without unreasonable / impossible paperwork, withholding tax problems or forex controls getting in the way
Even with those restrictions, there are still lots of fine companies worldwide that are investable. We cover well over half of them (the largest by revenues), in the Robur Terminal. Personally, if we want to invest in companies/countries that do not meet the criteria above, we typically use ETFs; but they are a tiny fraction of our portfolios. And if you want to invest in small companies, which tend to be illiquid, we can only suggest “invest in what you know; ignore what you don’t know”. It’s a very good rule which we follow.