We have all heard the statistic that points out 75% (or sometimes 90%) of active fund managers fail to outperform a basic index fund, depending on the length of time that is used as a measuring stick. Oftentimes, this fact is used to suggest that non-professional investors are foolish for attempting to invest in individual stocks when the professionals do not seem to possess the ability to beat an index fund. Normally, I treat this issue as a red herring side distraction, because the purpose of investing for most of us is to achieve financial independence by owning assets that we understand, and therefore, it does not matter if we get there by beating "the market" or trailing it. Nevertheless, I wanted to point out why it is entirely possible that an individual investor may be able to beat a pro.
The first thing that you should keep in mind is that fund managers are not completely autonomous. They have clients, and if they alienate their clients in the short term while adhering to a sound long-term strategy, they may be put out of business. Jason Zweig explains this phenomenon well in this old interview with Seth Klarman, the legendary investor of the Baupost Group:
"A chilling moment in Michael Lewis's wonderful book The Big Short is when Michael Burry, a very talented hedge fund manager in California, finds himself, in 2007, in the desperate situation of having to defend his short positions in leveraged mortgage securities against his own investors, who are just besieging him, screaming at him, why are you doing this? At the very moment when his temperament is telling him that he should be doubting his own judgment, his clients are compelling him to explain to them why he has no doubts about his judgment."
Most fund managers do not have a set-up like Walter Schloss where they can just sit in an office, find undervalued companies, and ignore their largest investors. As the example with Michael Burry shows, there is more to running a fund than just finding stocks that appear to provide the capital appreciation and dividend income necessary to outperform the market. Fund managers also have to play the PR game by catering to the body of investors they represent, or at the very least, satisfactorily explain to their investors why they are following a particular strategy. Individual investors have no such need to justify their investment decisions to dozens of others.
Along these lines, the second reason why professional investors may perform poorly is because they often feel the pressure to engage in "window dressing," or the practice of buying a hot stock at the end of a reporting period so that they can look good to investors for correctly calling the latest trend. One of the best illustrates of this phenomenon occurred last year with shares of Apple (NASDAQ:AAPL) common stock. Per this report from Forbes, "The first [reason why Apple may be up today] is end of year window dressing. While the stock is down 26% from its $705 peak in September, it is still up almost 30% from the start of the year. While a portfolio manager will still need to believe that Apple's shares will perform well, a number of them will want to show a large holding of it in their year-end shareholder reports."
The third reason why individual investors can beat the market is because they do not have to deal with redemptions. Let us take a quick look at the share price performance of five blue-chip companies entering the Great Recession of 2008-2009:
Procter & Gamble (NYSE:PG) fell from $75 in 2007 to $44 in 2009.
Pepsi (NYSE:PEP) fell from $79 in 2007 to $44 in 2009.
Chevron (NYSE:CVX) fell from $104 in 2008 to $56 in 2009.
Coca-Cola (NYSE:KO) fell from $32 per share (adjusting for the split) in 2007 to $19 in 2009.
Wells Fargo (NYSE:WFC) fell from $44 in 2008 to $8 in 2009.
If you followed the works of the great value investors, they were all saying that it was time to buy. Warren Buffett wrote an editorial in The New York Times exhorting investors to buy American stocks, explicitly noting that is what he was doing. Charlie Munger conducted a BBC interview claiming that if you were not ready for a couple of 50% paper losses in your lifetime, you got what you deserved because you had no business owning stocks in the first place. Donald Yacktman went on CNBC and, when shown a clip of Buffett saying that American stocks were undervalued, stated that he agreed with the Berkshire CEO. The managers at Tweedy, Browne were sending out notices to clients informing them that "now was the time to invest."
No doubt, plenty of other managers knew this as well. But they did not have full autonomy. The investors who owned the mutual funds, hedge funds, etc. were exiting the funds in record drives. As Morningstar reported, investors sold $121 billion worth of mutual funds in 2008. This forced many professional investors to sell at the bottom. Even if they knew Coca-Cola, Wells Fargo, and Pepsi were undervalued in 2008-2009, they may not have had the opportunity to make the purchases if 20% of the fund needed to be liquidated to meet the redemption requests of other investors. In fact, these fund managers would have to sell at precisely the time they may have wanted to buy due to the mutual fund outflows. Individual investors do not face these obstacles.
I am not claiming that individual investors are immune from these forces. Rather, you should be aware that there are many flaws in the mutual fund/hedge fund models that make it inherently difficult for professional investors to beat the market. They not only have to follow a sound strategy, but they have to explain it satisfactorily to clients. They face the peer pressure to engage in window dressing, less they appear to be behind the curve of other fund managers. And lastly (this is probably the biggest structural defect in the system), they must contend with fund redemptions that usually occur during severe stock market downturns, and this may prevent them from buying the undervalued stocks that they desire. The fact that many professional investors fail should not be regarded as automatic proof that you should be an index investor. Fund managers are handcuffed in a way that individual investors are not.