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Why investors do worse than the funds they invest in

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Why investors do worse than the funds they invest in

Over the very long term, it has been shown that equities provide the highest return for investors, and yet most investors are not reaping the full benefit of these returns. Intuitively investors know the principles of buying low and selling high, however research confirms that most investors fail to execute on this basic premise – consistently underperforming the funds they invest in.

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Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

11 Comments

  1. It’s all very interesting and I wonder where Buffet would stand now with his bet against the hedge fund managers had no trillions and trillions of funny money been splashed around the world through central banks support of all the zombies that make up these indexes he is praising ,and if there were a realistic value put on capital eg realistic interest rates, let’s see now GM gone,Ford gone,etc etc gone gone most of the banks, gone gone gone,ie most of investors capital GONE a long time ago.
    So the point is investing today is very much more about betting on the whim of central banks and the level of confidence people have that Monopoly money will keep raining on us, or to be more accurate, the people who have access to that Monopoly money .So to all the recently minted successful investors out there in the property and other casino like markets, sorry your not a genius it’s the guys at printing press you ow it to, and to a large extent so does buffet who is clearly a genius either way.

  2. Brett Edgerton
    :

    Roger

    Thank you for your response and that additional information.

    I am unsurprised that one of the richest men in the world has some detractors. But I think we can all accept that Buffett is on the whole very much admired – and widely – for his ethical approach to investing.

    I also note that fund managers need (in many ways) to compete with Berkshire Hathaway for at least a portion of their investment capital flows, and this is particularly sharp for value managers who will at the same time hold up Buffet and Munger as great advertisements to their approach to investing. I note that all Australian journalists that have attended the annual meeting in Omaha of late have commented on the large number of Aussies present. Certainly anyone who wishes to be entrusted by me must measure up well.

    In case your final comment was a little tongue in cheek, allow me to be clear that I did not mean to make out that you are not transparent enough. (In fact I thought I sung your praises fairly well on this front.) Still, the point about Buffett really is that genuine transparency is not just about providing the information that must be provided – by law or other convention – but by co-investors being treated as genuine partners and providing them with any and all information that you yourself would want to know if the roles were reversed.

    Your sensitivity around our comments on fees and performance gives me a slight perception that your incentives might not be so well aligned with your clients (or co-investors?). You probably disagree, but I wish to push you on this issue because I need to be satisfied of your response before I decide to invest with you.

    You mentioned that your structure is such that you are seeking patient capital. I know enough to know that this is good for the co-investor as well as the manager.

    However, if it is primarily the large initial investment sums that are required to which you refer then I would say two things – 1. to someone of relatively modest means (lets say a “category 1″ investor) it represents a large sum and they would rightly want to be certain that you are the best option for handling their money before they hand it over; and 2. it plays into the point Buffett makes about high net worth individuals feeling that their status dictates that they should have access to the best advisors (lets say “category 2″ investor). (I am sure your marketing team breaks categories down differently and far more intelligently.)

    I have been considering Roger Montgomery’s team for managing my money not because I want to brag that you are managing my money – for a start, being a stay-at-home dad, few of my house-husband/wife friends would even know who you are – but I would want you to manage my money if I am comfortable that you will manage my money well and will only prosper from managing my money if I also prosper. That is at the heart of the point Buffett is making, and it is a valid concern and that should be obvious to all and sundry.

    So I fit into category 1 and I have worked bloody hard to build up over the last 13 years (since my wife and I returned to Australia and I swapped being a professional scientist for being a stay at home dad) to take my wife’s superannuation from around $20K to over $300K (conservatively on a net tangible assets basis). (I have none outside of Govt. super – a consequence of studying until I was 26 and then working for only 4 years in Australia – science is a very low ROI profession!) Yes, I am proud of that investment performance – not one negative calendar year as we went to cash around 12 months before the GFC – and I am protective of the capital while well understanding the need to take on risk in a considered approach to achieve returns. (In case you are wondering, that is net of all fees and insurance premiums, and no salary sacrifice with SGC averaging below 50% of the caps over that period).

    I am pondering the following (and obviously I am in no way seeking advice.) We have an LRBA over a Gold Coast apartment which has appreciated around 40% since we bought it 3.5 years ago. While I still think that capital appreciation is more likely than depreciation over the next few years (as I said previously on your site), I think it highly unlikely that the bounce back in prices from their lows several years ago will continue at anywhere near that rate, and I am thinking it might be wise to take the profit and eliminate the debt. If not for the leverage I would not be considering selling. (I guess I am spelling this out so it is clear that I have no other agenda – I am not a troll!)

