Funds vs Individual Securities: Part 3 - Performance

Intro:

This week we are wrapping up a three-part series highlighting why Narwhal prefers investing in individual securities over mutual funds and ETFs. This series started with a post focused on the tax flexibility that buying individual securities affords investors. That original post laid out the potential dangers of the embedded gains that come with buying and holding funds over a long period of time and how individual security selection can combat that. Click this link if you would like to learn more about this topic. The second post in the series highlighted the cost difference of holding individual securities compared to funds. This post discussed the fees that are typically associated with investing in funds, where they are hidden and how they can quickly add up within a portfolio. Click this link for access to the post on this topic.

In the final installment of this series, we will explore the third factor that leads Narwhal to favor individual security investing; that is, the conviction that individual security selection can provide superior investment performance. Something important to remember as we dig into this topic is that our view of performance isn’t our attempt to say we are right and everyone that thinks differently is wrong. Rather, our goal is to convey that we are convicted in our methodology and believe strongly in the results that our process produces.

Putting performance in context:

Before digging into Narwhal’s conviction on this topic, it is important to set the stage by discussing the concept of investment performance. Investment performance is ultimately what we all strive for in investing. Its easy to measure, but more difficult to judge. How does an investor determine what should be considered quality investment performance? There’s no way to judge performance quality by looking at standalone data. In order for performance data to matter, it must be given context, and finding the correct supporting data to provide context can be tricky. Luckily, benchmarks are available to help investors make conclusions about the performance of an asset.

What is a benchmark?

A benchmark is a standard that an investment’s performance is measured against. Benchmarks act as barometers, providing context for investors and allowing them to make inferences about the returns they are generating on specific assets. Some commonly used benchmarks are the S&P 500, the DOW, and the Barclays Agg bond index, but the benchmarking options are endless. With an appropriate benchmark, one could confidently make a judgement on the quality of the performance of an investment. It should be noted that slapping any old benchmark next to an investment can be a dangerous game and won’t offer the investor much insight. A benchmark is only effective if it accurately represents the investment it is being measured against.

Does your benchmark make sense?

There are a number of factors that influence how fitting a potential benchmark is when comparing it to an investment. Factors such as the asset class of the investment, whether the investment is US based or international, whether the investment is considered a growth or a value investment; the list goes on and can become very granular. The goal in examining these characteristics is to determine whether or not the benchmark in question and the investment needing to be measured have matching risk profiles. This alignment of risk profiles will ultimately determine the validity of a benchmark. If you want to gauge the performance of a portfolio that is entirely invested in bonds, comparing those investment returns to that of the S&P 500 would not provide you with any helpful context, being that the S&P is comprised of stocks, which have a completely different risk profile compared to a bond portfolio. Instead, benchmarking that bond portfolio against the Barclays Agg Bond Index would provide the investor with a much more appropriate measuring stick. A benchmark might not ever be a perfect fit, but its risk profile should align closely with the investment. This concept is a great talking point with a current or potential financial advisor. Asking what benchmark the advisor uses and why they use it can help ensure that it is an appropriate measuring stick to draw sound conclusions about the quality of your investment’s performance.

How do different fund types perform?

Throughout this series we have focused on two of the most common types of funds held by investors: mutual funds and exchange traded funds (ETFs). In general, ETFs are passively managed funds that most often track an underlying index, while mutual funds are typically actively managed with the goal of outperformance (this isn’t true for all mutual funds and ETFs, but it usually the way these fund types operate). Because of these different fund management approaches, investors should anticipate different performance resulting from the ownership of each fund type. A passive ETF will always provide returns in line with the benchmark it is tracking. By design, this type of investment eliminates the opportunity for investors to achieve market beating returns. Actively managed mutual fund should (in theory) perform differently than the indexes used as benchmarks because of the active management strategy implemented by the fund managers. These active funds are often the place that individuals looking for outperformance prefer to invest.

So why do individual securities make a difference?

