Singular vs. Diversified
Investing
Charlie Munger reminds us that the great fortunes
that have been made come from entrepreneurs who focus on one product or service
and do it very well.
In maximizing their sound bites or column inches, the
talking heads of the news media often focus on a single concept or instrument.
While this specific input may be helpful if someone is looking to add to his or
her portfolio, following the advice is verging on the irresponsible in terms of
how it affects the whole portfolio and the total financial condition of the
investor.
Recently I have been researching the impact of ETFs
and other pre-packaged instruments and I found that many of the holders of these
instruments don't understand the changes in the market mechanisms about trading
in and through ETFs. Further they are confusing the difference between
individual and team performance.
The Analysis of Picking
Winners
As my readers know, I learned much about analysis
by handicapping at the racetrack. In order to cash winning tickets it is not
enough to find the fastest horse based on its prior races, work outs, breeding,
jockey and trainer capabilities. One also needs to guess how the other horses are likely to run in this particular race. If the fastest horse in the
race is your choice you would be better off if the horse is not blocked by a
crowd of horses running similarly. Some horses with early speed that soon tire
could help the ‘come from behind’ horse. Thus, in picking an instrument it is
important to have some idea what the other major securities are likely going to
be doing. Therefore the length of the race is
important. In short races the ability to rapidly accelerate and maintain the
acceleration until the finish line is critical to winning. In much longer races
stamina is a good deal more important.
Picking Your Measurement Time
When a
prospective investor asks me for a recommendation, I ask “What is the period of
preferred measurement?” This is like asking the length of the race. To aid the
investor, I introduced the concept of the four Timespan L PortfoliosTM,
which stretch from the near-term to the long-term. I find this approach useful in
contrast to almost all of the popular commentators, who appear to be focused only
on periods of under twelve months. To use a military analogy, this is like firing
a single rocket compared to a longer range guided missile with bigger and
multiple payloads.
Index Funds are
Different than Managed Mutual Funds
For
long-term accounts, let’s compare an index-tracking ETF with a fully discretionary
managed fund. The index tracking portfolio is like a rocket that once fired can
not be re-directed to new and better targets of opportunity. The managed
account can shift its portfolio composition to address a new or different
investment opportunity. It can change
its risks assumptions. As a matter of fact that is one of the reasons managed
funds have underperformed since 1987 and particularly since 2008; because of
fears that periodic down markets would bring on the need for cash to meet
redemptions, which has happened to US domestic-oriented funds for more than a
year.
A managed portfolio needs to pass a prudence screen, e.g., avoiding bankruptcies as well as perhaps some social screens, individual stock limits to share of portfolio, shares outstanding and liquidity concerns.
A index tracker does not have similar
constraints. Often its portfolio is constructed to
represent the central tendency of stock prices along a particular axis such as
market capitalization, sales, earnings, etc., that the publisher of the index selects
as the single most vital indicator. In the extreme a
managed fund manager can face a judge or regulator as to the prudence of the assembled portfolio; the
index publisher has no such constraints.*
*I hold the record for creating
the largest number of indices, in this case for mutual funds, which are now published by Lipper, Inc.
Managed Funds Out-performed Indices During Turmoil
Recently
S&P/Dow Jones Indices, a subsidiary of McGraw-Hill Financial reported that
relatively few mutual funds beat the various indices, regardless of whether
that was their goal. In an article in FT Money, Merrryn Somerset Webb of MoneyWeek pointed out that
many fund averages lost less than the security averages from April 13th through
August 24th. Her astute comment was not that the funds did better, but that the
indices did worse. I would suggest that the absence of cash explains much of
the sub-par performance of the indices.
Securities indices were never designed
to be prudent portfolios and follow normal managed portfolio constraints, therefore it is not really useful to
compare managed accounts to indices
and ETF tracking vehicles. Each has its place in tool kits of investing.
Conclusion
Some of us like
watching individual performers in the sports arena or on the theatrical stage.
Others like to view a team of talented individuals working together scoring
points or producing great symphonies. We should not confuse the attributes of
each to select one over the other.
_________
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Copyright © 2008 - 2015
A.
Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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