    Most of my investing success at this point has been based on a feel for macro factors – I accept perhaps more luck than anything else. Nonetheless, I basically think there are few macro themes to pick up on as a retail investor at present after several years of quantitative easing pushing most asset classes to very high levels.

    About the only view I have right now is that over the next few years there is likely to be a strong pull back which will take most global indices close to or lower (perhaps well lower) than their present levels. Thus I feel no urgency. (Again, rough timing of macro events has served me well thus far – timing to some extent is the greatest risk I have taken thus far).

    However, if we sell I need to have a good option and I need to decide whether I will invest passively – relying solely on my macro judgement – or choose a genuinely high quality stock picker to manage my money.

    I am not trying to be difficult, but, as a ” category 1″ investor, unfortunately I have not been convinced by what you have said thus far. The above contains lots of pointers to what will convince me, but (even as an outsider) I feel fairly certain that “category 2″ investors are far more profitable business. What’s more I am sure that I have occupied much more of your time than I am worth to your business and thus do not expect a response.

    Having said that, I honestly think a truly top shelf manager should be able to come up with a thoroughly thoughtful response that would satisfy the concerns of most category 1 investors, and that might well prove to be seminal in pushing that manager on to Munger status – I gather you like Charlie more :)

    Thanks for your time.

      • Brett Edgerton
        :

        Didn’t mean yourself, Roger – meant the anecdote to which you referred… Thanks for your time in reading my views… Cheers

  3. Fair comment Roger.

    However I remember reading a similar article in the Fin Review not so long ago that pointed out a very similar result from Aussie Fund managers i.e. not consistently outperforming their chosen bench mark index in Australia. Should have kept a copy. I think also that the oft quoted Buffet, a favourite of all fund managers, was not only referring to American fund managers. In fact he says:

    “If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win. (The academic in me requires me to mention that there is a very minor point – not worth detailing – that slightly modifies this formulation.) And if Group A has exorbitant costs, its shortfall will be substantial.”

    Quote from Jack Bogle, founder of Vanguard: “The magic of compound returns is overwhelmed by the tyranny of compound costs”

  4. Roger, your latest white paper was a good read – thank you.

    Buffett’s letter to shareholders was published over the weekend – as the earlier commenter mentioned – and as an investor in BH (through my SMSF) I was keen to have a read.

    Obviously what will resonate strongly globally will be the bet Mr Buffet made 9 years ago that a US Index fund will outperform his opponent’s choice of 5 hedge funds (net of fees) over a 10 year period. With the wager coming to an end 31 December 2017, not one of the hedge funds is even close to matching the 10 year performance of the index (and 3 of the 5 had a nine year total return of less than 10% compared with 85% for the index fund). The average annual return of the chosen 5 hedge funds was just 2.2% while the index fund returned 7.1%.

    If we consider the data in your white paper (also based on US stockmarket performance) alongside the results of Buffett’s bet, non-professional investors – even with their flaws and tendencies to buy and sell at the wrong time – may well be better off in passive index instruments as the cost to performance from these “flaws” are likely to be no greater than the factors reducing hedge fund performance. Moreover, they still have to select an active manager and Buffett’s opponent – a fund of fund manager – chose 3 managers who have returned less than 10% over 9 years compared with 85% for the index fund!

    That an industry insider chose so poorly – so publicly – illustrates how difficult and prone to error that decision is for an average part-time investor when outsourcing their capital allocation.

    Along with Steve Johnson (Forager), I have built up a perception that you are about the most knowledgeable and credible value investor in this country. (In other words I would like to think that I am knowledgeable enough to choose well :-) )

    And I believe that your generosity in sharing knowledge – through this site and through other media channels – even when you are taking a risk and staking your credibility on an assertion (e.g. the risks surrounding our property markets, which I largely agree with) – suggests to me that you are truly passionate about being a constructive voice in Australian society (not just attempting to become wealthy on ticket clipping capital flow).

    Your earlier response makes a valid – but not particularly satisfying point for a potential investor – that the Australian indices are poorly constructed and thus non-challenging to outperform.

    So here’s the tough question that all active fund managers have to answer today – and I ask this as a genuine potential investor – how can we be confident in asking you to manage our capital – which represents the resources from which we hope to fund a retirement in which we can enjoy a good standard of living and help out our precious family when we can see an opportunity to improve their quality of life – when there are so many passive low-cost options available based on foreign indices as well as local ones? If the Australian indices are easy to outperform and you are so confident that you will outperform it, will you place a genuinely aspirational benchmark for your funds net of fees?

    The reason why people feel comfortable having so much of their life’s savings in Buffett’s hands is because of his credibility and transparency. Your response to the earlier commenter was a bit disappointing. A genuinely thoughtful response would be much appreciated – perhaps a new white paper?

