The Secrets of Investing (Part 1)
The Good and the Bad of Mutual Funds
Today we’re talking about a topic that I think is going to be very interesting to most of you. Almost everybody that I’ve met or talked to has mutual funds or ETFs now or has had them.
I think they’ve thought that it’s the best way to invest, to be diversified. I kind of call it the diversification pixie dust. They think, “I have all these funds so I’m diversified,” but there’s a lot of inefficiencies with them.
We really want to dive into that today with Guy. So Guy, why don’t we just start out and say maybe what are some of the problems that you see. Share maybe the good and then the bad about mutual funds.
Funds have a real application within the business here for people and they hit on a very important tenement that’s involved with portfolio construction and really responsible for investing and its diversification.
So they are a way to get good proper diversification within your investments. When that really holds true is especially with lower balance or accounts or with smaller quantities of money that you’re trying to get invested.
Case in point; if you’re looking to invest $10,000 and if you were to build out individual securities within there, let’s say you’re shooting to get all the different sectors, a couple of stocks in each sector to really get that true proper diversification. You’re probably talking about buying at least 30 different securities, 30 different stocks.
Now, if you actually average that out on a $10,000 investment, that’s about $300 per stock that you would be allocated to. The problem is there are some stocks like Amazon and Google that you can’t even buy a share of that company for $300. To further my point, the mutual fund or an ETF, somewhere where you’re actually pooling your assets in with other investors, allow you to get access to all those different companies in a diversified way. So know it’s very applicable from that standpoint within the industry and why they’re very prevalent.
But where we find that they start to become inefficient is especially once you start to be growing larger and larger accounts where you can actually construct a diversified portfolio in the individual stocks and you don’t need to be pooling them. Once you have over $100,000, mutual funds become very inefficient.
Where a lot of the inefficiencies are driving from is because of the pool structure. So when it’s going in there, they’re not managing that fund or that investment to your particular needs. That’s really the biggest problem with them.
So some of the side effects that come with that is something like a capital gain distribution, which becomes very egregious. Those capital gain distributions a lot of times they’re being driven by the actions of other investors in the fund. So someone who may be invested in it and in a volatile market they kept their investment in, but other owners of the fund, if they were panic selling or making the wrong decisions at the wrong time, that’s forcing the fund manager’s hand to be selling securities potentially at the worst possible time.
In a taxable account, you get the tax liability or the tax bill at the end of the year for all the gains that the manager had to take. That in itself is just one example of how they’re inefficient.
The other side is when you’re holding it as a pooled security, you can actually carve out and buy or sell any of those specific aspects. So in any one market, there might be a whole bunch of sectors that are doing well, but there are typically one or two sectors that are lagging or are not doing well.
For example, this year we have the technology, consumer discretionary, a couple of those sectors are leading the way in the market, but then you look at certain sectors like finance and energy. They’re extremely depreciated this year, but if you own a mutual fund or an ETF that’s invested in say the S& P 500, that fund at this point would be actually positive, or up for the year. But within there, it’s got energy stocks and it’s got financial stocks that are both negative, but you can’t go out and actually carve out and sell those, especially for tax purposes
I think about March this year when COVID hit and everything’s kind of going crazy.
I look at it like getting rid of the losers and keeping the winners. There are certain industries, like hospitality when COVID hit, there were not going to be doing well.
There are things we didn’t want to be in, but then there are others, as you mentioned, technology already like Amazon, where there’s good.
So if you’re in the mutual fund, you’re kind of stuck, right? They have to keep the same level in all of them.
But if you are using individual positions, then you can say we’re going to keep this, but we’re going to maybe swap out this. We might not want to be in this stock right now and find better opportunities and sometimes for better deals, because all the other funds are selling what you actually want to buy.
Funds are constrained by a certain perspective that is going to require that they stick to a particular style or a certain parameter around the investment decisions. In a certain environment, even if the manager knows this is not a good time to be holding this particular position or buying more of this particular position, they have to buy perspectives. They’re kind of forced by cashflow.
So if more and more money is coming into the fund and the fund is by perspective, supposed to be buying these particular securities, the fund manager might even know this is not the right time to be buying these types of securities, but he or she has to buy them because they have to be putting the cash to work.
And it has to be put to work in certain things by the perspectives. So once again, the reason is the funds have to be managed to the prospectus. That’s the way that the mutual funds market themselves and now essentially get their investors in the first place. So it speaks to the fact that it’s not individualized to people’s needs. They’re individualized to be gaining market share within the fund.
Another issue is with index funds. The index funds are following a particular index. The most famous one obviously is the S&P 500. Interestingly, what we’re finding right now in this environment is that’s a cap-weighted index. So that’s the parameter that it’s got to hold a certain percentage of the 500 largest companies in the U.S., but it holds a higher weighting based on the market capitalization.
So the larger stocks hold a larger share, but what’s happening now is because it’s such a slim number of stocks that are really doing so well this year, it’s now the five largest stocks in the S&P 500 are now representing about 23% of the overall index.
