By Paul Farah
In this edition of Investing Chronicles, Lockstep CEO Paul Farah shares a few unexpected advantages individual investors hold over professional fund managers.
Investing is a fascinating place to play. It is one of the few professions where an individual investor, also known as a retail investor, who knows what they are doing, has an advantage over an institutional investor, also referred to as a professional fund manager, such that you can outperform these pros in the long term.
It sounds unreal, but let’s delve into the reasons for this claim:
Disadvantages of institutional investors
Institutional money managers face several limitations that hinder their ability to perform optimally. Their main shortcomings are:
A short-term focus
Investment funds typically manage assets on behalf of clients, including pension funds, endowments, and fund of funds often called multi-manager funds in South Africa. These clients typically expect regular updates on their investments, sometimes as frequently as monthly. Consequently, if a fund manager experiences several months or quarters of poor performance, they will face scrutiny from their clients.
Given that a fund manager’s income is directly tied to the fees they charge them for managing their investments, they naturally prioritise meeting client expectations. As a result, fund managers may unconsciously adopt a short-term mindset to avoid disappointment – and we know that focusing on short-term gains can hinder the long-term growth potential of investments.
Restrictive mandates
Naturally, clients don’t want money managers to take unnecessary risks, which could lead to the implementation of mandates that often limit the size of positions and the total exposure to industries or asset classes. Additionally, mandates usually require funds to be able to liquidate entire positions within a specified time frame.
Moreover, clients prefer managers to minimise cash holdings, as they would rather hold the cash themselves than having it lie idle in a fund that is charging them fees. So, even holding cash can be prohibited.
I have personally experienced this at my previous job. Our fund had an outstanding year in which it had appreciated 66%. Because of this strong performance, we reduced our equity holdings as share prices increased, resulting in a cash allocation of over 30%. At this point, one of our largest clients questioned the high cash allocation and said: “If we want to hold cash, we will hold it in our own bank account.”
Regrettably, we listened to them and reinvested in what we perceived as expensive investments at the time. Consequently, our performance was suboptimal in the following year.
While these restrictions are therefore reasonable from a risk management perspective, they inevitably limit performance.
Client behaviour
Investors who put their money into funds exhibit the same emotional tendencies that drive individual (retail) investors.
People have a natural inclination to seek out fund managers who have recently outperformed the market, often assuming that they are superior. However, this behaviour mirrors the concept of buying high instead of buying low, which is flawed thinking. Rarely do these funds sustain their exceptional performance as they amass more capital.
When a fund’s performance deteriorates, clients begin to question their investment decisions and the competence of the fund manager, which, in turn, places significant pressure on the manager. If poor performance persists, clients may withdraw their investments, often at the worst time which is akin to “selling low”.
Moreover, market fluctuations can trigger panic among fund clients, prompting them to pull their investments hastily. Such reactive behaviour can undermine the fund’s stability, particularly if it leads to the forced sale of shares during unfavourable market conditions.
Mimicking the market
A short-term focus, restrictive mandates, and the fear of going out of business can cause managers to inadvertently copy the market so as not to disappoint. When this happens, it has the opposite effect to what they’re trying to achieve. The more they resemble the market, the less likely they are to outperform it.
The S&P SPIVA scorecard reveals that in 2023, only 40% of funds surpassed the S&P 500. If you go 10 years back, it becomes evident that a mere 12.6% of funds outperformed the S&P 500 in the past decade. It shows just how challenging professional money management is, and part of the problem is the constraints I’ve mentioned.
While there are other shortcomings, they are natural hindrances that managers must deal with. Obviously, they are not issues you and I have and our real advantage stems from their combined effect on managers.
More money, more problems
Fund managers’ goal is to make money for their clients. As their success grows, they attract more attention and clients flock to them, hoping to capitalise on their expertise. Naturally, as professionals, managers accept more capital as it means a more prosperous fund and higher fees. It’s rare to find someone who turns down such offers.
However, it also leads to a significant challenge. With more assets under management (AUM), the fund’s investment opportunities diminish which, in turn, diminishes its performance. The larger the fund, the fewer options it has.
For instance, a $20 million fund can invest in almost any high-quality business, but a $20 billion fund faces limitations. It’s simply impractical for a $20 billion fund to purchase shares in a $200 million company as a 1% position would mean that they own the entire business.
As a result, large funds have to focus on larger, more established companies until it eventually resembles the very thing it is trying to outperform – the index.
Advantage US!
Individual investors are not confined by the same restrictions as professional fund managers. We can invest in anything regardless of size. We can hold these investments for as long as we want. We can keep them for decades or we can withdraw next month. Or we can decide not to invest and keep all our money in cash without upsetting anyone.
But best of all, we can uncover high-quality businesses that institutional investors simply ignore or are too big to invest in.
There’s plenty more to discover with Lockstep.
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* Paul Farah has worked in financial markets since 2006, holding positions at prestigious firms from New York to South Africa. Now, he manages his own money and provides access to his entire portfolio through his company Lockstep Investing. The views and opinions shared are his own and are for informational purposes only, it is not intended to serve as investment advice and it does not represent the view or opinion of Standard Bank. This information should be used as a starting point for generating investment ideas,and should not be relied upon as the sole basis for making investment decisions. Lockstep Investing (PTY) LTD and the Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.
