How to invest, individual stocks or mutual funds

“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”  - Robert G. Allen

Long-term return of equity

Professor Jeremy Siegel made a study of the long-term returns of stocks, gold and bond at various periods from 1871 to 2001. He presented his findings in his book, “Stock for the Long Run” as tabulated below:

Table 1: Real returns of assets

For a 130-year period from 1871-2001, stocks’ total real annual return including dividend yield and after adjusting for inflation of 2% is 11.4%, or a gross return of 13.4% as shown, compare to gross return of 4.8% for bonds and 1.9% for gold. The recent period of 1982-2001 provided the highest gross return of 16.6% per year for stock. For the 15-year period of 1966-1981, US stock’s total real return was only 3.5%, eroded by the high inflation of 7% during that period. However, this return is still much better than bonds of -4.2% although gold performed much better at a real return of 8.8%. The above data shows that stocks historically has been a better investment compare to bonds and gold for long term. Professor Jeremy Siegel also presented the maximum and minimum return of US stocks for the various holding periods from 1 year to 30 years for the period of 1802-2001 as shown.

Figure 1: Returns at various holding period (1802-2001)

The above figure shows that for US stock held over a one-year period, the maximum return was 67%. On the other hand, there was also a year with a maximum loss of 39%! Imagine how devastating it was when one entered the market in the beginning of that year and had to withdraw the money for retirement after that. However, when the stocks were held in longer duration, say for ten years, the maximum compounded annual return (CAR) was 17% and the minimum -4% as shown. If the holding period is longer, the CAR was always positive. Stocks held over a 30-year period would have a maximum CAR of 10.6% and a minimum of 2.0%. The above data shows that the next time if there is a snake oil salesman come and pursued you to buy his funds by promising you that his fund can return a CAR of 30% for your investment in 10 years. Be wary of him.

Individual stock investors

New investors looking to invest for in the equity market  are usually faced with two main options - mutual funds or individual stocks. There are many individual investors who claim that they have been making tons of money in the market. The majority of these people probably have forgotten, or refuse to remember that they have lost a sum more than what they have made some time ago. It is a jungle out there in the stock market. Many investors get pulled in by the greater fool theory[1] and buy stocks at all-time highs only to panic later during a pullback. Few individual investors have the necessary skills to pick stocks. It is not that simple as price-earnings ratios, price-to-book etc. Neither a person with MBA or CFA (certified financial analyst) is sure to make excess return in the market. In their 2009 paper on “option trading and individual investor performance”, Rob Bauer, Mathijs Casemans and Piet Eichholtz examine the performance and persistence of individual investors trading at a Dutch online broker. Using a database consisting of more than 68,000 accounts and eight million trades in stocks during January 2000 to March 2006, they find that: During 2000-2006, the average investor has negative alphas, meaning the return is below the market return. Not even the top tenth of performance manages to beat the market consistently. Those in the bottom tenth of performance lose more than 90% of value. So be wary if you want to invest yourself. So it appears that individual investors will have to rely on mutual funds. Is that true?

Mutual funds

The following link shows the five big benefits of mutual funds by exaggerating their return;

http://voices.yahoo.com/five-big-benefits-mutual-funds-9251.html?cat=3

Among the benefits of investing in mutual funds mentioned are:

1. “Mutual funds provide full-time, high quality professional management services by pooling the resources ….The fund manager's goals and interests are tied to your success because their pay check is based on how well the fund performs rather than on sales commissions. The fund manager has instant access to real market information…..”
2. “Shareholders benefit from diversification made possible by the amount of pooled investment dollars that most individual investors would not be able to achieve.”
3. “Low Cost, High Quality Investing” in terms of diversification.

Unfortunately with heaps of academic researches, among them of the famous Michael Jensen (1968), Grinblatt and Titman (1989), and Burton Malkiel (1995) which comprehensively evaluate fund performance, consistent show that actively managed funds do not outperform various broad market benchmarks as evidenced by the negative alphas. What about our Malaysian unit trusts?

The underperformance of mutual funds/unit trusts

The inability of the fund managers as a whole to beat the market is best explained by the efficiency market hypothesis which postulates that in an efficient capital market, current market prices reflect all available information about a security and the expected return based upon this price is consistent with its risk. As a result, it is impossible for an investor to consistently beat the market and profit from it. With this, the under-performance of the mutual funds/unit trusts can be solely attributed to the costs of investing in them. Very few mutual funds investors understand the complexities of mutual fund expenses and know the true costs associated with mutual fund ownership. The following link is a very good read and an eye opener for anyone wishing to invest through mutual funds/unit trusts.

       http://www.forbes.com/2011/04/04/real-cost-mutual-fund-taxes-fees-retirement-bernicke.html

The article explained in detail about the six different costs involved in investing in mutual funds: expense ratio, transaction costs (brokerage commissions, market impact cost, and spread cost), tax costs, cash drag, soft dollar cost and advisory fees. The total cost per year, according to the author, can add up to about 4% per annum, which is equal to 40% of a long-term return of equity investment! And how about the option of investing in the unit trust funds in Bursa?

Malaysian Unit trust industry

As at 31^st May 2012, there are 40 Fund Management Companies with 607 approved funds. The total net asset value is 272 billion ringgit, making up to 20.6% of the Bursa market capitalization. Do local funds provide a good alternative for investors interested in local share market? The following Table 1 shows the results of a simple research carried by me regarding the performance of local unit trust funds invested in Bursa as at a few months ago. The information can be obtained from the following link:

http://www.fundsupermart.com.my/main/fundinfo/compareFund.svdo?sectormaincode=EG&sectorareacode=FE2

Table 1: Fund performance in %

The average 1-year average return was 15.2%, 3 years 12.1% and the 5 years 11.6%, outperformed the KLSE of 10.8%, 9.9% and 9.3% respectively. Surprisingly they did pretty well on average. More than 72% of the funds beat the broad market. Even if one invested in the worst performer, he still earns more than the fixed deposit, assumed to be about 3.5%. Wasn’t that wonderful? I think I should make some observations as below:

1. The stock market in Bursa Malaysia, is far from efficient.
2. The performance of the good fund manager are pretty consistent too. For example, Philip Capital Master Growth Fund is the No. 1 for the 1-year return of 28.5%. It also did pretty well for the 3-year and 5-year return of 18.4% and 20% respectively. Similar consistency is shown by the top fund for the 3-year, Kenanga Growth Fund at 22%, and MAAKL-HDBS Flexi fund for the 5-year as shown in Table 2 below.

Table 2: Top fund managers, % CAR

My conclusion is that it may be a good idea for ordinary people who have not much time and knowledge and wish to invest in the equity market to invest in the local unit trust funds.

KC Chong (12/7/2012)