Four reasons why private investors have an edge over professional fund managers

Monday, Oct 08 2018 by
Four reasons why private investors have an edge over professional fund managers

Kevfle recently posted an intriguing article called “Can we beat the professionals?’ In this he touched on some interesting questions around the investment industry, which provoked a flurry of responses from our fantastic community here at Stockopedia.

Kevfle seemed to have several questions on his mind, including:

  • Can we actually ever outperform the pros?
  • Am I wasting my time?
  • Is it easier to choose and evaluate a group of funds instead?
  • Can I achieve similar results leaving it to the pros?

In the first of this two part series, I will seek to address the first two questions,  investigating where there might be scope for the individual investor to outperform and whether it’s worth the effort.

Can we ever outperform the pros?

In order to answer this, we need to define where our edge is.

Firstly, let’s take a look what we are up against. Our competitor investment management company has an army of analysts, each highly qualified with an MBA, PhD and several investing qualifications. They are able to assign individuals not to look at a whole market, but investigate businesses within an industry or in some cases just a handful of companies that the analyst will eventually get to know better than their CEOs. All of these ideas are pitched to the fund manager who then decides, with help from their 6-figure-per-year risk system, how to construct the portfolio.

The scale advantages may seem overwhelming, but there are several disadvantages that the institutional investor must contend with. It is in these disadvantages that the private investor can seek their edge.

The first is liquidity.

Investor Edge 1 - Liquidity

“It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” - Warren Buffett

“If I were working with a very small sum – you all should hope this doesn’t happen – I’d be doing almost entirely different things than I do. Your universe expands – there are thousands of times as many options if you’re investing $10,000 rather than $100 billion, other than buying entire businesses. You can earn very high returns with very small amounts of money.” - Warren Buffett

The average equity fund manager has around £650m in assets. This means that if they want to allocate 4% of their fund in a…

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. The author may own shares in any companies discussed, all opinions are his/her own & are general/impersonal. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.

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34 Comments on this Article show/hide all

Howard Marx 11th Oct '18 15 of 34

In reply to post #407109


Industry data is freely avaiable at Trustnet. For example, they provide performance data for 48 Funds which have the mandate of 'UK Smaller Companies'

But performance is disparate. In the past year Liontrust has outperformed Threadneedle by over 23 percentage points. Quite difficult to separate skill from risk taken & market cap range chosen (FTSE Small cap, FTSE Fledgling, AIM100, AIM AllShare?)

For this reason I just use the benchmarks as a sanity check on my own performance. After all, the Funds will on average perform in line with the benchmarks in the long run (pre-fees).

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Frankyboy 11th Oct '18 16 of 34

In reply to post #407204

You're correct Purpleski it was meant to be a joke answer to 'tagware' who, enviably, said that he made  450% total OVER a period of 5yrs.  I haven't made that in my 24yrs trading!! :)
Sorry if my post wasn't clear...and I can't edit it now.

I've been 'investing' in the market since I got drawn into it by some early success in the SKY flotation in 1994 and like you I've thoroughly enjoyed the intellectual experience.  It's like playing the piano, which I also don't do very well, in that it's totally open ended and no matter how many hours you devote to it you will never, realistically, master it all.

Life and emotion tends to get in the way of making money and, as you're finding, it is extremely painful seeing all one's hard work going up in smoke during a sell-off :(  I've done that many times but now sell sooner rather than later.  

When you get to my age, making use of the 'Eighth Wonder of the World' (compound interest) is less feasible or attainable! :)  Also it's increasingly futile to think 'long term'!! :)

You've got to laugh..... well, I believe that you are meant to!

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kevfle 11th Oct '18 17 of 34

It seems to me that there are four real alternatives here (or a combination of them):

1) Research and invest in individual shares. A lot of time needs to be devoted to this to be successful.
2) Research and invest in actively managed funds. This requires some time but less than (1)
3) Research and invest in passive funds. Again requires a bit of time but less than (1) and (2).
4) Outsource all investment decisions to a financial adviser. This requires no time but costs money.

Unless you do this as a hobby, then you need to value your own time in carrying out the research. The question then is whether you can recover the value of that time in the improved performance that you achieve and, if so, which of (1) (2) or (3) (or which combination of them) gives the best recovery rate.

For the last 7 years or so I have followed (1) and (2) as a hobby. If I price in my time however, I'm still not sure whether I am recovering the value of my time in improved performance.

