Pros and Cons of Investment Professionals

On 10/13/2010, in Mutual Funds, by Jordan Wilson

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

In some ways, I view it as competing against Tiger Woods 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.  

Two Types of Investment Professionals

I shall quickly differentiate between two types of investment professionals.

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

The second is the research analyst. That is 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.

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 Tiger Woods for money, I want to make sure that I am not using golf clubs from the 1950s when I do so.

I would also add that funds with significant investments in companies are often able to shift a company’s business agenda. This is usually done at shareholder meetings where funds hold enough shares to pressure companies to follow strategies that 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.

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.

Reviews of peer group performance and category ranking is the main way to assess relative performance.

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 would focus on oil and gas companies) or investment style (e.g. a Swiss large-cap equity fund would analyze the 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 they may be 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 and 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 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 through active management make the use of professionals a wise move?

I shall save that assessment until after our deeper look at relative manager performance; against one’s peers and the benchmark.

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