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Wednesday, April 22, 2015

How to invest, individual stocks or mutual funds kcchongnz

I have written a four-part series on the stock market crashes in the United States and at home as shown in the links below.

The articles describe how the stock market ran up during which investors had accumulated huge amount of wealth and then almost all lost what they had made, or more, during the market crashes which inevitably followed the previous euphoria.

The final article below deliberates how an individual investors could have capitalized the market cycle using the example of the most recent crash during the US Subprime Mortgage Crisis in 2008 to build long-term wealth. It was shown that a portfolio of stocks using established fundamental investing strategy had make extra-ordinary of compounded annual growth rate of 35.6%, more than twice that of the broad market of 16%. On the other hand, speculating basing on hypes and fads can result in heavy losses during the same period.

So one may be tempted by the good return from the stock market for building long-term wealth and for retirement. What are the investing choices he has in Malaysia?

Individual stock investors
New investors looking to invest for in the equity market are usually faced with two main options - mutual funds/exchange traded funds or individual stocks. First we will look at the performance of individual stocks picking by retail investors.

Brad M. Barber and Terrance Odean  in their paper “The behaviour of individual investors” in the link below shows that individual investors trading on their own under-performed the market due to information asymmetry, overconfidence, sensation seeking and action chasing, failure to diversify, easily influenced by rumours, tips, media and internet forums etc.

Another study by a Boston based consulting firm, Dalbar Financial Services in its 2005 report, “Quantitative Analysis of Investor Behaviour” shows that an average equity investor earned over 9% less annually than the S&P over the last twenty years. This huge chasm was attributed to investors’ trying to time the market and thus failing to keep their money in stocks for the entire time period.
Below shows a chart in JP Morgan’s 1Q 2014 Guide to the markets.

Based on their analysis, the average investor had a 2.3% annualized return over the 20 years from 1993 to 2012, way underperformed the market return of 8.4% during the same period. This return is not even enough to pay for the annual interest rate if one engages in margin financing investing in the stock market.

Managed or Unit Trust Funds
Among the benefits of investing in unit trust funds mentioned are:
  1. Unit trust funds provide full-time, highly qualified and skill professionals who conduct economic research and fund management which otherwise may not be available to the ordinary investors. The fund manager has instant access to real market information, coupled with the funds’ research facilities, experience and investment skills, the fund manager is supposed to be in a better position to make more informed investment decisions.
  2. Shareholders benefit from a level of low-cost diversification, and hence reduction of investment risk made possible by the amount of pooled investment dollars that most individual investors would not be able to achieve.
  3. Unit trust offers investors a simpler, more convenient, less time-consuming method of investing in securities than trading individually. You will be relieved from the burden of administrative paper work, investment research and analysis of the investment portfolio. All administrative work is done by the manager and does not require any active participation on the part of the unit holder.

The Return of Managed Funds
Michael Jensen (1968),, a top finance academic researcher examined the performance of 115 mutual funds in the United States found no evidence that on average, they were able to predict security prices well enough to outperform a buy-the-market-and-hold policy. It also mentioned that there was little evidence to show that any of the individual fund was able to significantly better than that was expected from mere random chance. The interesting thing was that the conclusions hold even when they measure the fund returns gross of management expenses, meaning that the funds were not even successful enough in their trading activities to recoup even their brokerage expenses. Other academic research such as Grinblatt and Titman (1989), and Burton Malkiel (1995) which comprehensively evaluate fund performance, provided the consistent conclusions that managed funds do not outperform broad market benchmarks as evidenced by their negative risk-adjusted excess returns.

Given the benefits of investing in managed funds as discussed above, especially the full-time, highly qualified and skill professionals who scour the markets for stock-picking opportunities, and the fast and abundant information plus other resources they have, how come they fail to deliver and consistently under-performed the market?

