The 10 Most Important Investment Management Decisions You Can Make
Consciously or not, all investors make a decision on the ten investment management choices. Of course, sometimes it’s by default when they hire an adviser to decide for them. Unfortunately, we find investors are almost always on the wrong side of each decision; the side on which they are most disadvantaged.
There are two main reasons for this:
- They get conflicted advice from agents (such as those who work for banks) or brokers (such as those who work for investment managers), and not from fiduciaries (who work solely for their clients);
- The ever present demon of investing – what feels right rarely is.
Take a look at the 10 decisions below.
What decision have you made with regard to each one? Did you even make a decision, or did you just end up at an answer unwittingly?
For a complementary portfolio analysis please contact Bradley Nuttall. We’ll be happy to help you analyse your investment management decisions.
Investment Management Decision 1: Academics vs. Investment Managers
Around the world, thousands of academics publish in peer reviewed journals, testing and re-testing various investment management claims and theories. Most academics have one overarching goal – to determine how investors can make good decisions. While academics are not perfect, they are not in the business of creating products, and are often in the position of questioning standard investment schemes to determine whether or not the data indicates that such schemes have merit. Investment managers, such as brokerages, are like grocery stores – if you want organic vegetables, they’ve got that. If you want potato chips and beer, they’ve got that too. In fact, they prefer to sell you the investing equivalent of potato chips and beer because they make more money that way.
So what does it mean to choose “Academics” over “Investment Managers”? Essentially, this; you pay attention to the conclusions of academic research and invest accordingly. Each one of the decisions that follow has been studied by academics. We present their findings where possible, to help guide you in making your decision.
Investment Management Decision 2: Funds vs. Individual Securities
Many New Zealanders, especially accountants, have a negative opinion of managed funds. This is largely due to that fact that they are expensive and once tax inefficient. Fair point, we’d say. However, new laws make managed funds far more tax efficient and many managed funds (probably just not the ones you’ve heard of) are very low cost.
Managed funds have one huge advantage over individual securities – diversification. By purchasing ten or so funds, my firm – Bradley Nuttall – is able to diversify into approximately 8,000 underlying investments. We have access to hard-to-purchase asset classes such as Emerging Markets small companies and value companies, as well as International Real Estate. We have access to securities of 45 different countries and many companies you’ve never heard of, all at a very low cost. When buying individual securities, investors concentrate their portfolios into a few positions. They often unwittingly take huge risks with no additional expected payoff.
There is a large volume of evidence that picking shares overall does not pay. Professors Brad Barber and Terrance Odean noted in the Journal of Finance that individual investors who hold common shares directly pay a tremendous performance penalty. They tested 66,465 households with accounts at large discount brokerage houses during the boom period of 1991 to 1996. Those that traded the most earned an annual return of 11.4%, compared to market returns of 17.9%.
Here’s another way of thinking about it. By 1996, an investor in the market portfolio had about 40% more wealth, even after accounting for the costs of owning the market fund.
These results are so shocking that it prompted study author Terrance Odean to say “Individuals aren’t as bad at picking stocks as many people think. They’re worse.”
This underperformance is especially sad because it’s avoidable. The market portfolio was easily available via a very low cost fund without any of the attendant worry that goes with selecting individual shares.
Investment Management Decision 3: Passively Managed Funds vs. Actively Managed Funds
Actively Managed Funds attempt to beat markets, and are generally expensive. Passively Managed Funds accept the returns of markets and are generally inexpensive. If you decided to trust academics rather than investment houses, you would have a lot of help making this decision. Academics have had a field day investigating the claims of investment houses about the superior quality of their actively managed funds. Their near unanimous conclusion? Passive beats active. The vast majority of actively managed funds do not beat their benchmarks. Worse however, is that those that do, repeat that performance less frequently than chance alone would predict. When investing in low-cost passive funds you can nearly guarantee that, over long time periods, you will beat 75% of the active funds in the same asset class, available at the time of your original investment.
