Many investors closely follow professional fund managers. We read their market outlooks, listen to their interviews, and sometimes replicate the investment ideas they discuss. In this episode we explore an important question: should individual investors actually invest the same way institutions do?

Professional investors operate in a very different environment from individuals. Their careers, compensation, and business objectives are often tied to performance relative to a benchmark. They manage large pools of capital and are supported by teams of analysts, access to sophisticated data, and significant research resources. But those advantages also come with constraints that shape how they invest. We run through why these constraints might mean a mismatch between their opportunities and top picks, and yours.

You can find the full article here.

Want to know what other advantages you have over professional investors? Find your investing edge here. Identifying your edge is key in choosing investments in your portfolio, your investment strategy and increasing your chances of success.

You can find the transcript below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Mark LaMonica: We’re going to start by talking about morning routines, Shani. And the reason this came up because we just saw that JPMorgan CEO, Jamie Dimon, came out with his morning routine. So, he wakes up at 4:30 every single morning and he reads five papers. So how does yours compare? What is your morning routine, Shani?

Jayamanne: I think people will stop listening to the podcast if they figure out what I do every morning. And you too actually, Mark, yours is a bit crazy.

LaMonica: I’ll stop listening to the podcast or…?

Jayamanne: No, your morning ritual is a little crazy.

LaMonica: Yes, yes. But I think part of it – we can describe part of our individual morning rituals is that we wake up and we do check our preferred media outlets, which are different, I will say.

Jayamanne: But it always include Morningstar.

LaMonica: Obviously. So, we also might check how our portfolio has done overnight. And then, of course, like everyone else, I think during the day, we have push notifications on our phones that pull us back into that news cycle. And this is sort of a rinse and repeat situation every single day.

Jayamanne: And we do this because as investors, we tell ourselves we’re staying up to date with what’s impacting markets and in turn, our portfolio. Many of us are constantly on the lookout for new opportunities and who we go to for guidance does matter. And it’s often professional money managers.

LaMonica: And many of these professional money managers that people turn to, they take care of millions or potentially billions of dollars. Many of them are purely focused on just a single asset class. And also, because they’re professionals, many of them have bonuses that are based on how they perform against a certain market benchmark.

Jayamanne: And a lot of them are fantastic storytellers and they can clearly articulate their conviction in a particular opportunity. The issue with this is that they may conveniently fail to mention that this once-in-a-lifetime opportunity only makes up 1% of their portfolio.

LaMonica: And I think the point we’re trying to make here, Shani, is many of us consume this institutional thinking and then we just apply that to our own personal portfolios. So, during today’s episode, we are going to look at the different places that individual investors are different and why that difference is really important.

So, let’s start with talking about a superstar in the financial world, Shani.

Jayamanne: Is it you, Mark?

LaMonica: It is not me, Shani. It is Peter Lynch. I have something in common with Peter Lynch. I also lived in Boston.

Jayamanne: You have a lot in common with Peter Lynch.

LaMonica: Okay. Well, we’re practically the same person, but Peter Lynch managed billions of dollars in Fidelity’s Magellan Fund. He wrote a book called One Up on Wall Street. I have not checked sales recently, but probably similar sales to Investing Your Way, right? Somewhere around there.

Jayamanne: Invest Your Way.

LaMonica: Invest Your Way. You see, the problem is I don’t remember the name of the book. It was so long ago. And in Peter Lynch’s book, One Up on Wall Street, he shared his security selection process with the world. And he believed that individual investors actually have an advantage on professional investors. That’s the one up, the One Up on Wall Street.

So, he thinks that individuals have a proximity and understanding of the companies that they are investing in that many professionals don’t. That means as an individual, you can spot opportunities with companies before professional investors do. And he speaks about the importance of ignoring this constant news cycle on market movements, interest rates, and all sorts of economic data. And we both think that that’s a really relevant lesson in this current environment.

Jayamanne: And I attended a lunch that brought together, arguably, some of the best economists in the country into one room, including a former RBA governor. And I’m not too sure what I was doing there, but they took turns talking about their forecasts for the next three to six months and the seriousness of the economic situation that we’re in. And I don’t disagree that interest rates, unemployment rates, and low wage growth cause many people stress, anxiety, and suffering. So, I anxiously waited for my turn to say that little of this factored into my work with long-term investing. In 20 years, the timing of a 0.25% increase to interest rates will have no impact on my portfolio and the impact of short-term movements for long-term investors is generally irrelevant. And it may concern professionals because it is their job to be concerned, but it shouldn’t concern you.

LaMonica: And there’s actually a name for this, this advantage that individuals have and that individuals can gain by focusing on the long term is called structural edge. So structural edge is an advantage gained when there are no constraints that govern the way an individual goes about the investing process. So, what we see is that professionals, and we talked about this a little bit before, but they operate in a very restrictive environment. So, they have to worry about their careers, their compensation, the goals of the business they work for, and that of course is going to influence the way that they exist. So, they have a lot of competing priorities. And they’re trying to support the company they work for, maximize their compensation, and sometimes this can lead to wise investment decisions, and sometimes it can lead to unwise investment decisions.

Jayamanne: But it’s not all bad for professional investors. They definitely have some advantages over us as individual investors. Getting paid to do a job and charging other people for that job means they must meet standards around education and expertise. They all have support from other professionals, time to dedicate to the pursuit of investing and access to tools and data. It also comes with pressure to perform over short periods of time to maximize compensation and limit career risk.

LaMonica: And the most important thing in summary of everything we’ve been saying is that institutions and professional investors have a different approach to us, individual investors. So, it’s really important that when we take their advice and we listen to their insights that we have that context so that we can appropriately use that to try to make better investment decisions ourselves.

