How Not to Invest
By Peter C. Thoms, CFA
December 19, 2014
Depending on a specific investor’s return objectives, tolerance for risk and requirements for liquidity, many sensible and reasonable portfolios for that specific investor can be created from a wide range of asset classes, including stocks, bonds, real estate, venture capital, commodities, private company investments and all types of derivatives (e.g. futures, options, etc.).
There is, however, one way we think investors should not invest, and it happens to be the way that many (if not most) of Americans saving for retirement invest.
Over the years we have conducted a significant number of portfolio reviews. We have found that many investors own too many actively managed mutual funds. Many do so, they say, for the purposes of diversification. For example, across all accounts an investor may own 20 funds, each of which may have an average of 150 individual holdings.
However, when we unbundle their funds to examine the actual underlying holdings across all funds, we often find that the investor often really just ends up owning a portfolio with true exposure that is very close to that of the broad stock market. The portfolio may be diversified among funds, but it still has the same market risk carried by the broad market as well as many overlapping stock positions.
Yet, by achieving what is basically default market exposure through actively managed mutual funds, the investor is bearing significantly more cost and tax bite than is necessary to achieve this exposure. Over time, excess costs weigh on returns and ultimately result in a smaller retirement nest egg for the investor.
If an investor’s objective is simply to gain broad market exposure, using actively managed mutual funds is a very expensive way to get it. When you add up the overt costs of owning funds (management fees, taxes and marketing costs) and the hidden costs (trading commissions and bid/ask spread “leakage”) most funds simply are not a good deal for the investor. True costs of owning an active fund may amount to 1%-3% per year, depending on the amount of trading done in the fund. A much more cost-effective and tax-efficient means for an investor to get broad exposure to the stock market would be to simply own an index fund that tracks one of the broad market indexes such as the S&P 500 or the Wilshire 5000.
The empirical data for active funds is not encouraging. (See slide below.) For an exhaustive look at the data driving our skepticism about active funds, visit us online to request a copy of the Mutual Fund Landscape.
Another observation about portfolios we have reviewed over the years is that the vast majority focuses on large-cap stocks. The “large-cap growth” category seems to be a particularly popular theme in portfolios despite the evidence that value stocks have outperformed growth by a wide margin over time, both here in the U.S. and overseas.
We think that as investors focus mostly on large-cap growth stocks, they are broadly ignoring two segments of the market that have historically delivered much better returns: value stocks and small-cap stocks. (See slide below, which encompasses 86 years of U.S. stock market return data from 1927 2013. Note the Value Premium and the Size Premium bar charts.)
For a more detailed explanation of why we believe investors should emphasize value stocks and small-cap stocks in their portfolios, please check out our recent article on that subject.
While value stocks and small-cap stocks have outperformed the broad market significantly over time, they do not do so every year. In fact, they canand and haveendured long stretches of underperformance relative to the broad market. However, in the past, the longer investors stuck with value and small-caps, the more likely they were to be rewarded. The chart below details 5-year rolling rates of return for small-caps versus large-caps (top bar chart) and value stocks versus growth stocks (bottom chart). As the chart indicates, value investors have done particularly well relative to growth investors.
Given the current era of low interest rates and healthy P/E multiples in stocks, we think it is more important than ever for investors to sharpen their pencils, get a handle on their fund costs and to consider repositioning (if necessary) their equity allocations.
Peter C. Thoms, CFA
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Tel: 619.435.1701
Email: [email protected]
About the Author:
Peter C. Thoms, CFA, is the founder and managing member of Orion Capital Management LLC, an independent Registered Investment Advisor based in Coronado, California. The firm manages assets for individuals, families, trusts, corporate pension plans and non-profit organizations.
Disclosure:
This document is for informational purposes only. Nothing in this report is to be construed as a specific investment recommendation. This document does not constitute the provision of investment advice, which is only provided by Orion Capital Management LLC under a written investment advisory agreement and only in states in which Orion Capital Management LLC is registered or is exempt from registration requirements. Orion is not a tax advisor and does not provide tax advice. For tax advice individuals should consult their CPA.
