Investing Wisely: Diversification and Picking the Right Fund

In Malta it’s common to know someone who’s had a bad experience investing in the stock market. As a result many of us have become averse to investing in anything other than real estate, government bonds or capital guaranteed products – investments deemed “safe”.

At first glance investing exclusively in bond and real estate holdings may seem prudent – but for many of us it’s not the way to go. An investment portfolio

lacking shares of good quality companies, with good earnings prospects, is a portfolio lacking the necessary diversification and “fire power” to assure good long-term investment returns. Nutritionists often tout the health benefits of eating a well-balanced diet. A diet full of proteins, with few carbohydrates, will leave you lethargic. All four of the major food groups play some part in sustaining us in a healthy and productive way.

The same can be said of an investment portfolio. A balanced portfolio including the four major asset classes – equity, bonds, real-estate and commodities – is to the investor what a well-balanced diet is to the competitive athlete: essential.

Just as the grain complex gives the body energy, owning a broad and diversified portfolio of equities over time will energise your portfolio towards solid returns. Few appreciate that equities are the best performing asset class historically. The S&P500 for example, a diversified index of 500 of the largest US stocks has returned about 10 per cent annually, solidly beating, bond, real-estate and commodity returns. A portfolio devoid of shares will underperform during periods of economic expansion and corporate earnings growth. An underperforming portfolio may keep you from fulfilling your retirement dreams.

Owning shares of companies implies having a right to a portion of the companies’ earnings; and of course as a company’s earnings grow, generally so too does the value of its shares. Many of us have gotten into trouble owning shares, not necessarily because we bought the wrong stock, but because we bought too much of it, relative to our net worth. Imagine Investor A and Investor B, both having an investment portfolio worth €10,000 and both buying XYZ Ltd. Let’s say, Investor A foolishly places all his cash into XYZ, yet Investor B puts just five per cent or €500 into it. Next day, XYZ announces very bad news and the stock plunges 50 per cent. Investor A anxiously loses half his account value, whereas Investor B calmly loses a meagre 2.5 per cent. Although both investors owned the same stock, Investor B mitigated the pain of the selloff by managing risk effectively, and not owning too much of it. It’s critical we manage the size of all our bets and invest in a portfolio of perhaps 10 to 20 stocks to diversify our holdings and spread out risk.

Risk management is by far the most essential element to successful investing! We often buy stocks at prices which already reflect good news – leaving them little impetus to rally further. Also we buy shares after significant rallies, instead of on dips as prices experience normal corrections. Warren Buffet, the legendary billionaire US investor, only buys good quality companies having a competitive advantage, which are priced at a significant discount to intrinsic or fair value. An analogy is to buy an excellent product on sale at a 50 per cent discount to its full price. Savvy investors always buy good companies on sale!

Investing in shares can be tricky if a disciplined approach to screening inexpensive companies with good earnings growth potential isn’t utilised. However, investing with a long-term horizon, managing the size of your bets and having a diversified portfolio should improve the odds of your success significantly.

Investing in Funds

When we invest in actively-managed funds few of us appreciate that less than 10-20 per cent of a fund manager’s annual performance beats the underlying index the manager tracks. This is not necessarily due to the managers’ competence, but is a function of the fees associated with actively managing a fund.

A majority of funds are actively managed, meaning the fund manager actively buys and sells stocks or bonds, attempting not only to generate profits, but to outperform an index and competitors. Although a portfolio manager is typically well trained, the rude reality is that few managers can consistently generate enough profits to overcome the expenses associated with managing a fund.

If you invest with an experienced low-cost fund, with a track record of managing risk effectively, you should be in a good position to benefit from investing in funds. As an example, imagine you invest in a fund which invests in large capitalisation US corporate shares. The fund manager will aim to either finish the year in line or preferably beat the index, which mirrors the fund he manages. If the underlying index finishes the year up 15 per cent, and the fund charges two per cent in total fees, the manager must on a gross basis return 17 per cent just to match the index. Besides a fund’s management fees, investors often have to pay a load (sales commissions), sometimes as high as five per cent, just to purchase such a fund.

Because so few funds can overcome the high expenses associated with active fund management, Wells Fargo Bank established the first index fund in 1971. The index fund concept today popularised by US fund manager Vanguard suggests that investing in low-cost passive funds is preferable to expensive actively-managed funds. Passive funds manage portfolios which significantly mimic the index they track, thus lowering the cost of managing assets. As a result, most index funds will post returns very close to the underlying index the fund tracks.

Most funds are created as open-ended funds with shares which are constantly bought or sold, usually at the day’s closing net asset value (NAV). A fund’s NAV measures the net worth or value of each share. Open-ended funds are continuously open to new investors, unlike closed-ended funds (CEF), which have a fixed number of outstanding shares. CEFs trade like shares on exchanges, and their value is set by the market. Sometimes their values deviate from the fund’s NAV and as a result could trade at significant premiums or discount. Investors should avoid buying CEFs trading at significant premiums to NAV.

CEFs, like their open-ended counterparts, could use leverage to magnify returns. It is also common for CEFs to make periodic distributions to shareholders, however, they may on occasion have high distribution yields as they could pay out part of their funds’ principal to meet their distribution goals.

Do the required due diligence prior to investing in funds. This includes scrutinising all fund fees and expenses. Also consider the funds’ age and size. A fund with a long track record is easier to analyse. Ensure the fund management company is well managed and regulated in a trusted domicile. Consider a fund not so large, whereby managing fund assets is too cumbersome, thus jeopardising returns. On the other hand smaller funds will have higher expense ratios. If you invest with an experienced low-cost fund, with a track record of managing risk effectively, you should be in a good position to benefit from investing in funds.

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