Equities - Implementation Pointers, Part I

While implementing a portfolio, an investor is faced with a variety of choices, whether to invest actively or passively and whether to go solo or delegate the task to a financial advisor. Lets discuss these choices in more detail:

Active vs Passive: Active investing refers to forming an opinion about the fair value of a stock and taking decision accordingly i.e. buy the undervalued & sell (often sell-short) the overvalued stock in anticipation of an increase/decrease in its market value. Passive investing is the by-product of the academic school of thought (a.k.a. The efficient market hypothesis, EMH) which belives the marketplace is full of smart players who quickly react to any new information about a security and their actions (i.e. buy/sell activities) gets reflected in its price. e.g. If too many people are bullish about the prospects of Google their buying would drive its price higher. Also if too many investors are bearish about GM or AIG, their selling (or lack of buying them) would get reflected in its lower price. So at any given time the market value will most likely reflect the fair price of a security and investors should just buy the overall market (as represented by an index fund) to accrue the core benefits (inflation protection & real growth in savings) of equities investing.

In some ways the debate between active & passive investing routinely takes the form of the political debate between democrat & republican supporters in USA. It is easy to understand the advantages & disadvantages of both approaches in their raw form but most investors end up taking sides much to their own peril. The active side routinely trashes EMH as non-sense citing wild fluctuations in market-price as a proof that stocks hardly trade at fair-value as suggested by the EMH. They also offer the specious but easily acceptable argument that owning a passive index fund would only fetch average returns as the investor would end up owning both the good as well as the bad securities. The passive side which rose to prominence by correctly pointing that only a handful of professional investors have managed to successfully beat an index fund over a long period of time but then go on to equate even truely successful investors like Mr. Buffett & Mr. Lynch to Oragutans (type of apes) and attribute their success mostly to luck. I think a good way for readers to get an understanding of this Active vs. Passive debate is to read a little known book named 'Investment Gurus' by Peter Tanous. This 1996 book features detailed interviews with top active proponents (those who generated exceptional returns over the 10 year interval from 1985-95. These include the likes of Peter Lynch, Michael Price, Mario Gabelli, etc.), the top passive investing proponents (Eugene Fama, William Sharpe, Rex Sinquefield, Merton Miller, etc.) as well as the ones in the middle like the hedge fund manager D. E. Shaw who acknowledges that the markets are largely efficient but there are some small cracks which can be taken advantage off. A good thing about reading a slightly dated book is the ability to see how things turned out afterwards. Most of the hot-shot active managers featured in the book are no longer considered superstars (baring Mr. Lynch & Price both of whom have long been retired and their funds haven't performed admirably thereafter). One fellow John Ballen was even barred from the industry for the mutual fund market timing scandal and the funds run by few others are no longer in existence because of poor performance! As for the passive investing folks, we all know of the two epic US stock market booms & busts that have followed since 1997 so anyone who invested with the blind faith that markets are always priced efficiently paid dearly. Even the ones in the middle like D. E. Shaw whose firm prided itself in hiring only the very best Phd candidates & using sophisticated computing resources to find those tiny cracks in the efficient market encountered some lean years. So what are the key takeways for a Sensible Investor from this Active Vs. Passive debate? One can really hit a jackpot by investing alongside a highly successful active manager (e.g. Warren Buffett, Peter Lynch, Michael Price, Seth Klarman, etc.) or by picking a winning stock (Abbott Laboratories, Walmart, Reliance Industries, Infosys, etc.) over a long term. Even a mere 2% point difference (10% vs. 8% annual return) over a 20 year period will translate into 44% higher wealth. However for an average investor the problem lies in successfully picking the active manager or a group of winning stocks that will generate such an outperformance over the next 20 years. The probability is so low that it is equivalent to finding a needle in a haystack. So primarily from this perspective, it makes sense to bet on a group of index funds (spanning across different market capitalizations and geographies) to come out ahead of a vast majority of accomplished active investors and generate higher returns (or less risk for the same level of returns) through other means (diversification, rebalancing, dollar cost averaging, etc.) which we will discuss later. If you still end up choosing an active manager or an active investing approach (because of limited fund options in your retirement plan or picking stocks gives you that warm & fuzzy feeling) then try to limit this exposure to a maximum of 20-30% of your portfolio. As far as picking a winning fund goes, I don't have a fool-proof receipe but picking a fund with following characteristics in the order mentioned might help: low portfolio turnover (< 25% per year), longer portfolio manager tenure (5+ years), reasonable size (not too big depending on market cap), reputation of mutual fund house and your liking of manager's portfolio/investment philosophy. Picking a winning stock is a vastly different ballgame which I will address once we are done discussing the concepts of all asset classess & portfolio management topics. In the next post I will address the other implementation issues pertaining to equities.