Over the last decade I have been asked by both my clients and students: What is better, to hold stock or bonds directly or to own managed funds that own those same stocks and bonds?
Many in the media have objected to managed money because they say it adds another layer of people who charge fees.
Successful investors like Warren Buffet believe markets are not always efficient. According to pundits of the efficient market theory, they believe that the price of a stock reflects a company's true underlining value. Those that believe in the efficient market theory believe that no single entity can affect the prices of stocks or bonds.
In reality, the managers of Canada's largest mutual fund companies – Investors Group/ Mackenzie Financial, AIM Trimark, Fidelity – can buy a significant percentage of a Canadian company's stock, causing the price of that stock to go up, as other buyers follow in the wake of these mutual fund companies' purchases.
Those who buy Canadian shares from full service or discount brokerages usually have no idea when the buying began.
So what are mutual funds, money managed accounts and pool funds? They are a collective of sorts, in which people have pooled their financial resources under professional management.
These managers claim that an individual investor may be able to buy the same stocks cheaper on his or her own, but he or she would not have bought the same stocks at the same time with the same knowledge.
If markets were perfectly efficient and research did not make a difference, then relative fund performance would be based on chance.
If it was that easy to make money from investing in stocks, individual investors would only need to watch business news programs. But information in an efficient market is disseminated randomly.
From my experience I would argue that although information may be random at its outset, its development is sequential. Stories have a beginning, middle and an end. Sometimes hearing the news and acting on it first provides an advantage.
Sometimes having the wisdom not to react will prove more successful. Sometimes it helps to know the people releasing the information in the first place.
Wisdom comes from making mistakes and then learning from those mistakes. These lessons can be expensive, especially for someone using their own money, as a hobbyist.
Money managers are people, like you and I. Maybe they are no smarter than we are, but they have the time and money to find that garage in Richmond Hills' Silicon Valley North where two recent grads from Waterloo University are working an Internet breakthrough.
Fund managers at Templeton and Fidelity are more likely to find out which companies in India or China will grow and which national government is about to fall. Efficient markets require that access to information be, if not free, at least equal.
Fund managers claim their information is not random, but the result of well-developed methodologies and access to information, which although public enough to avoid security violations, is too fresh to be widely disseminated.
When I took my Canadian Securities Course in 1990, the text stated that for a portfolio to be diversified it would need to hold between 15 to 30 stocks to avoid a single company's risk.
That is, the risk that a company's management team might do something stupid. Some people can afford the time and the money to design their own portfolios.
Owning this many companies in one's portfolio requires multiple costs for transactions, time for tracking, following and measuring performance. This all leads us back to my initial question.
If you believe in perfectly efficient markets, that there is no truth to the herd mentality then research does not matter, and there is no value in delegating you're investing-and there is no reason to buy money management products.
However, if you value your time and your money and believe that expert money managers can invest your money better than you, I have found the best criteria to pick these excellent money managers to run your portfolios are:
- Make sure they have done better than the average of their peers for a meaningful period of time, say 10 years.
- Make sure they have been running money for a while and had some combat experience, meaning managing money in both the boom years of the late 1990s and the bust years of the early part of this decade.
- Make sure they are long-term investors. They are owners of stock and bonds, they do not rent them.
In Canada, every time a portfolio is sold and bought, taxes are triggered on those transactions outside of RRSPs. A low turnover in a portfolio translates into lower fund expense ratios, lower taxes and at the end of the day more money in your pocket.
As Warren Buffett says when it comes to company's in his portfolio that “our favourite holding period is forever.”