Why do most fund managers underperform?

Most fund managers don’t beat the market. Are they lousy investors? Or do you have to be extraordinary to beat the market? I don’t believe it. And you shouldn’t believe it either. Because you want to beat the market.

I’m a stock picker, you know that already. And I’m a kind of value investor, too. Nothing new for you, I know. I say kind of value investor, because although investing in cigar butts, too, like Benjamin Graham called theses companies, I mostly invest in good or outstanding companies at a bargain or at a fair price. I’m not a big fan of funds whether they’re actively managed or just passive like ETFs. Finding the right fund manager is pretty much the same as finding the right stocks, but the last one is more fun.

I’m not extraordinary or bestowed with superior intelligence or knowledge. Yes, I read a lot, but many people do. I do my homework regarding investing, i.e. researching companies I’m interested in. This includes reading the financial reports of the last 10 years. I don’t read them in every detail, because today I know what I’m looking for.

I’m convinced that anybody can do this, too, and get a pretty good return on the invested capital. When I say pretty good, I mean 10-15% on average a year, maybe more. I think, this is a decent return for private investors with regard to the associated risk.

“A normal person using the brain can pick stocks just well, if not better, than the average Wall Street expert.” (Peter Lynch)

“People who lose money, always need someone to blame.” (James Chanos)

Why do I tell you this?

Well, that’s a good question and the answer could be, I like talking about investing which is undoubtedly right. But I have something else in mind as you can see in the heading.

When I’m reading through social media, I always find someone asking how to invest his little money. The answer that is mostly given is, put it into ETFs, followed by 2-3 ETFs that are worth investing in just because of their diversification. Okay, that’s not a bad advice. Not everyone wants to research companies and decide for himself. And many lack of the necessary knowledge. But everybody can achieve knowledge, so that’s just a matter of time and some experience. Some of the questioners want to invest in individual stocks and some others (like myself) encourage them. Then the arguing begins.

Most professional investors don’t beat the market!

That’s always the first (and all too often the only) argument, you can read. It is followed by

“If they don’t beat the market, you will certainly not do it.”

This statement has two meanings: first, you’re not good enough (or too stupid) for investing in individual stocks, second, you’re overconfident, if you think you can, which means nothing less than stop showing off. I admit that this could be a special problem of Germans (unfortunately I am one). We tend to demotivate people and making them average. It’s hard for many of us to acknowledge good performance. We like to focus on our mistakes rather than what we are good at and improving this.

Although it’s true that the most professional investors don’t beat the market, it’s also true that there are reasons for this. No, it’s not because they’re too stupid or overconfident. And it’s also not because of the efficiency of the market that no-one can’t beat it. What’s really annoying is that many don’t think about these reasons or even know them. But to serve as an argument against stock picking of small private investors, the reasons need to be clear.

Why do most actively managed funds underperform?

The main reason for the underperformance is their size. The bigger you are, the less the opportunities. Sounds crazy, but it’s true. That’s why I love being just a privat investor managing only my families money. This offers me a huge advantage. If you’re too big, you have less choices in picking stocks. And this is really a problem that shouldn’t be underestimated. Picking stocks successfully means buying them with a discount to its intrinsic value. That’s important for two reasons. On the one hand, you have a sufficient margin of safety, which reduces the risk of being wrong and losing money. On the other hand, the possibility of making a profit increases because over the long run, price always tends to reflect value. Making a decent return with an overpriced stock is more unlikely (even if it’s not impossible) and more risky. The problem for fund managers is that you mostly find good investment opportunities in a wider range of companies, in large cap, mid cap, and small cap. You find better opportunities in companies the mass don’t focus on. Unfortunately, many of these companies are much too small for many funds to invest in. So they can’t take advantage of them.

Size matters

This is true in different ways. Let’s assume that a fund manager has found a real good company at a bargain. He knows, buying stocks of that company would make him a huge profit. Buying massively into the company would be the best choice, but unfortunately he can’t. He has to miss a lot of these chances, just because of regulatory rules. He isn’t allowed to buy more than 10% of the shares outstanding. Even if buying 20% or 30% would be the better choice. Furthermore the fund manager has to make sure that every stock position he holds is less than 5% of the hole fund. You see that the fund manager is bound to hold at least 20 companies.

If the professional investor manages billions of dollars, it’s therefore much easier to concentrate on companies with a high market capitalization. But these companies are often not a bargain and don’t promise a more than average return.

Diversification

Maybe our fund manager decides to invest in mid cap and small cap companies, too, because he knows that his chance to find a great opportunity in this section is much better. Unfortunately he faces another problem. Because of the regulations, and due to the smaller size of each company, he has to buy more of mid cap and a lot more of small cap companies. The manager can’t invest a large amount of money in one of these stocks.  As a result, his advantage of finding great opportunities among a greater variety of companies is lost by diluting the result of these few outstanding companies with a huge amount of mediocre or less attractive companies. It’s almost impossible to have an unlimited amount of outstanding companies.

Never lose money

The job of fund managers is to manage other people’s money. So, they have a tremendous responsibility, even if we don’t have to feel sorry for them. The point is, people don’t like to lose money and fund managers don’t like it, too. Because, if they do, they not only lose the money but the clients, too. No fund manager wants to lose clients, because they pay their salary. So, better than losing money is doing average, even if this means not beating whatever market index you want. Nobody loses his job doing average.

As well as a portfolio of 15 to 20 chosen stocks has a good chance to beat the market, it also has a good chance to perform well below the market, at least for a certain period of time. But fund managers don’t have this time. That’s why they prefer to invest in hundreds of companies. Such a portfolio will likely do pretty average. And save the job of our manager.

Don’t blame the manager

You see, it’s not because they are lousy investors, why fund managers don’t beat the market. (Although this might be a reason, too. But we won’t find out.) It’s because of different things they have to take into account.

Arguing that a normal small private investor can’t beat the market, because the most fund managers don’t do it, is not a comprehensible argument.

So, if you want to invest in individual stocks, do it! Learn the things you need. It’s not that difficult. Read, learn and make experiences.