The Farmer’s Son and the Underperforming Fund Managers

Richfield

29 Sep The Farmer’s Son and the Underperforming Fund Managers

In a far away land, there lived a farmer and his son. They grew rice in padi fields. During the rainy season, torrential rains would fall and the fields would be flooded. 

The farmer and his son would then wade through the knee deep water to plant their seedlings. It was backbreaking work, and they toiled long hours each day. 

Finally, the work was completed, and the seedlings laid out in neat rows. Now all they could do was to sit back and wait for the rice to grow. 

One day the farmer had urgent matters to attend to in the village. He instructed his son to stay behind and look after the fields. ‘I will be back in the evening’ he said. ‘And I will leave you in charge of the fields today’. 

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The son beamed with pride. It was a great responsibility and he was sure he could live up to his father’s expectations.

He watched his father begin the long journey into the village and then turned his attention to the padi fields. It’s been a week since they sowed the seeds and the rice seemed to be hardly growing. He wish he could make them grow faster. 

He had an idea. He leaped into the fields and gave the first seedling a gentle tug upwards. The seedling became taller than the rest. It has grown. He must have the magic touch, the son is convinced. 

So he set out to work his way across the entire field. At the end of the day, he surveyed his handiwork with pleasure. He was certain that his father would be pleased when he sees the progress his crops has made. 

Long after nightfall, the farmer returned. The son could barely contain his excitement but decided to wait till the following morning to surprise his father. 

At dawn, the farmer and his son made their way into the fields. What greeted them was an expense of fallen seedlings. Uprooted and having lost their grip on the mud below, many ended up floating forlornly on the flooded field. 

Father and son could do nothing but look on in shock. It was a pitiful sight. 

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Last week, the Financial Times published an article titled ‘Active managers exposed as most US equity funds lag behind market‘.

Nine out of Ten US equity fund managers failed to beat the market over the past year. 

According to the S&P Index Versus Active Scorecard (SPIVA), 90.2% of actively managed US mutual funds (or Unit Trusts, as they are better known locally) underperformed their benchmark after taking into account fees.

Put yourselves in the position of an investor in the USA looking to invest a sum of money. You have some options.

One of them would be to purchase a mutual fund, where a fund manager selects the best stocks to buy and builds the most optimum portfolio for your investment. In return, he gets a small percentage of your invested sum every year as management fee.

Another option would be to invest the money in an index fund. Bought and sold just like any stock, the index fund tracks a particular index. The SPDR S&P 500 Exchange Traded Fund for example, tracks the S&P 500 Index. Should the index goes up, the fund increases in value. The investor is in effect buying the entire market.

Conventional wisdom suggests that option 1, leaving money in the hands of the professionals and being selective about what you invest in, is the better choice.

After all, the fund managers are the experts in their field and they have all the technology and information at hand to make the best investing decisions on your behalf.

Unfortunately that is hardly the case. The results are overwhelming and leaves no doubt that passive investing is the better option for most, if not all investors.

Nine out of ten managers whom we pay money to manage our money has actually made things worse.

It is not a one time phenomenon 

Based on data provided by the Financial Times, no matter which time frame we choose to compare the results over, passively managed funds have gained the upper hand over active fund managers.

In fact, for US equities, the percentage of fund managers that do better than the index they are supposed to track has remained relatively stable.

screen-shot-2016-09-26-at-12-27-20-pm

Source Financial Times

Over the past one, three, five and ten years, only approximately one in five managers have done better. Four out of five fund managers are better off buying the index and they should not be in the business of managing money at all.

Emerging markets are not Perfect markets

There is a bright spark though. Of the many markets and instruments the study tracks, international markets and emerging markets have provided staging grounds from where the best performance have emerged.

55 percent of fund managers who invest in emerging market equities have done better than the index. If you are an investor who insist on paying someone to help you invest, getting into a fund that invest in Brazil or Mexico or South Korea, might be your best bet ever (but only by a tad).

It might seem counter intuitive, but the simple explanation is as follows.

The United States is the closest we have to perfect market conditions. In a perfect market, there is little price dislocation, as any stock (or bond, future or option for that matter) that is cheap would be bought up immediately and any stock that is marginally over priced would be sold (or sold short) immediately.

Information is readily available, and there is no shortage of players willing and able to engage at all hours of the day. As such, stocks trade very closely to their intrinsic value.

In contrast, emerging markets are far from perfect. Stocks could be thinly traded, and regulatory requirements may not be so developed. This leads to slower information flow.

The possibility of discovering an undervalued stock is much higher. Emerging markets provide greater opportunities for stock picking. It is definitely an easier game to play.

For investors who are hung up on US equities because they are ‘the world’s largest economy, the most liquid market, the most innovative companies, the most read about in the media, and because everyone is investing in the US’, I do hope this piece of information will challenge your assumptions somewhat.

These are the reasons that make the US so comfortable to invest in. With comfort comes a price, and it is precisely these reasons that make it so hard to beat the US market.

Cost – the biggest bane

Some time ago, we pit the STI ETF against unit trusts investing in local equities. Funds performed admirably, with more than half outperforming the index. When fees are taken into consideration though, STI ETF shines through and leapfrogs many lesser funds in the stable.

More recently, I wrote about how cost is a massive drag on performance. I would like to make one further point on cost today.

Distribution cost 

To move any product at all, there is a distribution cost involved. Take cars for example. Before a dealership can even sell a car, they need to occupy a showroom, hire a team of sales people, prepare glossy brochures, budget for advertising and also make available physical cars for test drives. All these contribute to the cost of the product.

car-showroom

It is the same situation with mutual funds. Despite being the inferior product by far, underperforming the market by 9 to 1, mutual funds remains the de facto investment choice for many in the US.

The reason is simple, the high cost base allows fund houses and banks to splash on advertising and upkeep an effective (and expensive) distribution channel.

Exchange traded funds, despite being the superior product, clearly does not have that luxury. I cannot recall an instance where a financial advisor recommended me an ETF instead of a Unit Trust. Never Ever.

As an outcome, ETFs lose out and the vicious cycle perpetuates.

Mr Farmer’s heartbreak

The debate between active and passive investing strategies runs deep. SPIVA data has demonstrated beyond doubt that active alpha seeking strategies do worse than a passive approach.

Like rice seedlings, all our investments need is time to grow. Actively managing the portfolio, tugging at it and interfering with its growth, no matter how attractive the plan sounds like initially, is nine out of ten times the lousier option.

Understanding that can save us from heartbreak and avoid the plight of Mr Farmer and son.



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