Why investing in mutual funds or unit trusts may not be a good idea – part 2

Followers of bigfatpurse will know that I am not a definitely not a fan of mutual funds or unit trusts. I stated my reasons in this earlier post: Why investing in mutual funds or unit trusts may not be a good idea. It rekindled my thoughts about mutual funds when I was reading Peter Lynch’s “One Up on Wall Street“, who as a fund manager, believes an investment professional may not do as well as an ordinary retail investor. In his book, he provided elaboration that was not covered in my post and it was his view from the inside that made it even more convincing.

Analysts may not be qualified afterall

Peter was hired at Fidelity (a fund management company) as an intern while he was at Wharton University. He sounded very critical against the investment professionals like the research analysts (which I believe not all are bad) – “Summer interns such as me, with no experience in corporate finance or accounting, were put to work researching companies and writing reports, the same as the regular analysts. The whole intimidating business was suddenly demystified – even liberal arts majors could analyze a stock.”

He even called professional investing an oxymoron but redeemed himself speaking of a handful successful ones like John Templeton, Warren Buffett and a few others.

Professionals are slow to recognize business success than commoners

He argued that it takes a longer than desired time to identify a business that has tremendous growth potential. He termed it “Street lag”. “Under the current system, a stock isn’t truly attractive until a number of large institutions have recognized its suitability and an equal number of respected Wall Street analysts have put it on the recommended list. With so many people waiting for others to make the first move, it’s amazing that anything gets bought.” He substantiated with the example of The Limited, where many analysts missed the stock in it’s early days. It was up eighteenfold from 1979 to 1983, but only 6 analysts were tracking it from 1981. It was only until 1985, the stock came under the radar of the analysts and institutions chased after it at $15, up from the initial 50 cents.

He reckoned that many commoners visiting any of the 400 The Limited stores back in 1981 would have realized it’s thriving business earlier than the professionals.

The need to keep his job

Fund managers have big clients and bosses to answer to and they have to justify for their fund performance and stock selections to these people. “With survival at stake, it’s the rare professional who has the guts to traffic in an unknown La Quinta. In fact, between the chance of making an unusually large profit on an unknown company and the assurance of losing only a small amount on an established company, the normal mutual-fund manager, pension-fund manager, or corporate-portfolio manager would jump at the latter. Succes is one thing, but it’s more important not to look bad if you fail. There’s an unwritten rule on Wall Street: “You’ll never lose your job losing your client’s money in IBM.”"

“If IBM goes bad and you bought it, the clients and the bosses will ask: “What’s wrong with the damn IBM lately?” But if La Quinta Motor Inns goes bad, they’ll ask: “What’s wrong with you?”"

In other words, fund managers find it easier to justify their losing positions on big recognized companies than losing positions on almost unknown companies. And it is often that the greatest growth comes from the small companies.