Modeling Portfolios: Mutual Funds Versus Individual Stocks
An extension of “Principles of Investing” Piece:
As the world shut down last year due to the public health threats of the pandemic, the world of speculative day traders reminiscent of the ‘90s was awoken. The allure of capturing mammoth gains through concentrated stock positions can be attractive to many, and calls for an analysis comparing mutual funds to owning individual stocks. Even if one does not succumb to the substantial risk of day trading high beta, “hot” stocks, this evaluation of holding individual stock positions versus a broad mutual fund portfolio is relevant.
❖ Simply put, stock-picking is not easy. Investing in one individual company to gain sector exposure may require increased due diligence when compared to investing in a mutual fund with exposure to multiple companies within a sector. Allocating funds towards a single company can introduce unsystematic (company) risk, compared to the systematic risk that is assumed when allocating towards several within a sector.
❖ Choosing winning stocks or a star manager is only the initial hurdle. Consider the following example per Peter Lynch, one of the industry’s best - who posted 29% annualized return in his tenure. Lynch “calculated that the average investor in his fund made only around 7 percent during the same period. When he would have a setback, for example, the money would flow out of the fund through redemptions. Then when he got back on track it would flow back in, having missed the recovery.”[1]
❖ Managing Managers. A common strategy in developing a mutual fund
portfolio involves deploying a handful of mutual funds throughout different sectors and geographies, allocated at different percentages across a portfolio. The advantage in this strategy is the ability to rebalance to favor one sector over another - which is as simple as allocating a higher percentage of a portfolio towards a fund in the model, while reducing exposure in another. The thesis of this strategy aims to increase flexibility and mitigate the notion of “throwing the baby out with the bath water,” e.g. the limited rebalancing ability that is present when invested in a broad market index fund where the singular fund’s goal is to mirror a benchmark.
❖ Embrace collective intelligence. Expanding on the notion of managing mutual fund managers within a portfolio, the mutual fund approach as opposed to the individual security approach with respect to asset allocation embraces collective intelligence. Collective intelligence “refers to a group or a team’s combined capacity and capability to perform a wide variety of tasks and solve diverse problems”. [2] While this may be perceived as a nebulous concept as it relates to asset management, in selecting a basket of mutual funds within an overall portfolio, an advisor or investor can utilize to the due diligence of hundreds of fund companies that ultimately led to the allocation in their fund, while referencing an individual fund’s rank in its category versus its counterparts.
❖ Transparency concerns are oft inflated. Open end mutual funds are priced via forward pricing, meaning their shares are priced once per day after the close, which establishes the most current net asset value (NAV). At the end of each fiscal quarter, the fund’s holdings are disclosed. Ostensibly, the concerns with transparency that some individuals may hold are with the requirements of disclosures and the trading that occurs between each quarter. A countermeasure for this is concern is observing turnover within a fund. A given fund’s turnover rate will indicate the rapidity at which each holding is sold after purchase, which in many strategies is a factor that is important in the consideration to select one fund to allocate to versus another.
Overall, stock picking can introduce unsystematic risk that an investor must be willing to endure, that a mutual fund investor may be less exposed to. Mutual funds can offer a less capital intensive method of diversification that may prove to be easier to rebalance in time. Asset allocation across several handpicked mutual funds allows for this rebalancing and selective overweight allocation towards different sectors and geographies, and emphasizes the concept of collective intelligence between investor, advisor, and fund managers, along with secondary research produced by each party.
Disclosures:
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Investing in mutual funds involves risk, including possible loss of principal. Find value will fluctuate with market conditions and it may not achieve its investment objective.
Stock investing includes risks, including fluctuating prices and loss of principal.
Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect principal.
The Financial Consultants at Vintage Wealth Advisors are registered representatives with, and securities offered through, LPL Financial, Member FINRA/SIPC. Investment advice and financial planning offered through Financial Advocates Investment Management, DBA Vintage Wealth Advisors, a registered investment advisor. Financial Advocates Investment Management, Vintage Wealth Advisors, and LPL Financial are separate entities.
1) Spencer Jakab, Heads I Win, Tails I Win: Why Smart Investors Fail and How to Tilt the Odds in Your Favor.
2) Oxford Review-Encyclopedia of Terms, Collective Intelligence
