You can beat the professional investors

Most investment professionals could do better if they just focused on their best ideas. Find out how you could follow a 'best ideas' strategy.

We’re normally pretty rude about professional fund managers at lovemoney.com. All the evidence shows that professional fund managers don’t do a good job. They’re paid chunky salaries yet most of their funds fail to beat the market. In other words, if the FTSE 100 index rises by 5%, most relevant UK funds will rise by less than that.

That’s why we advise readers to normally steer clear of professional fund managers. Instead we advise investing in index tracker funds. These funds are designed to replicate a particular stock market index and all the work is done by a computer. So if the FTSE 100 index rises by 5%, a FTSE 100 tracker fund should rise by roughly 5% as well. What’s more, the charges are low. Find out more in Six great reasons to choose an index tracker.

Better than I realised

However, I’ve been reading an interesting paper* this week which suggests that professional fund managers are better investors than I had realised.

If you ever meet a fund manager, you’ll often find that he will talk enthusiastically and knowledgeably about some of his favourite shares in his portfolio. He’ll know loads about the companies concerned and will make a very strong case for investing in those companies. And then you’ll think, he can’t possibly know that much about the other hundred shares in his portfolio. There just isn’t enough time for him to gather that level of information about all his shares.

Interestingly, that distinction between ‘favourite’ shares and ‘other’ shares shows up in investment performance. The authors of the paper use some complex equations to find out which companies are the fund managers’ ‘best ideas’ and which aren’t. Lo and behold, they find that fund managers’ best ideas do beat the market – by between 1% and 2.5% a quarter.

So that raises the question: why don’t fund managers just focus on their ten favourite shares, rather building a portfolio with many more companies?

Well there are three main reasons:

• The ‘best ideas’ are often fairly small companies. Let’s consider an imaginary unit trust with assets worth £500 million. It’s hard for a fund of that size to make a meaningful investment in a ‘best idea’ company that is only valued at £100 million. Even if the fund manages to invest £5 million in the company, it still won’t make a huge difference to the performance of the fund if the company’s share price rises by 20% and beats the market.
• Fund managers want to manage big funds with lots of money. That’s because they’ll probably be paid bonuses based on the size of their funds. If you’re managing a big fund, the easiest way to invest the money is to buy shares in massive multinational companies that are worth billions of pounds.
• Investing in more companies reduces risk and volatility. Fund managers are terrified of risk. If they have a small portfolio, there’s a bigger chance that their fund will perform very badly and they’ll lose their job. They don’t want to take that risk, so they take the easy approach and invest in a wide range of shares. Then they deliver performance that is similar to lots of other actively managed funds, and they keep their job – even though they’re not keeping up with the market.

I can understand why most fund managers take the low-risk approach. But it’s also a great shame. It seems that many fund managers do have the skills and judgement to be good investors. They just don’t use those skills to manage successful funds.

Lessons

I think there are several lessons to be learned from this:

* For most people, it's best to focus on index tracker funds
* If you're keen to back professional managers, take a look at small funds that don't have a lot of assets
* Also look at funds which have a relatively small number of shares in the portfolio. You should try and find the fund managers who are prepared to take a risk, stand out from the crowd and back their judgement
* You could try and beat the market by investing directly in shares yourself. You don't need to find a home for millions of pounds: you needn't feel obliged to invest in large multinationals just because everyone else is doing that. By building a small portfolio of top shares, you might be able to prosper. You could get some share ideas here.

If you put the above lessons into practice, you may find it easier to beat the professional investors than you expected. You can do it!

* “Best ideas” by Randolph B. Cohen, Christopher Polk, and Bernard Silli