This week, investment professional, Jamie Ward discusses the ways in which private investors are at an advantage to professional investors. He then describes practical steps to exploiting these advantages and avoiding the pitfalls.
From the outside, the life of a fund manager looks to be a charmed life. Indeed, if you are interested in markets and investing, there can be few better jobs out there. As a fund manager, I spent my days looking at companies, meeting interesting people, and thinking about how best to position a portfolio. Occasionally, one would actually invest also but those days were rare. It is not however without difficulties, frustrations and slightly depressive episodes. A private investor does have disadvantages over a professional investor, but for a private investor who makes considered investments, the advantages far outweigh the disadvantages.
It is probably true to say that a disinterested private investor, disinclined to understand markets, is better off in some sort of low-cost managed portfolio. However, for those with the interest and acumen to invest on their own account, a more tailored portfolio can be constructed. Where a professional investor is at an advantage is time. If you are being paid for 40 or more hours per week to think about portfolio construction, you have the opportunity to learn far more than an enthusiastic private investor who perhaps has little more than a few hours per week. On the flip side, a private investor has a great deal of freedom on how and when to invest, which allows them to ignore the constraints a professional investor has to work under. Below are three of the key constraints.
I asked AI to create this image based on the following ‘a smug man sat in a reclining chair with a grin on his face and copies of financial reports around him. The room he is in is in the style of a stately home’
Too Much Diversification
A professional fund manager in the UK typically operates their fund under Undertakings for Collective Investment in Transferable Securities regulations (UK UCITS). One of the main rules in these regulations is often referred to as the 5, 10, 40 rule. It states that no more than 10% of a fund can be invested in a single investment and no more than 40% of a fund can be made up of positions of >5%. When followed through to its logical conclusion, a fund operating under UCITS rules cannot hold fewer than 20 positions. Most funds hold many more stocks than this.
My old fund was deliberately designed to be concentrated, which we stated to mean between 20 and 35 holdings. In reality, the fewest number of positions I ever held was 22 and the most was 30. Yet, you don’t need to be as diversified as that as a private investor. Several of the most successful investors of all time have maintained very concentrated portfolios. Warren Buffett posed the question, “Why would I buy my twentieth best idea when I can buy more of my first best?” Seth Klarman, of Baupost Group and author of Margin for Safety, runs a famously concentrated portfolio and has stated an idea to the effect that the benefits of diversification peak at around eight holdings. One of my own investment heroes is Stanley Druckenmiller who once summarised his style as “put all of your eggs in one basket and then watch the basket like a hawk”. None of these money managers have ever operated under UCITS rules and neither do private investors.
This is not to say that a private investor should become overly concentrated but nor do they need to buy additional holdings just for the sake of supposed additional diversification. Should an investor wish to go down this concentrated route, they need to do two things:
- Honestly appraise one’s financial and psychological ability to absorb losses. Markets go down, and not all investment ideas are successful, which exposes a concentrated investor to quite large losses. It’s easy to think that you can take a big loss during a bull market when you are making money, but can you really take a big loss if markets become nasty?
- Have a very sound understanding of what you own and why you own it and, ironically, make sure your ideas are spread evenly. The temptation is to fall in love with an idea and become overly exposed to one position. Even when you’re sure you’re right, you might be wrong. ShareScope is invaluable here for the private investor because it is a rich source of data that is useful for analysis.
When Things Don’t Feel Right
I’ve written in previous articles about how my investment style has evolved over time to account for trying to tune into the market. The most recent article on the subject is about trusting your heart when it comes to company-specific instances but this can be broadened out to markets as a whole. One of the constraints placed upon professional fund managers is that of cash. Cash is considered an asset class like bonds and equities. Consequently, an equity fund manager like me is discouraged from holding it. There is a sound logic to disallowing an equity fund manager to hold cash, which is the idea that people who invest in an equity fund might have their own view on the amount of cash they hold, and you holding cash distorts their underlying picture. In practice, it meant I was expected to hold between 2% and 10% in cash. Yet, at times, markets don’t feel right and you may wish to hold more cash.
