Can private investors really beat the market?

Independents face an army of managers, traders and robots.

Monkeys armed with darts could probably outperform benchmarks like the RBA cash rate, currently at 1.5 per cent.

Is the game stacked against the independent investor? With an army of managers, traders and researchers — not to mention algorithms and robots — lined up on the other side, is it time to pack it in and hand over your funds to the professionals?

The question has become highly relevant in a climate where so-called “passive” funds such as index funds and ETFs become ever more powerful while mercenary hedge funds alight on the local market with a vengeance.

Of course passive funds only get you average performance — and the average performance on the ASX over the last decade has been pretty miserable — in fact we are still 15 per cent or so below where we were in November 2007 — the ASX then was at 6800, today it is at 5900.

And surely, there must be a fighting chance for the private investor to beat fund managers who have rarely sunk so low in public estimation: More than 75 per cent of large-cap fund managers fail to beat the index.

The question of whether the private investor can really beat the market has been regularly addressed by academics with the typical outcomes that you might expect when trying to pin down how large numbers of people behave with large amounts of money.

The short answer yes, but nobody can pinpoint useful patterns. The long answer probably sounds something like this (from a Harvard Business School paper on the subject back in 2005):” A subset of individuals has ability of some sort — but it is not clear where the results offer a strategy to exploit.”

Oh yes, and this too from the same academic trio — Coval, Hirschleifer and Shamway: “Individual investors are a heterogeneous group that includes both foolish and sophisticated investors.”

That last quote does at least offer one useful takeaway — the idea that there are market winners and they can indeed be individual investors.

But a sceptic at this stage might very well jump in and say you should get “outperformance” from top managers if you are willing to pay for it. There is merit in this argument — the crux is trying to find outperformance fees that are fair or reasonable.

It might be unfair to single out a single example at this stage — but let’s do it anyway. Sydney-based Harvest Lane Asset Management comes up well in most industry surveys — it gets four out of five stars from SQM research for its Absolute Return fund which ranks it as a “superior investment product”.

It’s a fund which promotes itself heavily on the basis its fee structure, based solely on outperformance of its benchmark.

And what they must outperform is … wait for it … the RBA cash rate, which is currently at a generational low of 1.5 per cent.

Now anything these guys make above 1.5 per cent they can charge a 25 per cent outperformance fee.

The Harvest Lane example is used here not to knock the company (they’ve managed a very respectable 7.7 per cent annually for the last three years after fees) but rather to make the point that a monkey armed with a set of darts would probably do better than 1.5 per cent and be entitled to performance fees under this model.

Death of the sole trader

One useful thing the wider academic literature does tell us is that today’s market — while remaining perfectly open to the individual investor is without doubt stacked against the individual trader. The proliferation of high frequency trading programs has almost completely removed the possibility of the day trader acting faster than institutional manager.

Meanwhile, the mathematical power of algorithmic trading has also ironed out a lot of the temporary anomalies that once allowed lone wolf day traders to occasionally make big wins.

But for investors — as opposed to traders — the picture is not so gloomy.

Many of the issues that worked against the sole investor remain in place: Institutional investors have deeper research capability, better connections, and despite endless efforts by regulators to work on disclosure requirements, institutional investors get better ­briefings.

In many cases institutional investors will “know” the management — particularly at smaller companies and though they will occasionally get charmed with the same blarney and occasionally told the same lies as the private investor who turns up to an AGM … the professional investor has every chance to gain a more nuanced understanding of the market.

Offsetting these issues the private investor can now get an extraordinary level of information on listed companies over the internet for free.

In contrast, the controls and restrictions the professionals labour under are deeply restrictive: Just to mention a few:
• The compliance procedures are endless and complex,
• The institutional investor must retain high levels of liquidity (cash) which prevent them from acting when there is opportunity.
• Institutional investors are ­constantly trying to meet quarterly expectations, a pressure which invariably acts against long term results
• There is the intangible but important network of obligation and favours which exist in all businesses.
• There are so-called “mandates” which are the rules clients set for the manager to follow — so a manager might be limited in many ways from actually getting the best result — for example a manager may have a 10 per cent limit on, say, technology stocks.

The manager might see the opportunity of a lifetime but cannot exceed their mandate.

The individual investor — including the SMSF investor — has few of these concerns.

The private investor can beat the market, beat the fund managers and beat the passive funds.

What the individuals must deal with is an altogether more ­commonplace issue — their own human fallibility.

This means avoiding panic, minimising bias, sticking with a plan and, importantly, keeping a balanced allocation of assets even when one asset — residential property in 2017 — is clearly ­running hot.