Own Investments Directly

The barbell investing strategy, or “core and explore”, works to reinforce the asymetric return expectations that we discussed earlier and it controls some of the costs of active investing. Today, we look at the reasons to own investments directly, some of which are similar. Directly holding equity and fixed-income investments improves transparency and accountability, while reducing costs and risk.

When investing, there is no shortage of people willing to help and become involved in the process. To be clear, I am not focused on advice. In my opinion, advice is valuable and co-exists with the actual investment process. When a person invests their capital, they can either directly purchase stocks, bonds, real estate, etc., or they can buy through middle-men or derivatives. Derivatives, in my mind, are things like options and futures, but also equity-linked GICs and principal protected notes. Any “synthetic” investment that derives its value from another investment can be considered a derivative and it removed by one step the investor from their investment. A middle-man might be a stock broker, but I intend to consider pools of money such as mutual funds and hedge funds, where the target investments are owned within a structure that obscures granular control and reporting.

Derivatives have two problems that potential investors should be aware of. First, they constitute a form of leverage, which increases risk. This is true in the case of options, where a nominal amount of money can be committed to control a proportionately large number of shares. The change in value of the underlying shares influences the value of the options, magnified. But there is also path dependency to beware. This means that the sequence of returns influences the final value, something that’s not true for “long” stock or bond investments. This can be seen particularly clearly with inverse ETFs. Their daily performance is the opposite of the index they track, but over a longer period of time, there will be a divergence between the index level and the inverse ETF value, with a possibility that both lose money.

Mutual funds have been the subject of increased discussion recently over the fees and costs they contain. Without entering into this particular debate, the costs of a mutual fund are a constant drag on performance that doesn’t necessarily exist in a stock or bond portfolio where the investments are owned directly. If the mutual fund’s net performance outpaces the market, the extra cost is unimportant, but it could cause the fund to lag in performance. On the other hand, it’s possible that an investor who isn’t comfortable choosing their own investments might have better performance hiring a professional money manager, whether via a mutual fund or owning the investments directly, with similar costs in either case. An additional benefit, then, of owning the investments directly is the additional accountability. Mutual funds announce their holdings two or four times a year, at which point it is possible to tell (assuming low turnover in the fund) that the manager remains consistent with their stated strategy. Direct investment holdings, by contrast, are visible at any time, to see that the strategy continues to be executed as agreed.

Hedge funds combine the worst of all the drawbacks mentioned above. That’s not to say hedge funds cannot be a good investment. They are much less robust, however. First, they are able to make use of leverage and derivatives to execute their strategy. Second, they impose additional costs, usually “two and twenty”, meaning a flat 2% per year plus 20% of returns in excess of a benchmark. If the manager wants to maximise their fees, they could even select a benchmark that’s easy to beat, such as 10 year T-bills. Finally, there are reduced reporting requirements, meaning that an investor may never know what investments are owned within the hedge fund and may be unable to assess whether or not the manager remains consistent in executing their strategy.

Whether an investor makes their own investment choices or hires a professional money manager, it is more robust to own the underlying investments directly. It usually costs less when a large (eg. mutual fund) company is not involved in bundling the underlying investment. It also yields more granular control in the case of buying or selling a position. The investor is able to maintain a better understanding of which investments are held and how they are each contributing to the overall performance of the portfolio. The improved visibility also makes it easier for a professional manager to be accountable for remaining consistent in their strategy.


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