The underperformance of mutual funds/unit trusts
There are a host of reasons why the vast majority of funds are destined to continue their underperformance in relation to the broad market as detailed below.
  1. Market efficiency
The inability of the fund managers as a whole to beat the market is best explained by the efficiency market hypothesis which postulates that in an efficient capital market, current market prices reflect all available information about a security and the expected return based upon this price is consistent with its risk. As a result, it is impossible for an investor to consistently beat the market and profit from it.
In US, there are thousands of well qualified and experienced professionals watching over the market every second. As a consequence, any market mispricing would have been quickly arbitraged away by eagle-eyed professionals in a matter of seconds; low price stocks bidden up, and high price stocks sold down almost instantly. Hence in an efficient market, it is hard to find bargain stocks and harder for anyone to outperform.  

  1. Management fees and expenses
The under-performance of the mutual funds/unit trusts can be mainly attributed to the costs of investing in them. The following link is a very good read and an eye opener for anyone wishing to invest through mutual funds/unit trusts.

The article explained in detail about the six different costs involved in investing in mutual funds: expense ratio, transaction costs (brokerage commissions, market impact cost, and spread cost), tax costs, cash drag, soft dollar cost and advisory fees. The total cost per year, according to the author, can add up to about 4% per annum, which is equal to 40% of a long-term return of equity investment. How could one manage to get a reasonable return after all these exorbitant costs?

  1. Agency problems
Career risk
For a fund manager to try to beat the market, obviously he has to do something which is extra-ordinary and something different from what other fund managers are doing, like investing heavily in a stock which he thinks will rise sharply in price in the future but others don’t see. Well if he is proven right in his decision and actually outperformed the market, he probably will get a praise from his boss or his investors, well done, and that is what you are expected to do, right? But what if he is wrong and the fund loses heavily? You will be quite sure that he will get fired or his investors will desert him..

Closet indexing and over-diversification
Another reason for the underperformance of managed funds is closet indexing and over-diversification. Many managers exhibit similar qualities to lemmings. They will follow each other off the cliff rather than risk being different and thinking independently.

A concentrated portfolio of the best ideas for only ten to twenty stocks can do well above average, especially the fund manager can analyze them well. But, unfortunately, it can also has the chance to do well below the average, especially for the short term. In this aspect, short term can even mean a period of two to three years. In this case, most investors would have run away from the fund.

Asset under Management
What do you think it is better for the fund managers; to make extra-ordinary return for the investors by doing something extra-ordinary and risk desertion of investors or get fired if the outcome is below expectation, or to increase their fund sizes and hence the total amount of asset under management by pleasing the investors and following the crowd?

  1. They’re human
One would expect fund managers are emotionally calmer as they handle other people’s money, not theirs. But that has been proven often untrue. They are human too and influenced by the sentiment in the market. They tend to follow the crowd and chase hot stocks of the day too with the aim of beating the market, or simply to join in the fun. Cash holdings are always low during market euphoria and very high at market lows, fund managers are as prone to panic as anyone and most are too spooked to dive in during times of panic.

But surely there must be individual fund managers who could beat the average of the market. Unfortunately, several research studies tracked the investments of these large, “professional” managed fund allocators such as foundations, endowments and pension funds and analyzed their decisions to hire and fire investment managers. Most fund managers were hired due to good recent performance and those who were fired had recent underperformance of the market. The results weren’t pretty.

In the years following hire and fire decisions, the recent fired managers significantly outperformed the market while the recently hired didn’t show any performance at all.

Individual investors make even worse decisions. A research shows the best performing stock mutual fund in the 2000s made 18% annually compared to the S&P of minus 1%. Yet the average investor in the same fund managed to lose 11%per year over the same period. Why?

After every period in which the fund did well, investors piled in. After every period in which the fund did poorly, investors ran for the exits. The average investor managed to lose money in the best performing fund purely by buying and selling the fund at just the wrong times.

What about the performance of unit trusts investing in Bursa? I do have some interesting results which we will discuss in the next article.

KC Chong (22nd April 2015)

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