How individuals are beating the fund managers

On Friday, Robert Gottliebsen (SMSFs: The unsung super heroes) looked at evidence from the superannuation environment that showed individual investors, through self-managed super funds, were outperforming the commercial superannuation sector.

In a report that provides an interesting insight into the world of fund managers, the 2013 SPIVA Australian Scorecard looks at the performance of ‘active’ managed funds over the past five years, to the end of 2013. The findings are not good for managed funds, with only 30% of managed funds in the ‘Australian General Equities’ category beating the benchmark (ASX 200 Index). It should be noted that over one year the returns for managed funds were actually attractive, with 68% of funds outperforming the benchmark. However, by three years this had fallen to 37% of funds outperforming, and then down to 30% over five years.

From both these reports comes an interesting question. How can individual investors have an advantage over a fund manager just by capturing the average market return through a simple index fund, a lost-cost LIC (listed investment company) or a direct portfolio of shares when fund managers have amongst their resources a myriad of intellectual, technological and time advantages?

There are a number of factors that make life difficult for managers of “open ended” managed funds – one that has a regularly struck unit price that then creates/destroys units as investors either invest or withdraw money from the fund.

Less control over trading and timing

This leads to the first challenge for fund managers – as people withdraw or invest money there needs to be an amount of trading in the fund, with associated costs. An individual investor has an advantage here, as they completely control the timing of the purchasing or selling of their investments.

The second challenge for managed funds comes with their size. As an individual investor, we can purchase individual holdings without any material impact on the overall market. A fund manager, who has to trade with large amounts of money, can’t move as easily into and out of shares. If they are buying a large quantity of shares, then they have the potential to increase the price of the shares as they are buying them. Equally, as they are selling a large parcel of shares they can decrease the price of these shares. These “market impact costs” as managed funds trade are not something that individual investors have to cope with.

Higher fees create return disadvantage

Fees are another challenge for managed funds – which individual investors can manage/reduce through the use of direct shares, low-cost index funds and LICs. If the expected long-term return from shares is 7% above the rate of inflation (an estimate used by Wharton Business School Professor Jeremey Siegel), and if inflation is around 3%, then the expected return from shares over long periods of time will be 10% a year. If a managed fund has fees of 1.5% – and many have higher fees – this is equal to 15% of the expected return from the sharemarket. It is a tough ask to outperform the average market return as a fund manager looking after a very large portfolio if you are starting at a 15% disadvantage.

More than this, as a managed fund becomes bigger and moves from managing tens of millions of dollars to hundreds of millions of dollars, the sheer size of the fund means that they have to invest more and more money into the biggest shares in the market, and can’t put meaningful quantities of the managed fund’s assets into smaller companies. This means that the managed fund looks more and more like an index fund – large amounts invested into the largest companies in the market and less in the smaller ones – which makes it hard to build a performance that overcomes the 15% fee disadvantage.

The issue of tax effectiveness

We then come to a big issue for managed funds – tax effectiveness. Because of all of the trading that happens in a managed fund as money is invested and withdrawn, they often have amounts of capital gains that have to be passed onto investors each year in June 30 distributions. The challenge for investors in understanding the impact of large taxable distributions is that very few managed funds calculate after-tax returns. While index and passive fund providers such as Vanguard and Dimensional, whose funds are generally tax effective, do report after tax returns the vast majority of managed funds do not. Given that after-tax returns are what really count for an investor, the publication of after-tax returns by fund managers would provide valuation information. It is mandatory in other parts of the world, for example the US, and would be a great addition to the Australian investment environment.

In discussing some of the challenges that managed funds face, it should be kept in mind that there are some destructive tendencies that individual investors fall prey to. A large financial services firm, Dalbar, measures the ‘market timing’ ability of investors, and find that people destroy wealth through tending to invest when markets are high, and then withdrawing money from the markets when they have fallen.

Two academics, Barber and Odean from the University of California, have studied the behaviour of individual investors by looking at discount share broking accounts. They find that investors reduce returns through overconfidence with their trading – tending to sell shares that then outperform the shares they buy to replace them.

Conclusion

There are many reasons why investors might use managed funds in their portfolios – from accessing fund manager expertise in a section of the market through to the ease of being able to invest regularly in a portfolio.

However, there are a number of structural challenges that managed funds have that individual investors do not face, which helps explain both the outperformance of self-managed super funds and the challenge that fund managers have in keeping up with the average market return.

Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.