Should You Follow the Pros?

In my last post, I indicated that investors should normally not compete against professionals.

That does not mean you cannot rely on their skills in an attempt to enhance your own portfolio returns. In fact, many investors follow analyst recommendations and/or invest in mutual funds that are actively managed.

Whether this is a prudent investment approach is something we will look at.

As in all walks of life, some analysts and fund managers have better track records than others. If you intend to rely on their advice or investment decisions, you should try to find the ones with proven track records.

Mutual Fund Managers

We covered the key areas of consideration in a couple of previous posts.

Please review “Mutual Funds: Management” for suggestions on assessing fund management.

To try and separate the upper tier managers from the lower tier, I suggest using the recommendations contained in “Mutual Funds: Performance is Relative”.

Keep in mind that past performance is no guarantee of future results. A manager’s prior results may be suggestive of the future, but many other variables can impact the actual results.

Investment Analysts

Assessing an investment or research analyst is quite similar to evaluating a mutual fund manager.

As in “Mutual Funds: Management”, you want to know a little about the analyst you are interested in following.

How long a history does she have as an analyst? What are her technical credentials? Does she have experience in her area of research? For example, the analyst may have 10 years of experience analyzing European bonds. This may be good if she is still rating bonds. But it may not be a good sign if she is now analyzing Australian mining companies.

How has the analyst has performed in both bull and bear markets? When the markets are up, it is relatively simple to see one’s picks rise in value. But how did she do when the market as a whole fell? That may tell a different story.

You might also want to know the analyst’s financial interest in the recommendation. This can be a two-edged sword though. On the one side, it is nice to see the analyst own the securities she recommends and is putting her own money into the investment. On the other side, perhaps there is a conflict of interest if the analyst has a financial stake in the investment. That is, maybe the security is being recommended in the hopes that individuals will read the positive review, put their own money into the security, thereby driving up the price and enhancing profits for the analyst.

And exactly as in “Mutual Funds: Performance is Relative”, how did the analyst perform compared to her peers and any identified benchmarks?

Note that there may not be any associated benchmarks with selections of individual securities. However, that does not mean you cannot create your own as an assessment tool.

I would suggest something simple. For example, if the analyst is rating Swiss equities, the Swiss Market Index (SMI) might be adequate. The SMI holds the 20 largest stocks in the Swiss equity market.

Or you could use a number of other Swiss indices depending on your investment criteria. The SMI Mid (SMIM) that holds the 30 largest Swiss mid-cap equity stocks not included in the SMI. The SMI Expanded includes the 50 stocks that comprise the SMI and SMIM. And the Swiss Performance Index is Switzerland’s overall stock market index. And that is only a few indices from Switzerland. There are others you can use based on your needs.

Definitely not a perfect match as the risk-return profiles may differ. But a good starting point.

Next week, we continue our look at whether you should follow the investment professionals. We will consider whether investment analysts provide positive net returns to investors.

Investment Professionals

Having an investment professional managing your assets is usually perceived as a big positive. In fact, that is the marketing point for many mutual funds.

But should it be?

This is one of the biggest issues for investors. And a prelude to the active versus passive management debate.

I believe that non-professional investors should not normally compete with professionals.

In some ways, I view it as competing against Dustin Johnson or Jason Day on the golf course. Unless you have the same skills, it is difficult.

The professionals have an unfair advantage over the amateurs and it is not wise to try and beat them in picking investments. Professional asset managers have more technical expertise, better tools and data, and better access to information than you at home on your computer.

So it seems pretty straightforward. Go with the pros. Except ….

Two Types of Investment Professionals

I shall quickly differentiate between two types of investment professionals.

The first is the mutual fund manager. The person who makes the investment decisions on behalf of the fund.

The second is the research analyst. The person who prepares the buy and sell recommendations on specific investments.

There are other investment professionals including individuals who invest for their own livelihood. But for discussion purposes here, we will focus on fund managers and analysts.

Advantages of Investment Professionals

Investment Skills and Experience

It is not a simple process to pick individual stocks, bonds, or other investments. Fundamental analysis requires strong quantifiable skills and an understanding of the business, industry, and economic conditions to properly assess the qualifiable considerations. We quickly looked at Quantitative and Qualitative Analysis previously.

Professional fund managers and analysts should have the financial skills and experience to conduct better investment analysis than the average investor.