There are some who argue that an equity manager is paid to own equities and by not doing so, you are paying for nothing. I have less sympathy for this view however since the decision not to invest at an inopportune time is still a decision, which has the potential to add value by protecting capital when appropriate.
Beauty Parades
As a fund manager, whether you wanted it to be the case or not, you were constantly compared to other fund managers and the index – this is often called a beauty parade. Essentially, you are being judged and must justify everything you do. A private investor is under no such obligations. As part of your constraints, you have a mandate, usually created for you, which can be anything from fairly general to very specific. Either way, it directly dictates how your fund is invested. In an ideal world, you would set your own mandate but mostly a fund manager would receive the mandate from elsewhere such as the Authorised Corporate Director. Ultimately, this dictated the fund management style you used. Unfortunately, styles can go out of fashion; sometimes for prolonged periods, and this can lead to disappointing performance. Our fund never went through a long period of poor performance and overall, it performed rather well, but plenty do have long periods of poor performance. Regardless, private investors don’t have to conform to any particular mandate and are free to invest how they feel appropriate however markets are behaving.
In professional investment management, you will often hear that professional fund buyers have a long-term time horizon. In reality, this is often not true. Fund buyers themselves are under similar constraints to fund managers insofar as they are judged on the performance of their decisions. For me, a long-term horizon is at least the length of a business cycle. A business cycle is analogous to the length of a piece of string but I’d say somewhere in the range of four to seven years is a fair approximation. Therefore, this is the length of time over which performance ought to be measured. Despite this, there are plenty of instances where large fund flows are driven by periods of much less time than this – sometimes less than a year. Anecdotally, I know of one fund manager who had a £300m inflow that was taken and became a £300m outflow in six weeks. Apparently, the fund buyer decided six weeks of equity ownership was preferable to having cash on deposit.
There are two things about this where a private investor is at an advantage:
- Stress – when you are going through a period of underperformance, it is stressful. Moreover, it can be frustrating when you know that the portfolio is behaving as it is designed to do. There is a feeling that you have to justify every position – recall what was mentioned above about owning lots of stocks. At any moment, even if your performance is stellar, something in the portfolio will be underperforming badly. When you are underperforming, these positions come under intense scrutiny. More than once, I sat in hour-long sales meetings and spent 50 minutes talking about why I held 3% in one stock that was performing badly. With the risk of sounding flippant, a diverse portfolio is supposed to have positions whose performance deviates from the rest. Sometimes this deviation is underperformance. It’s not that managing one’s own portfolio isn’t stressful, but at least you only have to justify your decisions to yourself.
- The performance itself – point one follows to point two. Ultimately, to a private investor, performance doesn’t actually matter. You’re never going to lose your job if your private portfolio is going through a rough patch. I’ve written in the past about passive investment where I stated that there were numerous reasons why an individual might wish to invest in a particular business and performance isn’t all of it. As long as you understand why you own something or a portfolio of things, it should never matter how it happens to be performing compared to an arbitrary index – particularly in the short to medium term.
For private investors, not worrying about performance should remove a layer of stress and allow them to have a truly long-term outlook. This shouldn’t lead to complacency because an investor must regularly challenge why they hold a particular investment. But individual investors have individual goals and rarely does that goal have anything to do with how an index is performing. If you are investing on your own account in individual stocks, what is important to you, should remain front and centre. A professional investor doesn’t have that luxury.
In Charge of Your Own Destiny
Overall, whilst professional investors are perhaps at an informational advantage, professional fund management can be akin to playing tennis with one hand behind your back. It can be done, and rather well, but you’d much rather have the use of both hands. Private investors must always consider their investment opportunities according to their own aims, values and goals. However, an individual who thinks deeply about their portfolio and avoids the pitfalls is at a tremendous advantage. Don’t squander your advantages.
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Jamie Ward
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