Brent Sheather: A word of advice for Larry Longshot

Photo / Richard Robinson

The email was from a prospective client. Part of his due diligence, after asking about fees, was what research we had on "quality stocks" listed on the NZ, Australian and world stockmarkets?

Reading between the lines "Larry Longshot" hoped that he, with the help of his adviser, could pick "quality stocks" from the 50 or so big ones in NZ, the 300 odd in Australia, the thousands listed globally and "beat the market".

Having been a stockbroker from 1984 to 2000 I had been down this road before and whilst I hadn't lost all my own or my clients money, over 15 years it gradually became obvious that neither relying on stockbroker research nor buying what got good press in the newspaper was a particularly profitable, let alone sensible, investment strategy.

Back then I read the newspapers enthusiastically seven days a week, got research from brokers in NZ, Australia and globally, had meetings with analysts and strategists and tried to get insider information from companies visited. An enormous amount of effort and in hindsight almost a total waste of time. The question is therefore am I an idiot or just in the wrong job?

I leave readers to reach their own conclusions but offer in defence a recent report from US fund management research group Lipper.

They found that over rolling 10 year periods less than 21 per cent of US fund managers were able to beat the stockmarket average. Think of all the resources the Fidelity's and Templeton's of this world have Bloomberg screens by the dozen, teams of analysts, company managers who are keen to talk to them and brokers who would kill for their business.

If anyone is going to get inside information these people are - but despite employing the brightest minds from Harvard, Stanford etc. to pick stocks, just buying the market then going to the beach wins out most of the time.

Lipper reports the same, uncomfortable facts for other stockmarkets in Europe only 35 per cent of fund managers outperformed, in emerging market only 25 per cent beat the average.

But if you think that's bad beating the bond market is even more difficult only 6 per cent of US bond fund managers beat the index over 10 years.

So what chance has our friend wanting to identify "quality stocks"? What will most likely happen is that Larry will buy six-eight stocks in NZ, maybe the same number in Australia and four or five in the US or UK.

They will probably be "defensive stocks" with high dividend yields because that's what's popular at present or maybe he will buy shares in Apple because they have done so well. Unless Mr Longshot is lucky it's likely to be a losing strategy financially but perhaps the worst thing about it is that it rejects diversification despite that being the No. 1 rule for successful investing.

A Harvard paper says to get the most out of diversification, the only free lunch there is, you need 50 stocks in each market. There are 300 odd big stocks in Australia how likely is it that the six Larry Longshot owns will be any better than the other 294? And if one of them goes bust or dramatically underperforms will the beneficiaries of Larry Longshot's trust sue the other trustees for reckless disregard of common sense?

It is now easy to "buy the market" so this sort of legal action is going to be more common. Indeed if I was a trustee of a family trust where an "ignore risk, hope for the best" strategy was employed I think I would get my own assets into a family trust quick smart. Anyway this leads us to the solution - exchange traded funds or ETF's.

In the past some retail investors argued with some validity that managed funds weren't a good option for them because whilst diversifying properly the annual fees were so high that managed funds frequently gave you the risk of shares with, after fees, the return of bank deposits. Well today that argument is no longer valid.

Today with the advent of ETFs we can for example buy the 300 biggest stocks in Australia for the same brokerage charge as buying BHP and an annual fee of around one fifth of one per cent.

So what are ETFs? They are just funds listed on the stock exchange which track a particular market, index or commodity. What differentiates them from normal managed funds is that they have ultra-low annual fees and there is no human intervention a computer does all the work.

Best thing about this is that the ETF in 99.9 per cent of cases tracks the index it follows very closely and of course in a good year the computer doesn't demand a performance fee. Many non-expert investors buy the stockmarket because they believe it does well. ETFs allow you to do just this without seeing hardly any of your return disappear in fees.

Perfect? Well almost.

ETFs are not the total answer because they rely on someone else to pay the fees to keep the market priced correctly. Think of the scenario whereby if everybody hitchhiked no one would own a car and hitchhiking wouldn't be a viable option.

For this reason it isn't fair to own a portfolio just made up of index funds. Everybody needs to pay the extra fees to active managers on some of their portfolios to ensure that the market is efficient. The average pension fund in USA seems to index about half of their equity portfolio.

So that's the solution? Have a good proportion of ETFs in your portfolio with some actively managed funds and maybe a few direct investments in NZ shares. Despite the obvious advantages of ETFs there are always going to be some people who either go to the wrong adviser or genuinely think they can beat the market. So best of luck to Larry Longshot and his cohorts.

However just in case things don't go as well as they hope, these investors should each year compare their total return performance in each market to an appropriate index - and don't be ashamed to admit defeat.

As Warren Buffett might well have said "the first step to investment success is to acknowledge your weaknesses".

If you are not an investment genius exchange traded funds are a more reliable alternative to luck and you get to spend more time at the beach.