Better Information and Tools

Investment professional likely have access to better analytical tools and data than you or I.

They also have better access to the corporations that they follow. This includes access to a company’s investor relations staff or management as well as to special conference calls that companies conduct for investors.

These two areas make life difficult for investors such as myself. I would be considered an investment professional given my technical qualifications and experience. But having less timely access to corporate information and other relevant data puts me at a disadvantage to a financial analyst in a large firm or mutual fund. While I may not mind playing Jason Day for money, I want to make sure that I am not using golf clubs from the 1970s when I do so.

Also, funds with significant investments in companies are often able to shift the company’s business agenda. This is usually done at shareholder meetings where funds hold enough shares to pressure companies to follow strategies the funds prefer.

It’s Their Job

Another problem for most individuals is that they are not full-time investors. Fund managers and financial analysts spend their days researching investments. That is their job.

Some of you are students. Others are lawyers, doctors, dentists, plumbers, government employees, and so on. Whatever you do, you put in a full week at your own job. Any time for investing comes at night or on the weekends.

If you had the time and the tools, you might be better able to compete with the professionals. But you do not. This also puts you at a competitive disadvantage.

So many advantages in having professionals manage your money. Except ….

Disadvantages of Investment Professionals

There are a few potential disadvantages to using fund managers or analyst recommendations when investing. I will expand on a couple of these points in subsequent posts.

Some Professionals are Better than Others

As should be expected, some research analysts and fund managers are better than others.

The trick is to find the good ones and to avoid the poor.

Not always a simple thing to do. In fact, often you see rankings that have one analyst or manager perform highly in one period, then less so the next. And vice-versa.

Reviews of peer group performance and category ranking is the main way to assess relative performance. But they are not always a perfect predictor of future results.

Does Active Management Work?

There is great debate as to whether analysts or fund managers can out-perform their relevant benchmarks.

In some select instances, I believe it is possible. But for the most part, I am doubtful as to whether active management can beat a passive approach to investing.

We will look at the arguments for and against active management later in some detail.

Neglected Market Segments

Professional investors focus on specific market segments. The segment may relate to their area of expertise (e.g., an oil and gas analyst focuses on oil and gas companies) or investment style (e.g., a Swiss large-cap equity fund analyzes relevant Swiss companies).

Often there are neglected market segments that analysts do not follow and/or funds do not invest in.

These may be extremely small segments such as micro-cap mining companies in Australia. Or markets where information is scarce so that analysts and managers do not follow the segment closely. Equity investments in Iraq might be a good example. Or perhaps the local market is relatively inefficient and analysts/fund managers cannot match the local expertise. For example, a New York based real estate analyst trying to assess the residential real estate in Tucson, Arizona.

In neglected or inefficient markets, small investors, especially those with specialized knowledge of the market segment, can out-perform the investment professional.

An amateur investor with sophisticated knowledge in 18th Century art may be equally skilled against professional investors who trade in fine art. Or a geologist working in Calgary, Canada who deals with small oil and gas companies on a daily basis may have an advantage over a professional investor who lacks the local knowledge and contacts.

Fund Management Fees

Like anything in life, if you want a service you must pay for it.

For every dollar spent on management fees, that is one less dollar of performance. And one less dollar that can be reinvested to compound over time.

We have previously reviewed mutual fund operating costs and seen that management fees can be a significant component in a mutual fund’s expenses.

Not surprisingly, management fees can be a relative concept.

Top fund managers command greater compensation levels which impacts fund performance. Is it better to choose a fund without a star manager? You may forego potentially better future returns but you will certainly save money on fees.

Or what about funds that require greater amounts of work by the managers. Investing in developing markets typically requires more work (i.e., management time and other costs) than in developed nations. Is it better to pay greater fees and expenses for access to these markets?

Do the Advantages Outweigh the Disadvantages?

I do not think that the typical investor should compete against the professionals. And by competing, I refer to the selecting of individual securities and other assets.

The typical investor lacks the technical skills, investment and economic experience, and time to be a professional investor.

Unless you have specialized expertise or access to better information in an inefficient or neglected market segment, I suggest avoiding selecting specific investments on your own.

That said, do the costs and performance achieved via active management make use of professionals a wise move? Except in specific circumstances, I generally think not.

I shall expand on why I generally think not in coming weeks. As part of the active versus passive management debate.