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.

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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.

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