Individual Investors Can Easily Beat the Performance of Professional Money Managers ... It's a Simple Formula

Harvard, Yale and others have huge endowment funds in the billions of dollars. They also have access to the world's leading professional hedge fund and other money managers.

But ordinary individual investors are likely to achieve better investment performance over time just by sticking to a DIY low cost buy and hold strategy with a mix of stocks to bonds of 60/40. For the more venturesome, owning all stocks would be even better.

A Hard Landing for University Endowments has the details behind the somewhat surprising story:

"For years, America’s largest, richest and most prestigious universities have been the envy of investors. They churned out double-digit returns over the last two decades, even with steep losses during the financial crisis. Harvard’s endowment today is over $30 billion and has generated annualized returns of 12.5 percent over the last 20 years.

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Surprise Performance

Their investing success along with their vaunted academic reputations led many financial experts to conclude that Harvard and its peers at the pinnacle of higher education had solved an age-old conundrum: how to generate higher returns with lower risk. . . .

College and university endowment returns for the most recent fiscal year, which ended June 30, are starting to roll in. And in many cases, they warrant a grade of “C” at best, and in some cases, an “F.” Harvard reported a 0.05 percent loss and a drop in its endowment of over $1 billion in the same period, even as a simple Standard & Poor’s 500 index fund gained about 5.5 percent.... 

Even more startling, data compiled by the National Association of College and University Business Officers for the 2011 fiscal year (the most recent available) show that large, medium and small endowments all underperformed a simple mix of 60 percent stocks and 40 percent bonds over one-, three-and five--year periods. The 91 percent of endowments with less than $1 billion in assets underperformed in every time period since records have been maintained. Given the weak results being reported this year, that underperformance is likely to be even more pronounced when the fiscal year 2012 results are included. . . .

“The compelling simplicity of a 60/40 strategy is very hard to beat,” Timothy J. Keating, president of Keating Investments in Greenwood Village, Colo., and author of two reports on endowment performance, told me this week. “Many investors would be much better served with a simple 60/40 strategy, or at least a core where you have low-cost index funds. When you understand the role of transaction fees, it’s a very high mountain to scale.” . . .

 Simon Lack, a founder of SL Advisors in Westfield, N.J., and a hedge fund insider — he allocated capital to hedge funds during his 23 years at J.P. Morgan — caused a stir earlier this year with his book, “The Hedge Fund Mirage,” in which he calculated that the hedge fund industry as a whole lost more money in one year (2008) than it had made in the previous 10 years. “If all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good,” he asserted. And he maintained that nearly all the hedge funds’ gains had gone to hedge fund managers rather than clients.

“If you look at the data, hedge funds have underperformed a simple 60/40 stock/bond mix every year for the past 10 years,” Mr. Lack told me this week. “They did well in the downturn of 2000-2. But that’s when assets under management were less than half what they are now. There’s no disputing that as assets have grown, performance has declined.” . . .

Among those raising questions about the Ivy League model and its heavy dependence on alternative investments is Vanguard, the giant mutual fund company that has long promoted a radically simpler approach based on low-cost index and mutual funds. “I feel that there was endowment envy, or maybe emulation is a better word,” Francis M. Kinniry Jr., a principal in Vanguard’s Investment Strategy Group, told me this week. “Everybody wanted to look like the Yales and Harvards of the world. But they were early. They were doing these techniques in the mid-1990s and late 1990s when equities looked overvalued, and alternative strategies could capture market imperfections. That’s no longer true. Those universities were forward-looking and deserve a lot of credit. But emulating that process three, five or seven years later is very problematic.”"

Summing Up

Stocks outperform other investment vehicles over any extended period of time. As an example, there has never been a 30 year timeframe when bonds have beaten stocks.

Of course, stock prices change by the moment and price volatility is ever present. We just have to get used to that.

So if we buy shares of good companies, hold on to those shares (and in taxable accounts minimize the payment of capital gains taxes), pay virtually no management fees in our DIY buy-and-hold portfolio and make sure not to get overly excited about the short term ups and downs of share prices, we'll do better than most professional money managers without even trying. And we'll accomplish this simple but surprising feat by not paying the "pros" management fees for their non-market beating performance

And that's attributable to two fundamental factors: (1) professional money managers charge fees which properly need to be subtracted from the portfolio's overall performance when calculating the individual investor's rate of return and (2) stocks are winners over time compared to all other forms of investment.

So all we need to do to "beat the pros" is buy and hold the shares of solid companies (as long as they stay solid companies), and not get caught up in the evening news or daily gyrations of the stock market.

In essence, we can just let "Mr. Market" be our investment manager over the long haul.

He won't charge us commissions or fees and as a result, over time he will make sure that we outperform the "pros."

Thanks. Bob.