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  • Writer's pictureAlpesh Patel

The Inherent Flaws of Fund Management: A Closer Look

In the complex world of investment, the allure of fund managers and their promises of significant returns on stocks like Meta (formerly Facebook) is hard to resist. However, a deeper understanding reveals a fundamental flaw in the fund management industry that often leads to disappointing outcomes for investors.


This article delves into the reasons why even the most successful fund managers struggle to maintain consistent gains and why individual stock picking might be a more viable strategy for the savvy investor.




The Design Flaw in Fund Management

At the heart of the issue is a design flaw within the fund management industry. Consider the journey of a fund that invested in Meta around 2016-2017. For years, the stock experienced a substantial rise, with fund managers boasting a fourfold increase from approximately $100 to $400. This success story, heavily marketed, attracts more investors, drawn by the impressive historical performance.


However, the market is cyclical, and approximately every six to seven years, a downturn occurs. When this inevitable drop happens, fund managers face a significant limitation: they cannot convert their holdings entirely into cash.


Regulations require them to remain invested, meaning they can sell one asset but must immediately reinvest in another, often in a declining market. This constraint can lead to an 80% drop in the value of previously successful investments, erasing years of gains and bringing investors back to square one.


The Stairs Up, Elevator Down Phenomenon

The market is known for its slow and steady climbs, followed by rapid declines—a phenomenon often described as taking the stairs up and the elevator down. This characteristic of the market means that gains accumulated over years can be wiped out in a matter of months, leaving investors' dreams and financial plans in disarray.


The Private Investor Advantage

Unlike fund managers, private investors have the flexibility to set their own rules for managing downturns, such as selling a certain percentage of their holdings if the value falls by a predetermined amount. This strategy allows individuals to mitigate losses and potentially re-enter the market under more favorable conditions.


The Challenge of Recovering from Losses

Even if a fund's investments recover after a downturn, the gains may only bring the value back to its pre-drop level, effectively resulting in a 0% return over an extended period. This situation can be frustrating for investors, especially when they see the market itself has risen significantly.


The Case for Individual Stock Picking

The limitations faced by fund managers highlight the potential advantages of individual stock picking. By managing their own investments, individuals can apply strategies that fund managers cannot, such as exiting positions based on specific criteria to protect against losses or re-entering the market when conditions are favourable.


For instance, the fundamentals of a company like Meta might look appealing at a certain point, prompting a well-informed investor to invest based on growth potential, dividend yields, cash flow, and other indicators of value and momentum.


Conclusion

The inherent design flaw in the fund management industry, combined with the cyclical nature of the market, poses significant challenges to maintaining and growing investments through managed funds.


While fund managers may have periods of success, the restrictions they face and the market's volatility often lead to disappointing long-term results for their investors. In contrast, individual investors, equipped with knowledge and flexibility, have the potential to navigate the market more effectively, making informed decisions that align with their financial goals and risk tolerance.


Alpesh Patel OBE


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