I’ve alluded to different investment options, such as mutual funds or index funds. There are three options, so let’s consider them here.
1. Buying Individual Stocks
You can open a brokerage account and buy your own stocks, but as we know, stocks carry a lot of risks. Relative to options that aggregate many stocks, you are holding a lot of extra non-systemic risk without an offsetting reason to expect additional returns. Because individual company problems are unpredictable, individual stocks are a poor way of implementing an investment strategy. Moreover, this is a labor-intensive option, and it will require that you stay on top of the news for each company in which you are invested, and judiciously avoid the Investor’s Dilemma.
2. Actively Managed Funds
Another approach is buying actively managed funds, but the research says that active management does not work. The simple fact is that the vast majority of active managers underperform their benchmark, even though active funds are more expensive than the more passive options.
3. Indexing
Indexing is a third way to implement your strategy. Indexes are pegged to a specifically defined set of stocks. They require little management, and therefore the fees are lower relative to other options. But indexes have their own problems. If you choose a Sector Fund, which is limited to a particular market sector, such as technology, or even the S&P 500, you run an unsystematic risk due to insufficient diversification. Remember, from 1966–1982, the return on Large U.S. Stocks after inflation was zero. One of the best ways to keep your costs extremely low is simply to cap-weight a portfolio to large companies, because it requires no effort whatsoever.
Size-Based Indices
If you choose a capitalization-based index, such as the S&P 500, you may be diversified in terms of market sectors, but you are missing out on potential gains from smaller or Value companies.
Sector Funds
Sector fund-investing refers to using an index pegged to the performance of companies in a particular market sector, such technology, or oil, or mining. This involves betting on market sectors and is one of the riskiest investment strategies due to the lack of diversification. If you own only a handful of stocks in a sector that is decimated, your investment could be wiped out (think of what happened to horse-drawn-carriage makers after the advent of the automobile).
As economists have shown, it is safer to diversify across sectors and sizes to ensure you have a healthy mix of investment classes with a low or negative correlation. That way, there will always be some investments that will do well and offset the impact of those that perform poorly.
Reconstitution
Another issue with indexing is reconstitution. The S&P 500 is an index of the 500 largest U.S. companies. What happens when some of these companies are removed from the index? Everybody who runs an index fund must sell those companies within a short period of time and buy the companies that have edged their way into the top 500. Hedge fund managers take advantage of this, buying up potential contenders to the top 500 before they make the cut, and selling the shares at a higher price when there is increased demand from index funds. The index is essentially forced to buy high by its own rules.
4. Institutional Mutual Funds
The fourth way of implementing your strategy is the one we use at Rosen Investment Management: pure asset class funds, or institutional funds. As we know, mutual funds represent the simplest way to diversify broadly. Many mutual hold over 10,000 different stocks. But not all mutual funds are created equal. A brokerage creates identical twin funds; one is marketed to the public (the “retail fund”) and the other is marketed to “institutional investors” (e.g., rich people or other funds). The goal is to keep the small investor out of institutional funds because small investors tend to panic and pull their money out more frequently (and usually at just the wrong time), which generates a high turnover and transaction costs.