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herbie47 11th Oct '18 18 of 34

In reply to post #407234

I think you are right, I think there is a lot more stress in your portfolio, if say several shares fall 15% or so as has happened this week, you wonder why, shall I sell etc. If they are in a fund you probably won't even know. Looking at some funds they seem to be holding up better than my shares.

Going forward I think I will cut back my portfolio and put about 50% in funds, let them take the strain and someone else can stress about them. It is also too time consuming. Going forward I probably won't have so much time.

Funds do have certain advantages, lower costs and sometimes can buy shares at a discount and wider diversification.

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shauniekent 11th Oct '18 19 of 34

In reply to post #407409

5) Create a Stockopedia NAPS portfolio requiring a couple of hours efort per year.

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Frankyboy 11th Oct '18 20 of 34

In reply to post #407519

You could do a LOT worse; that's for sure!

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roddy10 11th Oct '18 21 of 34

I have both worked (and work) in a fund and have been a (fulltime) private investor at different times in my career. A couple of observations (for either side of the argument):

1. Many private investors are selective about their recall of the performance of their investments. Their memory recalls their successes and forgets their failures - especially in the pub!

2. Time cost - to truly understand your returns as a private investor you ought to estimate what the value of your time is - and charge that against your portfolio returns. If you invest in my fund you are paying for me to invest whilst you sit on the beach (or do your day job etc). As well as time you are paying for my experience and expertise (or my degree of incompetence).

3. Mandates are important. For instance saying that an index fund beats 99% of active fund managers is nonsense because 100% of active fund managers do not have a mandate to beat the index (and often the index that they are compared against is not even in their mandate).

4. The pressure to invest. I am an extremely conservative investor. To misquote Michael Caine I don't want to shoot 'until I see the whites of their eyes'. This means that I have run a high degree of cash through this year. I am now in a position to deploy some of that in this market shakeup. However all year, my institutional investors (and some of my colleagues), though incredibly supportive have, I am sure, been wondering why are they paying me to sit on cash.

5. Environment. My best investing period was working for myself from home. I could control the environment from simply things like chair, desk, noise, temperature. Working on a trading floor is incredibly distracting. The positive is that one gets some 'sense' of the market - but often that is overstated. I sit in a corner and put on big over the ear noise cancelling headphones. Would I prefer to sit at home - absolutely! Would institutional investors or regulators be happy with that - no!

6. Decision making. As a private investor you can change your mind 20 times in a day. You can take a position behind the bike sheds and shoot it. My investors get transparency into my fund, and I write monthly and quarterly reports which fill numerous pages (I am probably more wordy than most). I think it is a good discipline to write down why you have invested in something. But when it is circulated it becomes psychological much harder to say 'I got it wrong' or 'I have changed my mind'. When you see private investors who have made money by holding a position for eg 10 years it is not always clear whether that applies to all their portfolio nor is it clear how many other positions have their closed etc

7. Time. There is a degree of stereotyping of investment managers which basically goes along the lines of 'they turn up to work at 10am, they go for long lunches, get inside tips and brokers tell them what is hot, and they are out the door by 4.30pm'.

I am sure there are some like that. But I grew up on the wrong side of the tracks. Tomorrow I will be out of bed around 5.30am. I will be on my way to the City by 6am. I will arrive at work a little after 7am. Some days I do not leave until 7 - 8pm. (+ then 1.5 hour commute home). Last two nights I had business dinners and did not get home till midnight.

I will frequently be working at weekends. I will be working on the train and the tube.

When I worked for myself from home I got up when I wanted, walked across the house and was at work. That alone probably saved me 3 hours plus per day. Add in all the internal meetings I have to go to and I reckon a full time private investor might have a 3 - 4 hour advantage over an institutional fund manager.

And I don't get paid enough to afford to move into central London. Incidentally on that topic I know a number of people who work in the City whose families live 3 - 4 hours away so eg the husband ends up either living in a flat or hotel etc for 3 - 4 nights a week and leaves early Fridays to get home; and wakes up early on Monday to get to work (or goes to London on Sunday night). Don' t underestimate the number of divorces in the City; and the pressure on people. I have known colleagues having prescription anti-ulcer tablets on their desk.

8. Tax - some of the comparisons do not fully adjust for tax. For instance if I buy a US stock in my fund it will receive dividends after withholding tax. Often the comparison to index funds is flawed as index returns _might_ include gross dividends. (This is not totally black and white - depending on your position you might have to pay tax as an individual on the dividends your index ETF receives - or you might not!)

