Sep 28 2021 (Tue)
Imagine you’re a new investor who just downloaded a brokerage app. Now image you’re in charge of an actively managed fund with a team of PhDs working for you. Both of these parties are planning on actively managing their portfolios by selecting individual stocks or bonds. Which one is going to generate higher returns? The answer probably seems pretty clear. If there’s any amount of inefficiency in the market worth taking advantage of it’s going to be captured by those with the most resources and the best education, right?
Wrong, which is what makes the stock market great. There are five key advantages individuals have compared to intuitional investors and passive funds.
We will dive into this in more detail, but first let’s look at a bit of history.
Advocates of passive index investing are quick to point out that passive funds have beaten active funds 86% of the time over the past 20 years . Between 1991 and 1996 it was a tossup with active funds winning three years and losing three others . That time frame was chosen so that we can have a fair comparison later on. In more recent memory, passive funds have won every year since 2013 with no signs of letting up. People quickly conclude that if actively managed funds with teams of PhDs can’t outperform a market index consistently that it must be nearly impossible for a retail investor to do so. This comparison sounds pretty logical on the surface but doesn’t look into the differences between the two groups.
Retail investors can skip the management fees, can’t be fired for underperforming, are able to invest in a wider range of companies, and can take on as much risk as they want.
Armed with these advantages retail investors outperformed market weighted index funds 49% of the time before fees from 1991 to 1996, almost the exact same rate as the active funds . If you include fees that number drops to 43%. However, many modern brokerages no longer have fees to place orders. Both sides have advantages and disadvantages when compared to the other. This race is a lot closer than most people think.
If you’re a fund manager who decides to go a little outside of the box and ends up buying a lot of stocks that aren’t part of the S&P 500 you could run into an issue. Let’s say those stocks you picked ended up doing really poorly this year while the S&P did fine. Managing this fund is your job. If you don’t do well you could be removed from your position. Maybe they let one bad year slide, but could you underperform your peers for two years? How about three? At some point you’re going to get fired. The retail investor could underperform for a decade and still come out on top. The market is very cyclical and some popular and reliable strategies just don’t work for years at a time. Take value investing during the last decade as an example. The market has been dominated by highly valued growth stocks. Even if you carefully selected strong value stocks you would probably not be above the S&P 500 during this period. Despite this, value stocks have outperformed growth stocks by an average of 4.54% per year since 1928 .
When you have a team of PhDs working for you to help select your stocks you have to pay them. You also need to pay yourself, pay for the office, and for any other resources you use during the selection process. These costs are going to be passed onto the investors of the fund in the form of management fees.
These fees often cost between 0.5% and 1% annually .
This piece is taken each year whether the fund does well or not. This means that even if the retail investor and the fund held the exact same stocks the retail investor would come out ahead.
Any active fund is going to be extra aware of their quarterly and annual goals. They’re going to be frequently rebalancing to meet certain requirements whether it be a risk level, an amount of diversification, or a reevaluation of their pick’s financials .
A retail investor can hold a single stock for 40 years if they believe in the long term future of the business. Let’s say both the retail investor and the fund bought Apple at the same time 20 years ago. Apple has grown an insane amount during this time frame. As one stock outpaces the rest it starts to take up a larger and larger portion of your portfolio.
The fund would likely end up selling some of their shares to bring the size of their Apple holding back in line with the rest. This also lowers their exposure to the tech sector which they would also want to keep at a certain level. The retail investor on the other hand has no such limit. He can buy it and hold it until he retires.
The average retail investor is buying thousands of dollars of stock at most. The average fund is buying hundreds of thousands of dollars and often millions. This is important for a few reasons. Thousands of dollars will not have any effect on the price of most stocks whereas a million dollars can move a sizeable company. The more money being invested the more it can push the price. When you are buying tons of shares the price is going to creep upwards as you look for more and more sellers. This means that the more you buy the worse your average entry price will be. The same thing happens when you sell. Unloading millions of dollars in shares is going to drop the price which means you get a poor exit price as well. The retail trader does not have to deal with this and will have better prices on both ends which leads to better performance, even if the same stocks are picked!
The size of the investment doesn’t only affect the prices you get, it also influences what you can even attempt to buy in the first place. Some publicly traded companies have market caps of 50 million or less. It’s just not feasible for huge funds to be buying into these companies. If a fund ever buys so much of a company that it owns 5% it will need to register that with the SEC and is forced to file beneficial own reports . The retail trader will never run into this issue.
We’ve seen a few reasons why funds tend to stick the S&P 500 companies. We’ve also seen that they are surprisingly risk averse. Whether it be buying smaller companies, having a more concentrated portfolio, or making use of derivatives like long term call options, the retail investor has the ability to take on as much risk as they want.
If you’re familiar with the statistics behind optimized betting you’ll know what the Kelly Criterion is. In short, it’s a way to determine the optimal size bet you should take.
The Kelly Criterion says that you should be holding a little more than 200% in the S&P 500 for maximum returns, at least historically .
This is a heavily leveraged and high risk account but was able to survive both the Dot Com Bubble and the 2008 Financial Crisis. Despite higher returns in the long term this portfolio underperforms the market for years after each crash. This makes it unrealistic for a fund manager to try to execute, but if you can handle the risk it’s an option available to every retail investor who has a long time horizon.
It’s true that most actively managed funds do not outperform their passive counterparts. This is often used to cast doubt on the performance of retail investors. If the experts can’t outperform, how could you? Well, it turns out there are a lot of differences between billion dollar funds and some guy on his Robinhood app. A surprising amount of these differences offer the retail investor an advantage, or at the very least an additional degree of freedom. Using actively managed funds as a benchmark is incredibly misleading.
The odds are not in your favor as an average stock picking retail investor, but they’re not nearly as bad as they’re usually portrayed.
In the same 1991-1996 study 25% of retail investors outperformed the index by 6% or more annually.
If you dedicate the time and have good emotional control you can capitalize on these advantages most people don’t even know they have.
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