By: David Baskin
Most prominent mutual funds, and many prominent stock pickers had poor years yet again in 2014, with over half failing to exceed the returns from a passive index-based portfolio. These mediocre to poor returns feed the cynicism of those who cast a cold eye on the business of managing money for others. Newspaper columnists waste no time in telling their readers that the best solution is the one with the lowest cost: Exchange Traded Funds (EFT) or “do it yourself” investing through a discount broker. As professional portfolio managers, we have a horse in this race, and in this essay we will explain why, at least in our view, the average investor benefits from having a professional funds manager.
The cynic is the man who knows the price of everything and the value of nothing, said Oscar Wilde. It is easy to see the cost of mutual funds, for example. In Canada they are disgracefully high, often more than 2.5% or even 3.0% per year, not including trading costs. That they seem to produce little added value on a reliable basis confirms the cynic’s bias. However, the real question is not the performance of the mutual funds, however dismal, against a benchmark or index. It is the performance of the funds against the unadvised “do it yourself” investor that is the real measure. For if the funds offer mediocre performance, it is still better than that of the great mass of unadvised investors. Therein lies in the unrecognized value which the cynic cannot see.
Academic studies have shown repeatedly that most investors do worse than almost anything in which they choose to invest. How can this be? Simply put, people buy high, when a product or fund is at the height or its popularity, and sell low, when it is unloved and undervalued. Fidelity, the giant mutual fund company, found that its most successful holders, those whose returns were the best over an extended time period, were investors who had forgotten they owned the fund, or who had died. They did not fall prey to the fatal flaw of trying to time the market.
Daniel Kahneman, Noble Prize winner and author of the recent book “Thinking Fast and Slow”, points out a large number of systematic mistakes that investors make, many driven by deeply rooted psychological needs and tendencies. Our brains, on average, are not well adapted to investing, and that is why most people are not very good at it. Professional investors try to eliminate, or at least be aware of, the cognitive errors that drive poor investment decision making. This is the first major value-added benefit for the professional portfolio manager. The good ones are more systematic, more dispassionate and less prone to those kinds of mistakes.
The second major area in which the portfolio manager adds value is in the crucial area of asset allocation – that is, how the portfolio is divided among the categories of fixed income, equities, and alternative investments, and also, in which markets investments will be held (such as foreign, emerging, exempt market). There is no question that asset allocation has a larger effect on portfolio performance outcomes than any other factor, including stock picking. Most individuals do a bad job at asset allocation; when they feel the market is risky, they run to cash; when markets are good, they go all-in. Few recognize that the division of assets among stable income producers, more volatile growth producers and cash reserves is not only crucial, but that this division must be re-examined regularly based on the changing conditions in the market and as importantly, on the changing circumstances of the individual’s life.
Some firms, and some now rising in prominence, believe that asset allocation can be determined mechanistically, based on factors such as age, professed appetite for risk and so on. Some do this without human assistance, by way of a computer algorithm. In the interest of cutting costs, they reduce value to the investor. Asset allocation is, at least in our view, best done based on a full evaluation of the investor in the context of the market, and must be examined and reviewed at least annually. Individuals vary greatly in their need for income, their desire for security, their appetite for risk, their tax situation and their aspirations for growth. Moreover, all of these factors change over time, often in unpredictable ways. At the same time, the markets are in constant motion. Currencies and interest rates rise and fall, markets become more or less expensive and laws and government policies change continually. Only an actively involved human advisor can accommodate these changes and ensure that the asset allocation is optimal for each client at all times.
The third place in which an advisor adds value is in the crucial area of sector allocation and diversification. Most Canadian investors are aware that the TSX Index, against which the performance of most funds and most managed portfolios is judged, is profoundly flawed. It is an index completely dominated by only three sectors: Finance (34%), Energy (21%) and Materials (11%). It is very noticeably deficient in exposure to such vital areas as healthcare (4%) and technology (2%). Those who focused on cost alone prescribe the use of passive index-based products such as ETFs doom their followers to the highly volatile vagaries of the commodity price cycle and to the changing perceptions of the fortunes of Canada’s big six banks.
In contrast, the best portfolio managers are index agnostic. That this, they manage portfolios without regard to the components of the TSX Index. If they perceive little value in precious metals, they simply do not invest in that sector. If they believe that banks are a worthwhile holding but would constitute a huge overweight at 34% of a portfolio, they buy fewer bank stocks. In this way the portfolio manager can construct a portfolio with lower volatility, greater diversification, more exposure to important sectors under-represented in the TSX, and more consistent returns.
Finally, and most controversially, is the area of stock picking. Studies have repeatedly shown that very few, if any, managers can consistently pick stocks that “beat the market”. We do not disagree. However, it is crucial to understand that there are three closely inter-related areas when it comes to stock ownership: buying, selling, and monitoring during ownership. Each is equally important. Most individuals fall down particularly in the time-consuming and ideally emotionless activity of monitoring existing investments. Errors as simple as missing an important press release or as well-known as the fallacy of “falling in love with your stocks” can undermine what were, at inception, good investments. Selling raises its own problems, and few individuals have the discipline to trim over-weight positions when stocks rise, or ruthlessly cut losers when conditions demand it.
At portfolio management firms, monitoring is a full-time activity for a staff of professionals who read every press release, analyst’s report and piece of news from competitors. Few individuals have the time, talent or inclination to follow portfolios with this degree of rigour.
We cannot and will not speak for other firms in our industry, but we can examine the cost to benefit proposition for our investors. Over the past four years, Baskin Wealth Management has added major value for our investors.
Over these years, our clients have enjoyed annual and cumulative returns which dwarf their costs, and which are far higher than they would have achieved with almost any combination of ETFs.
We believe that we, as professional managers, add value. The numbers agree. So do our clients. In 2014 we had a client retention rate in excess of 99% (measured by value).