That structure, because it’s forced to be that way, there’s inherently actually more risk. Whereas in a managed portfolio like ours, if we start to see some of our winners really getting ahead of themselves, starting to dictate more and more of the portfolio and starting to trade at higher and higher multiples, we’re not confined by a prospectus to keep a certain exposure to them. We’re going to look to trim and sell into the strength and take some profits.
Giving us that ability ends up being much more in our client’s favor because we’re not managing to a prospectus, we’re managing to their needs, while keeping their interests as first and foremost in mind when we’re managing.
Should I Invest In Individual Stocks?
Yes. You touched on what I was going to talk about next, which is how you do it differently. I think you’ve alluded to it using individual stocks and holdings versus the funds. I think there are two ways. Managing it to the individual, but also then managing it based on what you’re seeing in the market. What’s going on and being able to be agile and moving where you need to move, versus stuck to perspectives.
So if you want to talk just a little bit more about how you build the portfolios differently from the funds and some of the downside risk management you can put in the portfolios by doing this versus using the funds.
Absolutely. What we tend to find is the way that funds are positioned is to be trying to outperform certain benchmarks or each other in good markets because inherently they know that the way that they’re getting more business is when people are actually looking. They’re looking at performance, they’re looking at certain things, but when people tend to look at those things are in good times when markets are doing well. People usually are not shopping for new funds when we’re in the middle of a major market correction, most people are either paralyzed holding still, or they’re just selling and going to cash.
So, they’re not necessarily shopping to find the next mutual fund they’re going to be going into. Because of that dynamic that they know the mutual funds are geared to try and be outperforming a good market.
Sometimes they’re even over-leveraged to make sure that they’re outperforming in good markets but are not going to have any emphasis for that downside protection because they don’t care if the market’s down 30% and they’re temporarily down 35%. What they care about is if they’re beating the S&P by 1%, when things are on the upside. But we know it is important for our clients to have downside protection.
So the way we tend to manage is we’re set to be outperforming a falling market. We’re going to be preserving the downside. We do that by being proactive, selling disciplines, using stop orders, and other mechanics like that. But we know that’s important because if we can be limiting a lot of downsides, then we know there’s that much on the upside. We need to be capturing to get first back to even, and then back to positive.
Our approach is really to limit the downside risk and then participate in capturing a certain amount of the upside, which most funds inherently are not going to have that structure on the equity side.
You made a point that most clients, especially as they are closer to retirement, are more conservative and don’t want to lose so much on the downside. While it might not bother the fund that they lost 35%, it probably bothers the individuals, especially the individuals like in retirement.
If the market drops 30%, you gotta make 43% just to get back to even. So having downside protection in place is important.
I think you just made a good point of understanding why it’s not important to the funds because again, they’re just trying to get money in the funds. They’re trying to build their business and are not necessarily concerned about your business as the investor, is that right?
Absolutely. And they can’t be because to you, to them, you’re just a number within there. So that’s, that’s how their business is structured.
It’s maybe buying different stocks where you might hold an Amazon or Apple, or different tech stacks where you’re owning some of those stacks that are making up a lot of the fund. Anyway, you’re just owning them individually and building around that which is nice too.
If somebody has one of those, we can kind of build around it. Building around those things, if it’s, non-qualified watching the taxes if it’s an IRA that part is not as important. So if you want to sell one, or if you want to buy it at certain times, you’re not constrained on when to buy and sell based on what the prospectus says. You can do it based on what’s going on in the market and what the client needs.
Yeah, absolutely. So for transitioning a portfolio over time, it becomes much more efficient because like you said, if someone has a large position and it’s dictating particularly one sector, but we don’t necessarily want to sell too much of it in any one year because just the tax ramifications themselves might be inhibitive on that.
What we can do is we can be building out around that and prioritizing other sectors that they don’t have exposure to, whereas with a fund it’s tougher to do that.
There’s a reason I think a lot of advisors or managers don’t do what you do, it’s because it’s more work, if I’m being candid. If you’re getting the fund, they’re getting paid. I think what you’re doing is a lot more labor-intensive. It’s why most managers aren’t doing it. Is that what you would do?
Yeah, absolutely. Because it is more labor-intensive like you said. There’s a lot more thought process that has to go into it. So it’s, it’s not only the thought process on the selection side, but then it’s a whole other aspect of the actual execution side of things and that’s for both stocks and bonds.
So that means you have to have individuals on your team where that is their primary focus. You know, they can’t be focusing on anything other than following specific securities in their set sectors so that they can be executed timely.
The perfect example is if you don’t have that team built around you and people are wearing multiple hats, talking with clients, going out of the office a lot, etc. then you can’t possibly execute efficiently or with individual stocks and bonds.
That is why I think we find that most advisors are using those diversified structures as a placeholder, but we’ve invested in that team infrastructure because we know if we can get that working efficiently there’s so much value add for our clients by actually utilizing the individual securities.
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