    • The question you ask does not require a complicated answer Brett. You are asking us to set a broader benchmark, perhaps a global benchmark or perhaps the best performing benchmark in any year against which to measure our success. FOr domestic funds that is entirely unfair because a domestic fund cannot invest in any global stocks. We would lose our talented staff very quickly if we were to offer it. Note Buffett’s early partnerships set a hurdle of a flat 6% per annum – even if the market moved up 20% and the partnership rose 18%, there be a fee paid. And Buffett’s transparency equalled one report on performance per annum. In Roger Lowestein’s book The making of an American Capitalist, the author recounts a story of an investor who went to Buffett’s office to demand an update outside of the usual once-per-year letter. According to teh book, Buffett simply instructed his assistant to liquidate that investors holding and cash him out.

      We believe we have an edge in understanding the respective abilities of companies to generate above average returns on incremental equity and we combine this with a business plan that reduces our attractiveness to investors who look for short term gains. Combined, we have an approach that requires patience and attract only those who have patience, in turn allowing the process to work or giving the process time to ride through the inevitable periods of underperformance. If you look at the best performing stocks over a decade, you will find they correspond to the best performing underlying businesses. That won’t however be true over the short term. We also believe there is a place for both domestic and global investments in a portfolio thanks to relative valuation, sequencing and currency risks. I hope that is clear. Please to continue to let us know if and when you think we aren’t being transparent enough.

  5. Roger, your latest white paper was a good read – thank you.

    Buffett’s letter to shareholders was published over the weekend and as an investor in BH (through my SMSF) I was keen to have a read.

    There was loads of good information, as usual, but the one that is likely to resonate strongly globally will be the bet he made 9 years ago that a US Index fund will outperform his opponent’s choice of 5 hedge funds (net of fees) over a 10 year period. With the wager coming to an end 31 December 2017, not one of the hedge funds is even close to matching the 10 year performance of the index (and 3 of the 5 had a nine year total return of less than 10% compared with 85% for the index fund). The average annual return of the chosen 5 hedge funds was just 2.2% while the index fund returned 7.1%.

    If we consider the data in your white paper alongside the results of Buffett’s bet, non-professional investors – even with their flaws and tendencies to buy and sell at the wrong time – may well be better off in passive index instruments as the cost to performance from these “flaws” are likely to be no greater than the factors reducing hedge fund performance. Moreover, they still have to select an active manager and Buffett’s opponent – a fund of fund manager – chose 3 managers who have returned less than 10% over 9 years compared with 85% for the index fund!

    That an industry insider chose so poorly – so publicly – how difficult and prone to error that decision is for an average part-time investor when outsourcing their capital allocation.

    Along with Steve Johnson (Forager), I have built up a perception that you are about the most knowledgeable and credible value investor in this country. (In other words I would like to think that I am knowledgeable enough to choose well :-) )

    And I believe that your generosity in sharing knowledge – through this site and through other media channels – even when you are taking a risk and staking your credibility on an assertion (e.g. the risks surrounding our property markets, which I largely agree with) – suggests to me that you are truly passionate about being a constructive voice in Australian society (not just attempting to become wealthy on ticket clipping capital flow).

    So here’s the tough question that all fund managers have to answer today – and I ask this as a genuine potential investor – why will your funds outperform index funds or ETFs hugging their relevant benchmarks – net of fees – over the next 10 years and more?

  6. Warren Buffet, in his latest annual newsletter, has again reiterated that most investors would be better of in index funds which charge low fees. Managed funds charging a fee and a performance fee consume investor’s returns and it is the managers that get rich.

    He saved his sharpest comments for pricey money managers who pledge to beat the market, saying that in his lifetime he has identified “ten or so professionals” who can do so successfully.

    Also “If 1000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years,” he wrote. “Of course, 1000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.”

    Not exactly a glowing recommendation for managed funds!

    • Each year S&P release a report showing the majority of American managers underperform the American index. The reverse is true in Australia because the indices here are plain rubbish. Look at the return of the ASX200 and ASX300 over a decade. Don’t be suprised that they’ve gone nowhere for a very long time. This is simply because the local indices are dominated by a narrow band of very mature companies who are paying out the bulk of their earnings as dividends and therefore aren’t growing. This is easy to beat over the longer term. Indeed the majority of mid cap and small cap managers beat their index in Australia. Be careful you aren’t using arguments that apply in the US to justify investing in an Oz index. We wrote about ‘dumb investing’ here 18 months ago: http://rogermontgomery.com/dumb-investing/#more-15791

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