As discussed in the introduction, Narwhal is convicted that a strategy of individual security selection can result in better performance when compared to a fund strategy. Narwhal’s rationale behind this belief is multifaceted and is unique depending on the asset being discussed. Let’s look first at the benefits, through the lens of performance, that an investor could realize when picking individual equities over funds.

Conviction in individual equity selection:

Understanding your investment

Our first argument in favor of buying individual stocks can be summarized by the mantra “you should own companies that you know and understand.” This philosophy is widely appreciated throughout the world of investing and is something we advocate for. We believe that it is much more realistic follow this approach by buying individual stocks in place of ETFs and Mutual funds. With individual stock selection, the investor has the opportunity to deeply examine the fundamentals of each company to determine whether or not they are confident in the direction of the underlying business. This is much more difficult to do when holding a fund. Take SPY - the most widely held ETF - for example. This ETF tracks the S&P 500, which is a collection of the 500 largest US companies. There is no way to expect an investor to have a good understanding of the underlying business of 500 companies with any level of detail; there are just too many companies to keep track of. Consider Roper Technologies (ROP). I’m sure I’m not the only one that has never heard of this company before. Surprisingly, however, Roper Technologies makes up .13% of the S&P, which is in line with Twitter’s market weighting. By holding an ETF like SPY, you are holding a collection of companies, some of which you know well, and some (like Roper Tech) that are a complete mystery. By investing without a firm grasp of what each business does or how they operate, you are, in essence, investing blind. With individual security selection, that issue doesn’t arise.

Position size customization

The next advantage of holding individual stocks over funds is the fluidity that this method affords investors. When investing in a fund, you own the investments that the fund holds, in the position sizes that the fund holds them. There isn’t much room for creativity and flexibility. In a portfolio of individual securities, managers have the opportunity to build out a lineup of investments that reflects their current convictions. One of the ways Narwhal demonstrates conviction in a specific investment opportunity is by increasing the size of the holding relative to the other investments in a portfolio. Disney currently makes up just under 1% of the S&P 500. If someone were to buy a full portfolio of SPY, they would hold about a 1% position in Disney. If a portfolio manager at Narwhal believed that Disney was undervalued, they could demonstrate their conviction by owning the company as a larger proportion of the portfolio than the market does, say a 2% position, giving them an opportunity to earn outsized returns. The more convicted a portfolio manager is, the larger they could increase that position size.

Risk adjustment

Risk isn’t something that should be equally applied to everyone. Some investors can tolerate more while some should be less exposed to risky investments. The flexibility of individual stock portfolios allows the investor to tailor risk to levels that are appropriate. If there is a position in a portfolio that Narwhal becomes less confident in or wants to avoid for certain clients because of the unwanted risk, exposure to the stock can be reduced by shrinking the position or removing it from the portfolio all together. Tesla is a great way to demonstrate the benefits of this principle. Tesla is an extremely volatile company that is disproportionately exposed to headline risk thanks in large part to their CEO Elon Musk. The stock tends to swing up and down much more wildly than many others. Many investors would be better suited to not take on that much uncertainty. The interesting thing is, Tesla is the 8th largest company by weight in the S&P. By owning a popular index like SPY (1.3% exposed to Tesla) or the popular NASDAQ tracking fund, QQQ (3.66% exposed to Tesla), you are placing large bets on Tesla by default. So, whether you want to hold the company or not, you are stuck with them if you hold a fund that tracks the broader market. Unlike a fund approach, by building out a portfolio of individual securities, you have the ability to increase or decrease your exposure to any company, at the rate you desire, allowing for a much more customized approach to investing.

Conviction in individual bond selection:

Many of the benefits that were discussed above regarding individual stock selection apply to the selection of individual bonds as well. There is a level of flexibility and creativity that holders of individual bonds have that is not available to holders of bond funds. Additionally, there are other factors that make individual bonds uniquely attractive. As you probably know, nothing is ever straight forward when it comes to bonds. These aspects that are bond specific are a little more technical, so if you find that none of what follows makes sense, you’re not alone.

