Investment funds explained
Most of us who buy shares do so via investment funds - unit trusts, investment trusts and the like. And most of these are ‘managed funds’, where you’re buying a piece of a much larger bundle of shares sold and bought by an expert in the city … a fund manager. The problem is … managed funds just don’t seem to work. The weight of academic work, with studies by economists going back almost fifty years, is that the expert fund managers tend to underperform the market.
In other words you’re paying somebody to do worse than YOU could do yourself, if you stuck pins in a printout of the FTSE 100. We’ll not mention all the surveys here, but you’ll find a link to the various reports down the years at the end of this article. The theory of the expert stock picker, powering a fund that outperforms the market, HAS to rest on markets being imperfect. In other words, there is a disparity between what a stock is priced at and what it is ACTUALLY worth.
So, Ace Oilwells may be priced at £100 a share, but Fund Manager Bob knows that they have new wells coming on stream in Brazil in the coming year, and adjudges the stock undervalued. He piles in (on your behalf) and the shares, and your fund, soars. There’s a problem with this of course. If Bob knows this, then the information is in the public domain. Now it’s arguable that once upon a time even public domain information could travel so slowly that somebody on the ground in Brazil could buy up shares before the news got back to London and the price went up. But THAT ruse went out of the window with electrical telegraphy. And things have moved on a bit since Samuel Morse in 1839. With the free availability of information on the internet and the ever increasing sophistication of stock analysis software, it’s hard to see how anyone today can consistently get an edge. THE ONLY WAY IS IF … the information ISN’T in the public domain, in which case it’s insider trading, and thus illegal.
However you slice it, it’s hard to see how a dealer in London can get an exclusive ‘IN’ to a soon to rise stock. Markets, in the parlance, are already ‘efficient’. Not perfect - there will always be a disparity between the price and the value of a stock, that’s why share prices move. But the chance of your fund manager lucking in to that disparity are, to be generous, small.
Now let’s be fair here. Fund managers DO have good runs. New star managers and funds appear all the time. But here’s where averages bite you (and your investment) in the backside. Take a typical (if very simplified) example. Superfund Emerging Markets was launched three years ago and has outperformed the FTSE 100 for each of those last three years. The odds and the academics say that your fund is only likely to match the market at best … more likely to underperform it. But let’s be generous and say IT WILL match the Footsie. That means it’s likely to UNDERPERFORM the market for the next few, to balance out the good years it’s already had. They might have a better run .. but the principle remains. You’re too late - you’ve bought in just AFTER the fund has had its best years.
Now you see why ‘past performance is no guide to future results’ is more than just a disclaimer. But surely the fact that the funds are underperforming the market over times doesn’t make sense either does it? I’ll leave aside the puzzling fact that these guys with the sharpest brains, the best university degrees and access to ALL the latest data on the markets don’t seem to be able to beat the market. Surely they should at least be MATCHING the performance of the stock market indices? Well the experts are often doing, on a micro scale, just what you’re doing with your fund as a whole. Buying in after a share’s price has already flown.
They are also hopping in and out of the markets, and that in itself is expensive, as there are transaction costs every time you buy or sell a share. And that’s all cash that ISN’T being invested back in buying more stock. Fidelity Investments published some interesting stats a few years ago that showed how dramatically gains in share price were concentrated in just a few days a year. Between 1987 and 2002, looking at the FTSE All Share Index, there was a 9.4% gain, per year, if you bought across the entire index … and left your shares untouched. If you were out of the market for the best ten days of the year, gains fell to 6.3%. If you missed the best 40 days your gains would be just 0.6%. It was a pattern repeated across several of the world indices.
Let’s be fair here, there are two opposing points of view. The fund companies will say ‘We will beat the market’. The people producing these reports say ‘you won’t’. The first guys are trying to sell you a fund, the others are disinterested academics. So who do you believe? We’ll go with the academics.
Links: Underperforming fund managers, Why fund managers don’t make money, www.fidelity.co.uk
Tags: Investment funds explained, Investment funds, investment trusts, managed funds