Investment Management Decision 4: Low Turnover vs. High Turnover
Turnover is a term that describes how often a fund buys and sells in their portfolio. The reason it’s important is that buying and selling isn’t free. Each time a managed fund buys and sells, it typically incurs brokerage costs, liquidity costs, and research costs.
But aren’t these costs necessary if a fund tries to beat the benchmark?
Yes, however academic research published in the Journal of Indexes shows that funds with high turnover have lower returns. We show the results of the study below. Note that 100% turnover implies that the average holding period of an investment in the fund is one year. If, for example, a managed fund held investments on average for six months, the turnover would be 200%. If the average was three months, turnover would be 400%.
The conclusion is obvious; funds with low turnover are a better investment.
Investment Management Decision 5: Low Expenses vs. High Expenses
Academic research has proven that the most meaningful variable in determining the future performance of an investment portfolio, is expenses. Nothing matters more. Morningstar Director of Mutual Fund Research, Russel Kinnel, observed: “In every single time period and data point tested, low-cost funds beat high-cost funds.”
We estimate that the typical investor working with a bank or share broker pays about 3%, in all-in-fees. Disclosure of fees is often buried in the fine print, inadequately explained, and not even understood by most investors. All-in-fees of 3% are too common and far too high. If investors can lower their fees by even half a percent, they will dramatically increase their returns, thanks to the value of compounding.
Below we compare the management expense ratio (MER) of the average New Zealand managed fund, KiwiSaver Funds, and the low-cost funds used by Bradley Nuttall:
Investment Management Decision 6: Large Cap only vs. Large Cap and Small Cap
Many New Zealand investors simply invest in the companies with whom they are familiar. This includes big names like Sky TV, Fletcher Building, and Auckland Airport. What they don’t realise is that academic evidence proves that these large companies should, on average, have lower returns than the smaller listed companies you’re less familiar with. Why? Simply because the smaller shares are riskier. In order to induce investors to own them, they must offer the chance of higher returns.
Below, we show some evidence of this in New Zealand. We compare the return of the large cap dominated NZSX Index, with a similar index fund that holds a higher percentage in smaller New Zealand listed shares:
Investment Management Decision 7: Growth vs. Growth and Value
Academics segment shares into two broad categories. They call the first category “Growth”, because these shares are expensive on the premise that they have excellent growth prospects. They call the second group “Value” because these shares are inexpensive, meaning they potentially represent better value. Growth firms are the ones you’ve probably heard of – BHP, Apple, and Fletcher Building. Because investors have heard of these companies, they are comfortable owning them in their portfolios. “Growth” also includes small companies that have little current revenue, but from which investors expect big things. These include the technology shares that were all the rage in the late 1990s.
Eighty years of evidence shows that, when held as a group and over long periods of time, “Value” shares have higher returns than “Growth” shares. People debate why, but it is robust and repeatable across nearly all international markets. We show the evidence below:
We recommend investors hold both Growth and Value companies for diversification’s sake, but tilt towards Value.
Investment Management Decision 8: New Zealand only vs. New Zealand and International
New Zealand investors, like those all over the world, overweight their portfolio with domestic investments. We do this for several reasons; domestic investments feel safer (although this is often a great fallacy), domestic investments are more readily available than international investments (especially if working with a broker that underwrites new domestic issues), and domestic investments do have a tax advantage.
Nevertheless, the evidence is potent that owning international investments does two amazing things. Firstly, it lowers risk and secondly, it increases returns.
Below, we compare the returns of a classic New Zealand only 50/50 Equity & Cash portfolio, to a similar portfolio that’s diversified internationally:
The domestic and international portfolio has both higher returns even after accounting for the underlying management expense ratios and, although not shown above, lower volatility.
Investment Management Decision 9: Unhedged vs. Hedged and Unhedged
When holding international fixed-income and equities you can choose to hedge the currency risk. What does it mean to hedge the currency risk? It means you make a decision that you want your investments, whether domestic or international, to be denominated in NZ Dollars. By hedging your international investments to New Zealand dollars, you receive higher returns. The reason is that the NZ Dollar is considered riskier and more volatile than other major currencies, such as the Pound and US Dollar; as a result, our interest rates are much higher in New Zealand than in America or the UK. By hedging to New Zealand Dollars, investors pick up this higher rate. Essentially, investors trade in the interest rates overseas for the interest rates in New Zealand with the knowledge that ours are higher. However by hedging, investors are subject to more volatility in their portfolios.