9. Technology. Retail brokerage platforms are designed to deal with high volumes of trading with lots of customers so their systems are designed to do this. I have worked at a number of institutions - and each one had a different system with different 'features'. And not all systems work smoothly or cleanly. Sometimes technology can be extremely painful for an institutional fund manager.

10. I run two funds, both of which trade internationally, with different currency rules. For one I have to manage the whole balance sheet - ie I have to hedge the currencies. So I have to trade currency forwards and do spot trades every time I buy a stock in a non-fund currency. I also do shorts so I have to borrow stock. I have to use CFDs (contracts for differences). And I have to ensure treasury management ie buy treasury bills and roll them. Our back office has to reconcile our positions with our custodian and prime broker. And we have to make sure both funds are roughly in line (subject to acceptable slippage). So one 'trade' can lead to multiple separate activities (eg sell a treasury bill to get cash; move cash from one bank account to another; convert from one currency to another; buy a fx forward; check that the equity trade has been reconciled and then delivery vs payment; ensure that the trade has been appropriately split between the funds etc).

Sometimes I miss the simplicity of running my own money from home.

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roddy10 11th Oct '18 22 of 34

I am sometimes 'bemused' by what people think. I was told by a private investor he had 'Bloomberg'. What he meant was that he watched Bloomberg TV and used the website to read articles. There is a reason we pay tens of thousands per seat at the firm I am at for Bloomberg.

Nonetheless Bloomberg can be incredibly distracting - and I still fondly remember sitting at home and reading annual reports myself in peace and quiet. Though I really like Stockopedia I would highly recommend that a private investor print out and read the annual report of a company they are looking at. Add in company presentations, conference call transcripts etc and you will have an advantage over many in the City.

If you want to understand the advantage that a private investor has then do the following:
- print out a 200 page + annual report in colour (and remember in some institutions I have worked at they frowned at the use of colour ink!)
- go and sit in a busy railyway station (eg Waterloo or Victoria) on the concourse during rush hour
- and try going through the report
- that is a pretty good simulation of the environment of a typical desk analyst at a large fund or bank!

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roddy10 11th Oct '18 23 of 34

Career risk:
Oliver wrote about career risk. Let me add something else to the mix:
Most private and insitutional investors will not invest in a fund unless the fund manager has 'skin in the game'.
So a very substanial amount of my net worth is in my fund,

Now think about what happens on a day like today (FTSE down nearly 2%; and down 8.86% for the year). I face the following (i) career risk (ii) financial risk (iii) family stress as a result of the previous two.

Suppose I was also mortgaged to the hilt and had very young children and student loans.
What pressures would I be under - of course I would want to focus on career risk - every minute of every day.

(Fortunately or unfortunately I am too old and grumpy to worry about career risk - partially as my plan B is working from home! But if I was younger I surely would be index hugging for that reason).

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covkid 11th Oct '18 24 of 34

Thanks roddy10 for an eye opening insight into the world of fund managers..........really interesting & thought provoking stuff.

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JohnEustace 11th Oct '18 25 of 34

That's a very thorough and illuminating post roddy10.

I particularly relate to the joys of being able to do research in the home environment in some peace and quiet. Open plan offices must be the greatest causes of inefficiency for anyone whose job involves the need to do some actual thinking.
Then add in the irritation of petty corporate cost controls like colour printing for some further distraction. At home I can have as many large computer screens on my desk as I want to pay for.
It's noticeable from videos I have seen of Warren Buffet that he has a very peaceful, homely, and comfortable office well away from the distractions of Wall Street.

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skinner66 12th Oct '18 26 of 34

as i heard earlier fund managers only invest in bigger shares coz of the trading volume,, so private investors can jump in on bargains they cant.,, plus when you see down trends easier to sell for smaller investments,,ive been hit like most, but if continues tom ill get out until market settles, fund managers cant just sell millions ,,

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herbie47 12th Oct '18 27 of 34

In reply to post #407709

Some funds invest in small companies such as 3 Marlborough ones. Problem is they own a fair proportion of the company so when things go wrong it’s difficult for them to get out. Those 3 funds have good record returning about 20% per annum but have been hit this week.

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Oliver Cooper 12th Oct '18 28 of 34

In reply to post #407129

Thank you for your kind words regarding the article. The impact of fees is one of the aspects that I will be investigating in my follow up article, which should be available next week.

