Can a private investor beat professional fund managers?
Not only large fund managers beat benchmarks. Simon Brown discusses two huge advantages a private investor has over such investment firms.
arecent study by Morningstar into South African unit trusts showed that the best predictor of which funds would beat their benchmark was low fees. This makes perfect sense. If you have, say, 100 fund managers with the same benchmark, only 50 can beat the benchmark while 50 will underperform. But as soon as we bring fees into the equation, we see the number outperforming dropping markedly.
S&P Global released its most recent S&P Indices Versus Active (SPIVA) research report for South Africa for the year 2016 and it again shows very few funds beating the S&P South Africa Domestic Shareholder Weighted (DSW) Index that they use as a benchmark.
Over one year (a period that is far too short to be meaningful), just over 27.5% of funds beat the benchmark. Over three years just fewer than 20% did so and over five years (the minimum time frame for any investor) a fraction over 23% beat the index. So broadly we can say that one in four funds beat the benchmark. But the trick is knowing which it will be.
Taking the Morningstar research into account, the only real way we have of selecting is based on fees. If half of any group of fund managers must underperform before fees, then it figures that the lower the fees, the better chance one has of outperforming.
But there is another side to this story and it starts with a question I often get asked: if fund managers struggle to beat benchmarks, how much chance does a private investor have of beating the benchmark?
More choice and more flexibility
My view is that we have several advantages that give us an edge over fund managers when it comes to performance.
The first is that as we have much smaller portfolio sizes, we have a lot more flexibility. Even a modest-sized fund likely has several hundred million rand to invest and this means it has a smaller set of stocks that it can buy into due to market cap and liquidity. A large multibillion-rand fund has an even smaller number of stocks it can invest in.
So, while the individual investor has a universe of several hundred potential stocks to invest in, the fund managers have maybe 50 to 100 stocks. Now this is less about these stocks being smaller and hence potential 10-baggers (stocks that has the potential to increase 10-fold, or more broadly, stocks with exponential growth potential), which while true is only partly our edge. It is more about being able to buy quality smaller companies that do very well over the long term. More choice, used wisely, gives us a real edge.
We also have another advantage that is important. Because private investors have much smaller portfolios and hence much smaller position sizes, we have an advantage of speed in that we can get in or out of an investment usually in one trade. Think of Allan Gray’s position in Net1 UEPS. Even if the investment company wants out, it owns a huge chunk of the stock and is simply unable to sell the stocks in a hurry. Likely it would take months if not years to exit the position. Yet a private investor could be out in just a few clicks of their mouse.
So, it is not just that fund managers typically underperform their benchmarks, but it is also that we have a real chance, due to our smaller size, to actually beat the benchmark. This means we don’t need to be reckless trying to grow our portfolio. We can use our smaller size to buy the quality stocks that fund managers can’t, and without any real stress we can create marketbeating returns.
Because private investors have much smaller portfolios and hence much smaller position sizes, we have an advantage of speed in that we can get in or out of an investment usually in one trade.