Increased autonomy

One of the main benefits of owning a portfolio of individual bonds is the autonomy that this strategy gives the investor. By holding individual bonds, the investor has the control to sell out of (or add to) particular positions when it is in their best interest. This is an important factor when considering bond investments because of the characteristics of these securities. Bond prices fluctuate over their lifetime based on changes in interest rates, but one can anticipate that prices will normalize as a bond gets closer to maturity (when the bond will be repaid at face value). These fluctuations don’t impact an investor unless the investor is forced to sell out of a position before they would like. Knowing this, bond holders can tolerate short-term swings in prices because of the assurance of the value at maturity. Those invested in funds do not have the same luxury. The structure of a fund is such that, each time an investor buys or sells a share, action needs to be taken by the fund manager to satisfy that request. If an investor decides to sell shares of a fund, the fund manager must sell some of the underlying bonds held in the fund to raise the money to repay the investor. This action is required whether the timing of the sale is favorable for the fund or not, meaning that the decision made by a random investor could force the fund manager to sell bonds at an inopportune time. This has implications for other investors within the fund. If enough investors made poorly timed exits out of a fund, the value of the fund itself could begin to erode, reducing the value of the fund for all shareholders involved. The same is true for investors who enter into a fund at a poor time. If bond prices are inflated, but an investor decides to enter a fund, the fund manager is forced to buy bonds at those elevated prices. Both scenarios are out of the control of fellow investors, but both can reduce the value of their investment. This lack of autonomy is a risk that owners of individual bonds are not faced with and is a big advantage for those who choose to implement this strategy.

Defined maturity

Narwhal believes that the defined maturity that individual bonds provide investors is a huge advantage compared to the undefined maturity that characterizes most bond funds. Structurally speaking, as a bond approaches maturity it becomes less exposed to interest rate risk. The level of impact that a change in interest rates has on the price of a bond (aka the bond’s duration) decreases as it approaches maturity. For this reason, you could design a bond portfolio with a clear view of when each bond will mature in order to determine the risk those investments present in the event that interest rates change. Funds, on the other hand, do not typically offer this same clarity. Fund managers often try and maintain a constant level of duration throughout the life of the fund which never reduces the interest rate risk profile of the investment.

Odd lots

Another benefit that investors of individual bonds experience is the opportunity to buy odd lot bonds. Typically, bonds are traded in round lots worth $100,000 (100 bonds valued at $1,000 each). Bond offerings that are smaller than round lots are referred to as “odd lots.” These odd lots create an interesting opportunity for individual bond investors. Because of their small size, odd lots are not sought out by institutional investors, simply on the principle of scale. Funds that are building out billion-dollar bond portfolios don’t want to waste their time conducting diligence on a bond offering that won’t make up a material amount of their product. This reality drastically reduces the amount of coverage that odd lot offerings receive resulting in some good quality bonds slipping through the cracks. This scenario creates tremendous opportunity for individual bond investors to add desirable, and materially impactful pieces to their portfolio. This is not to say that all odd lot offerings are high quality, but for the investors that have the time and ability to turn over rocks, they can find high quality bonds that aren’t in as high of demand.

Conclusion:

As we wrap up this series, I want to emphasize again that our goal in writing these posts was not to say that anyone that sees value in holding funds is incorrect. While we understand the arguments that advocates would make for choosing a fund strategy, we believe that the combination of potential benefits that can be achieved through individual security selection give us more than enough conviction to implement this strategy for our clients. We believe that individual security selection can keep a portfolio from becoming unnecessarily burdened by huge embedded taxes over time. From a cost perspective, we think individual security selection is much more affordable and transparent compared to a fund strategy. And finally, for the reasons mentioned above, we think those who invest correctly in individual securities have unique opportunities that can result in better performance. Each of these factors alone creates a compelling argument to invest using an individual security strategy, but, when considered in conjunction, the combination can make a meaningful impact on the success of a portfolio.