Below we show the returns of the MSCI both hedged to Australian dollars and unhedged. Note: we use Australian dollars because longer-term data is more readily available. We expect that hedging to New Zealand dollars produced similar results.
Does this mean that a speculator who happened to guess exchange rate movements couldn’t have made a killing determining when to hedge and when to go unhedged? No, but exchange rates are notoriously difficult to forecast and speculating incorrectly is just as likely as speculating correctly. We’d advocate not speculating at all in your portfolio and strategically picking up the hedging premium as a long-term decision, where available.
Unfortunately hedging is not available for all overseas managed funds (such as those that invest in Australia and Emerging Markets). Nevertheless, the returns on cash in those countries are more similar to New Zealand than in the US, UK, Europe, and Japan for which hedging is available.
Investment Management Decision 10: Invest Methodically vs. Invest When You Feel Like it
Investing methodically means that you invest when you have money, either with a scheme such as KiwiSaver, or when you receive sudden money, such as an inheritance. Likewise, you withdraw money when you need it to pay for expenses.
Put even more simply:
- Invest when you have money
- Sell when you need money
At odds with this are investors that invest when they feel like it. Unfortunately, the two most powerful emotions that compel investors to act are fear and greed, and they work against you. Greed occurs when the market’s gone up considerably and you pile in money hoping for more of the same. It also occurs when all your friends tell you about their big gains and you feel like you’re missing out. Fear occurs after the market has gone down and you feel more big losses are on the way.
In other words, greed makes you buy at the top and fear makes you sell at the bottom. This is obviously an awful way to invest.
We illustrate this tendency below.
In fact, investors should almost always count on the fact that their emotions are much more likely to work against them than for them. They are better to set up methodical decisions in advance, that will occur irrespective of market movements.
One final important investment management decision… Do it yourself, or use an adviser?
This might be the most important decision of all and it’s an individual one. If investing is easy, why do so many people do it wrong? It’s not from lack of trying. The spirit is willing, the math is not that hard, and the research is readily available. Yet evidence shows that even the world’s largest pension funds can’t get this right.
The job of a great adviser is not to find you the returns that will beat the market. The job of a great adviser is to make you a great investor. That means ensuring you get the returns of the market at risks you are willing bear, and that those risks are adequate for you to reach your goals and dreams. It’s the adviser’s job to help you determine your goals and to develop a clear and transparent strategy to allow you to reach them. A great adviser is there to hold you back in moments when you don’t perceive all the risks, and there to encourage you when you don’t perceive all the benefits.
Here’s the caveat. You must work with an adviser that is 100% on your side. This means your adviser should never take any revenue from the investments they recommend. Sales agents that represent products and brokers that are paid by the products they recommend are not fiduciaries, and arguably not on your side.
A real fiduciary will ensure that your relationship is never conflicted, will be fully disclosed and transparent. Finding such an adviser will increase your chance of reaching your goals and provide you tremendous peace of mind.
Want an independent review of your investment management strategy?
Contact us and we’ll put you in touch with one of our expert fiduciary advisers.
By Ben Brinkerhoff
Ben is head of Partner Growth at Consilium.
Find out more about Bradley Nuttall’s Wealth Management and Investment Management.
A disclosure statement is available on request free of charge.
Barber and Odean, Trading is Hazardous To Your Wealth, The Journal of Finance • VOL. LV, NO. 2 • APRIL 2000
“The Pre-Tax Costs Of Portfolio Turnover”, By David Blanchett http://www.indexuniverse.com/publications/journalofindexes/joi-articles/2623.html
(Russel Kinnel. “Fund Spy—How Fund Expense Ratios and Star Ratings Predict Success” Morningstar, August 9, 2010)
“Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors,” Financial Analysts Journal, Nov/Dec 2009, Stewart, Neumann, Knittel, and Heisler