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herbie47 12th Oct '18 29 of 34

In reply to post #408044

Hi Oliver,
How about discussing pros buying shares at a discount, don't think that has been covered? What I mean is often when new shares are issued they are only offered to the pros (fund managers etc.). This has happened quite a bit to my shares recently, Burford Capital (LON:BUR) was the latest, they could buy them about 7% cheaper than the current market price, PIs were not allowed to participate. Also I have read that brokers can fill orders at a discount, it has even been suggested that they may downgrade the shares in order to reduce the price.

There is also the issue of information, now PIs get little access to broker notes etc. something Paul Scott has complained about. This is not a level playing field.

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Lawman 12th Oct '18 30 of 34

Roddy10 para 4 makes an important point: I do not have to invest. When the market turns sour I can sell immediately and stay in cash for as long as I like.

Re time devoted: Yes - when I worked for a living I had no free time 7:30 to 18:30, and outside those hours had other things to do. As a retired person I can make investing a hobby, reading for the enjoyment whether or not it is directly related to my modest investments.

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Andrew L 13th Oct '18 31 of 34

Thanks Oliver. All very good an interesting points. I personally think the benchmark should generally be passive funds rather than professionals. But actually in the mid-cap space I think active managers are meant to add value.

Excellent points in the article. At the same time private investors have disadvantages over institutional investors. So it is another question as to whether there is a net advantage for private investors? Institutional investors are able to meet management etc.

If I look at some of the best active managers - Terry Smith, Keith Ashworth-Lord, Nick Train - it might be the case that they are hard to beat. So probably we can change the question again to can a private investor beat the best professional investors? We can all invest in their funds.

Personally I think funds and stocks if you want are a good way to go. It doesn't have to be a all stocks or all funds approach. As Patisserie Holdings (LON:CAKE) shows we really need say 30 stocks if we own small caps. That can be a lot of monitoring. So maybe 6 funds at 80% of a portfolio and 10 stocks might not be a bad approach.

The hard part about picking stocks, in my view, is waiting for the exceptional opportunities. Picking less stocks and having funds to fall back on helps an investor to wait for these great opportunities to come along.

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roddy10 14th Oct '18 32 of 34

Valerie Patisserie illustrates a couple of important points:
1. How much due diligence do you do?
2. How much do you trust others?
3. Are higher priced stocks more risky?

Re due diligence - over the years I have found that to really get to know a company I need to read, read and read. However the issue that disconcerts me is that sometimes I have found companies that others find value but I scratch my head eg:
- a $10bn company with broken links on its website, overexaggerated claims on the product it made (ie the physic was impossible) and claims of academic expertise that was overstated
- a multi-billion UK company with 'interesting' accounting and questions around its product (ok, you guessed it - Autonomy)
- a billion plus UK company which appears to have broken UK credit rules (indeed the actual basis of its business appears legally dubious)
- a multi-billion Euro company where I am not sure any number in the accounts is real

I have been known to stand outside an office counting staff going in and out - in one case this was because I believed a company was overexaggerating how many clients it had processed.

One really useful question I ask myself is 'are the management open, frank and honest'? It is remarkable over the years how many companies fail this simple test. I also then ask 'what is the pedigree' of the management?

For instance, over the years, I met a number of companies where the management team originated in Hanson Trust or similar companies. Often the managements would focus on cost cutting.

Often I was most successful in finding frauds as a private investor because you have to time to dig and stand outside an office etc.

I hope the above helps

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joseph ppatroni 15th Oct '18 33 of 34

I disagree with the idea that less money is better, both for the fact that it drives prices higher when buying, and leverage is cheaper; A 400 million investment into a 1B market cap company produces an instant equity buffer once significant purchases have been made, as an extreme example.
Leverage is also significantly cheaper the bigger you are, generally.

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Oliver Cooper 16th Oct '18 34 of 34

In reply to post #408404

Hello Andrew, thanks for the comment.

It is certainly conversely true that institutional investors have some advantages over private investors as noted at the start of the article; whether there is a net advantage depends on how much the investor adopts their advantages into their process.

With regards to whether we can beat the best investors….the challenge here is also identifying the best investors ex-ante as investing in their funds after success may not imply future returns. This is something I investigate in my follow up article here.

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About Oliver Cooper

Oliver Cooper

I am an Analyst at Stockopedia - my job here is to get the most out of our fundamental data by exploring new ways to present and interpret it. My experience is predominantly based around Portfolio Construction & Risk; researching and implementing quantitative techniques to create better portfolios and make better decisions. more »

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