Fund managers get most of their bets wrong ? but still make millions. Here's how...
It sounds impossible, but clever professionals can make a fortune even if less than half of their bets come off. It's all down to smart tactics - and private investors can use them too.
For investors who put their faith in fund managers, the hope is surely that these experts can spot winning companies that the rest of the market has overlooked.
The in-depth research and access to management at the disposal of these professional investors means, the argument goes, that they have special insight that the rest of us can?t have.
Except they don?t.
Not, at least, in the view of Lee Freeman-Shor, author of The Art of Execution, a new book that does much to debunk the myth that fund managers enjoy some Midas touch that the rest of us lack.
And he should know ? the book was written after Mr Freeman-Shor, still working as a fund of funds manager for Old Mutual Global Investors, analysed 1,866 investments made by the managers whose funds he put his customers? money into, who included some of the biggest names in asset management.
These investments were the ?best ideas? of those managers yet the research showed that just 49pc of them rose in price after the manager invested ? slightly worse than a 50pc success ratio.
Fans of ?passive? investing, which cuts out the fund manger by simply buying every share in a stock market index, may rejoice at the finding, but this is not the full story. The subtitle of the book is: How the world?s best investors get it wrong and still make millions.
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Fund managers are winning despite being unable to magically pick winning stocks, Mr Freeman-Shor says. But how?
?The basis for the whole book was the case of one very famous fund manager, an absolute legend who would appear of TV,? he said.
?I knew that most of his ideas didn?t make money, yet the performance was very strong. I had to know why.?
Then ensured a huge analysis of 30,000 trades made by the managers working for Mr Freeman-Shor.
The key to their success came down to how they responded when investments rose and when they fell. Winning big on just a few successes and minimising losses meant a manager could still do seriously well, even when fewer than half of his or her bets came off.
Mr Freeman-Shor identified both good and bad habits and divided managers into group ? Rabbits, Assassins, Hunters, Raiders and Connoisseurs.
Rabbits come in for the harshest criticism. These investors fail to act, like rabbits in the headlights, when an investment falls.
This means they hold on to losing assets so long that it would take an extremely unlikely reversal in fortunes for them to get their money back.
Investors can avoid being a Rabbit, Mr Freeman-Shor says, by using ?stop-loss? orders, which automatically sell an investment when it falls to a predetermined level. In doing so they become Assassins ? investors who achieve success by limiting their losses and exiting even favoured investments with little emotion.
Alternatively they could become a Hunter.
Instead of freezing when a share falls like Rabbits, or exiting quickly like Assassins, Hunters use a price fall to buy more at the lower price.
In doing so, they reduce the overall cost of the shares they hold and it is possible for them to make money even if the share fails to recover to the value at which they originally bought.
Mr Freeman-Shor said it took conviction that the original investment decision was correct, but also a ready supply of cash in order to buy more. Investors should buy in stages to leave themselves the money to do it.
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He said both Assassins and Hunters gave themselves the chance to avoid a worse outcome when shares fell, but Rabbits hardly ever did. He said: ?I start to apply pressure on my managers when a stock is down by 20pc to ensure action is taken.?
Investors should decide when they invest, he said, whether they will exit shares like an Assassin or buy more like a Hunter if the price falls, and stick to the plan.
Managers can also make a difference when an investment rises. To be avoided, Mr Freeman-Shor says, are Raiders. These investors respond to a winning investment by booking the profit too early, typically when gains reach around 20pc.
His review of trades showed that 66pc of all investments that rose in value were sold for a profit of 20pc or less. Yet, of these, 61pc kept going up in value. This was critical, Mr Freeman-Shor said.
?The most successful investors I worked with, those who made the most money, all had one thing in common: the presence of a couple of big winners in their portfolios. Any approach that does not embrace the possibility of winning big is doomed.?
Much better than a Raider, the book explains, is a Connoisseur ? an investor who skims some profit after a modest rise but still leaves the bulk invested for the chance of a much higher return. Mr Freeman-Shor said this group of managers actually had a worse record for picking winners than the others.
?The trick was, when they won, they won big,? he said.
The book provides real examples from the track records of the managers Mr Freeman-Shor has hired, along with detailed explanations to help investors of all levels avoid the traps.
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