Jayamanne: So, let’s talk a little bit about the difference in portfolios. And just like there are different types of individual investors, there’s different types of professional investors. And one of the differences that certain institutional investors have is a perpetual timeline. And you know, investing serves a different purpose for individual investors. We want our investments to see at some point when we’re able to enjoy them and enjoy everything that we’ve sacrificed for investing. So, our portfolios do reflect this.

LaMonica: Professional investors operate on the assumption that the fund will continue forever. And this can influence their decisions, the investment decisions that they’re making. So, there are some endowment funds and sovereign wealth funds that operate with centuries as their time horizon. There’s no glide path to the end of a financial goal. And they do not need to account for retirement spending, short-term volatility, and they have a different perspective on cash flow management. This means that their approach, that the approach that they take to risk in their portfolio is different from ours.

Jayamanne: And because of this asset allocation can vary drastically. The large amounts of capital teamed with perpetual timelines mean that they can maintain exposure to hedge funds, alternative assets, private equity and real estate.

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LaMonica: So, we do have the opportunity to think long term as individual investors. We don’t have any of those restraints that prevent a long-term focus. But as Shani said, there are different types of professionals. Many fund managers that aren’t judged on these perpetual timelines say that they’re long-term investors. But a lot of these professionals operate in an environment that structurally discourages this. They’re under a lot of pressure to outpace or at least match their peers over one-year periods or even shorter in some cases. And if they fail, a lot of investors get tempted and they look elsewhere.

Jayamanne: And in a study that Morningstar conducted of US domestic equity funds, it was found that the turnover rate was around 63%. That means that the average holding period for stocks in that fund was 19 months. This definitely doesn’t meet the definition of long-term investing. And the transaction costs and distributed capital gains do eat into investor returns.

LaMonica: The only thing getting in the way of individual investors for most individual investors focusing on the long term, the only thing getting in the way of that is their own lack of patience.

So, let’s talk about another big difference and that is pre-tax returns and after-tax returns. And we’ll look at costs as well. So, when we think about professional investors, they’re judged on the performance of their funds against a benchmark minus their management fee. And this amount is not representative of the number that matters to us. And that is the figure that ends up in our bank accounts after you pay taxes and after costs.

Jayamanne: Professionals can trade frequently without really having much consideration for the consequences of capital gains that are passed on to the end investor. This obviously makes a huge difference for investors and can influence where investors allocate funds to and whether it goes into a particular structure. We’ve got to decide between multiple options, pay off a mortgage if it’s relevant, putting funds into superannuation or investing outside of superannuation. Professional investors can invest without thinking of the most tax or cost-effective structure.

LaMonica: Our next topic is concentration. And one of the main ways that all of us get exposure to professional investors is that we’re reading financial news articles. They’re often talking about their latest stock picks or why a particular asset class or sector is going to blow all the other ones out of the water. And it’s their job to make these narratives as compelling as possible and sound attractive enough for you to give them your money so that they can invest.

Jayamanne: And we both attend a lot of investment conferences for work. And every time there’s a presenter on that mentions a ticker, you hear the scribbling of hundreds of pens on paper. But what we don’t hear in those pitches is how much this bet makes up of their portfolio. So, I looked up a high-conviction active ETF on Morningstar and used Morningstar data. And the top holding didn’t exceed 5% of that fund.

A passive ETF that is tracking the ASX 200 has 17% in their top two holdings. And I get that this isn’t a fair comparison, but it’s illustrative that the conviction that is conveyed to us may not be represented by action.

LaMonica: All of this is not to say that there’s nothing that you can take from professional investors. We think that there’s a lot of insights and opportunities that can be derived from their experience and their views. But it just needs to include that context, the different things we mentioned today. One of the largest lessons that we can take from professional investors is setting the proper frameworks and structure around investment decisions.

Jayamanne: Professional investors operate in a heavily regulated and structured environment that requires compliant funds and processes. And this includes transparency in investment strategies and mandates so that investors understand the exposures that they’re taking on. If they color outside of the lines of these mandates, they’re in trouble. This is a framework that can really help with investors making poor behavioral decisions and be their own regulator.

LaMonica: And we do talk about this a lot on this podcast, Shani. But really, this framework and structure for an individual investor is an investment policy statement. Clarifies your thinking, which limits poor behavior, and it guides your decision making while you’re trying to manage your portfolio.

Jayamanne: And professional investors have years of experience, teams of analysts, and institutional-grade data that inform their decisions. It is worthwhile listening to what they have to say. What is important to understand is a context in which they have viewed that opportunity and whether it is still an opportunity when viewed in your context. And an IPS can really help with that.

LaMonica: So, when you are getting insights from professionals, figure out a way to adapt what works out of that advice and guidance that you’re getting. And you do this by reconciling the academic or institutional insights with the practical constraints of managing your own portfolio. So, we’re dealing with different portfolio sizes, different behavioral influences, different time horizons, and different market realities.

Jayamanne: And most of all, understand what you’re investing in and why. An IPS is a framework that works for professionals and for individual investors. If an opportunity from a professional investor fits into your investment strategy and your circumstances, it might be worth pursuing.

LaMonica: Okay, great. Well, thank you all very much for joining us on another episode of Investing Compass. Go down to the show notes and we have some additional resources to you. Thank you very much.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

Invest Your Way

A message from Mark and Shani

For the past five years, we’ve released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.

We’ve shared our journeys with you, and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey – Invest Your Way. Invest Your Way is a book that focuses on the investor, instead of the investments. It is a guide to successful investing, with actionable insights and practical applications.

If anyone would like to support this project you can buy the book now. Thanks in advance!

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