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The views reflected in the commentary are subject to change at any time without notice. Nothing on this blog constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security.

Stocks vs. Funds: Why PASI Favors Individual Assets

Friday, July 19, 2019

Written by Jeremy Goldberg, CFA

Categories: PASI Stocks

Comments: 0

Ever since mutual funds and ETFs (“funds”) became prevalent in long-term portfolio management some 20 years ago, active managers have tackled the dichotomous question: Is it better to own stocks and bonds (individual securities) or funds (baskets of securities)? We get versions of this question often when asked about our PASI Equity Portfolio and during reviews of client/prospect outside holdings.

Active portfolio management is the process of buying and selling securities in an attempt to outperform a specified benchmark, rather than passively holding an index fund to match the benchmark’s return. At PASI, we buy and sell stocks with the goal of outperforming the S&P 500 index while managing risk. Active fund managers do the same thing – they buy and sell a variety of funds, which are simply baskets of individual securities traded as a single investment product, with the goal of outperforming the respective benchmarks. It’s important to note that the investment performance of these funds is strictly dictated by the underlying holdings, which can be stocks, bonds, commodities (like gold), etc.

Interestingly, funds don’t have the best track record of success. Over the 15-year period ending December 31, 2018, our equity portfolio returned 9.02% annually before fees vs. the S&P 500’s return of 7.77%. Even after deducting maximum annual investment and custodian fees of 1.00% and 0.10% respectively, and small transaction (brokerage) expenses averaging less than 0.05% annually, PASI still outperformed. Over the same time period, only 8.4% of all funds benchmarked to the S&P 500 achieved that goal.(1)

How have we been able to maintain such a strong track record? We own a small number of high-quality businesses that undergo significant due diligence and require a majority vote from our nine-member investment committee before we take any position. We currently have 31 stocks in our portfolio, diversified across the S&P 500 industries. Of the 673 actively-managed funds benchmarked to the S&P 500 index, the median number of holdings is 71.(2) If a client is invested in more than one fund, there could potentially be 100+ underlying investments that, in our opinion, should be monitored with the same scrutiny.

While the dilution of 100+ investments (through funds) may help a portfolio better weather the storm of a single falling stock, the opposite is also true: A portfolio will not benefit from significant outperformance of a single stock if it holds hundreds. First coined by Peter Lynch in his book One Up on Wall Street, this “diworsification” underpins the logic that once you own too many stocks, your performance will match that of the benchmark or index, making it impossible to outperform after deducting fees.

Importantly, with so many underlying investments in funds, there can be significant overlap between holdings. While this reduces the overall number of securities to monitor (maybe), it also makes maintaining an asset allocation more difficult. Further, some holdings may not be appropriate for the fund. It’s common for a large-cap. fund to hold a cash position, but the because the fund is categorized as “large-cap.,” the cash position may not be reflected in the client’s asset allocation. If multiple funds hold cash, then cash may have a higher weight in a client’s portfolio than planned.

This highlights another concern: transparency. One of the biggest issues we see with funds is the difficulty identifying expenses, i.e., the total cost of fund management. Funds can have a variety of expenses, including front-end load and back-end load charges (fees to buy or sell the fund that are in addition to transaction costs), 12(b)-1 fees (distribution, marketing, and service fees) and expense ratios (management, accounting, and other expenses). Generally, these are not presented to the client before investment and these fees are in addition to the investment management fees paid to the advisor. The average expense ratio of all actively-managed funds benchmarked to the S&P 500 index is 1.17%.(3) Again, these fees are on top of the annual fees paid to the advisor. Consider that if a fund manager were to charge 1.00%, for example, above and beyond the fund’s 1.17% expense ratio, total client cost could be well be in excess of 2.00%.

Lastly, tax management is a service funds do not provide. We strategically review buying/selling opportunities relative to the client’s potential tax liability. We perform tax-trades and take advantage of losses to offset gains when feasible and prudent. Actively-managed funds, on the other hand, face uncontrollable taxable events as a result of turnover, redemptions, and gains/losses in security holdings throughout the year that are automatically passed through to the investors. Again, this goes back to a lack of transparency; clients don’t have as much color on the total costs of owning funds.

So back to the original question: Is owning individual assets better than owning baskets of securities? At the end of the day, we care about performance, transparency, and consistency, and we believe owning individual securities rather than funds allows the most flexibility and control, ultimately providing the best risk-adjusted returns for our clients.

Sources:
1) S&P Dow Jones Indices LLC’s SPIVA® U.S. Scorecard.
2) PASI Investment Research.
3) Ibid.

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