The one big advantage you have over fund managers

published 8 March 2012

As a group, fund managers do a poor job. It's not just a problem in the UK. Last year, nearly 80% of large-cap fund managers in the US underperformed the S&P 500 index, according to Morningstar.

Given that the US index only returned 2% last year, that's not very encouraging. That standard of stock-picking isn't going to leave you with a healthy retirement pot.

So it's little wonder that passive investing tracking the market rather than trying to beat it is becoming more popular. But as many critics point out, index investing means you buy stocks as they get more popular and sell them as they fall in price. In other words, you buy high, and sell low the opposite of sound investing.

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So what's an investor to do?

Why do investors stick with active fund managers?

Passive investing where you attempt to track a market, rather than beat it is becoming steadily more popular. As investors wake up to the high fees and generally poor performance delivered by active fund managers, more and more are making the switch to index funds.

However, active managers are still by far the most popular choice for private investors. US academics Lubos Pastor and Robert Stambaugh of the University of Pennsylvania have tried to understand why.

Most of us would say that it's because investors are apathetic, or have too much confidence in their own ability to pick funds. But like most academics, Pastor and Stambaugh think there has to be some sort of rational' reason underpinning all this.

Here's how they explain it. When you invest with an active fund manager, you are seeking alpha'. Alpha is the industry jargon for beating the market. Beta' is what the market gives you. Alpha' is what the active manager gives you on top.

The trouble is, say Pastor and Stambaugh, that as more money chases alpha, it becomes harder to find. Why? Well, if you want to beat the market, you have to find assets that the market has mispriced', then bet on them returning to the right' price. If markets are even remotely efficient, then the more money that's chasing these sorts of opportunities, the quicker such mispricings' will be corrected.

"Think of active managers as police officers and of mispricing as a crime," says Pastor on Bloomberg. "If there were no officers patrolling the streets, there would probably be some crime. But as the number of officers increases, the amount of crime is likely to decline."

In other words, the bigger the active fund management industry gets, the worse they get at their jobs. And the smaller the industry, the more chance they have of delivering.

So the reason investors stick with active management isn't because they are lazy or stupid. It's because they realise that, if enough money flows into passive funds which make no effort to correct mispricings' and in fact, probably encourage them - then active managers might genuinely start to outperform.

The real value of tracker funds

It's an interesting theory. The bit about private investors is nonsense of course. People don't stick with active managers because they have some deep-rooted understanding of how the tectonics of money flows might one day affect performance. They stick with dud fund managers for the same stupid reasons we all stick with dud stocks we don't want to admit we were wrong.

However, Pastor and Stambaugh's point about index funds seems more valid. One of the core rules' of investing is to buy low, sell high'. That's much easier said than done, of course. But index trackers don't even try. In effect, the higher a stock goes, the more of it your average tracker will buy. And the further it falls, the more it will sell.

So, you might think, why buy an index fund, or exchange-traded fund (ETF) at all? But for me, this misses the point of trackers. Lots of investors get obsessed with this idea of beating the market'. But this is a side-effect of being brainwashed by the fund management industry.

If your investment has dropped in value by 8%, but the market' has fallen by 10%, then you've beaten the market. But who cares? You could have stuck your money in cash at 0% and done much better for no risk.

The fact is, much of the time, good investing is not about stock-picking it's about being in the right place at the right time. If you were in tech stocks in the 1990s, your stock-picking skills were irrelevant. You almost certainly made money. And if you were in tech stocks for the decade after that, you almost certainly lost money.

This is where you have the big advantage over the average fund manager. You have absolute freedom over where to put your money. You could have had a big chunk of your portfolio in gold since 2000, enjoying returns from the best-performing asset of the decade at a time when most fund managers have been completely unable to access it. Or you could have shunned developed markets in favour of emerging ones.

And once you start looking at your portfolio in terms of asset classes and sectors, rather than individual stocks, the advantage of trackers becomes clear. If you think, say, that Indian stocks are going to beat US stocks by 10% next year, then all you really need is cheap access to the Indian market. You're not going to fret too much about finding someone who may or may not deliver an extra couple of percent on top of that.

On the other hand, this is also where active management can be worth the fees. Some active managers are clearly successful in their chosen field. If you think defensives are the place to be, Neil Woodford is your man, for example. So if you can find a cheap fund structure - such as an investment trust - that lets you access quality active management, this can be worth paying for too.

The point is to understand how you want to allocate your money, and then pick the best way to access that market, whether that's passive or active. My colleague Bengt Saelensminde often discusses asset allocation in his free email, The Right Side you can sign up to it here.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.