Investing is for many people a very difficult and exhaustive task under normal circumstances. If we add one more component, such as the current crisis because of COVID19, the decision might seem even more challenging.
Crises like this one bring uncertainty, confusion and lack of confidence in the stock market. As discussed in one of our blogs from last week, the storm will pass. In the end, Governments, Central Banks, and Corporations will find a way to succeed. The real question here is how long will it take for a business to recover from this crisis. Unlike previous crises, where there was a slowdown in the pace of economic activity, this time Governments were telling small, medium enterprises and big companies to suspend operations.
If we assume that business will resume, then we can focus on the next question when it comes to investing: how can I access the financial market?
There are three ways you can find to invest in stocks:
- Mutual Funds (Active Management)
- ETFs (Passive Management)
- Stock Picking
Mutual Funds (Active Managers): When choosing a mutual fund you are delegating the job to a manager to buy and sell stocks for you. The number of holdings (companies) in the fund may vary from fund to fund. However, on average you can find between 30-50 names on the portfolio.
As we discussed last week, the strategy of each manager also varies. You can see managers that focus for example in US stocks, with a specific market size (small, mid. large-caps), a specific sector (technology, healthcare, telecom, utilities, materials) and sometimes specific risk. Each of these managers work with analysts to have a more in-depth analysis of the companies they invest, understanding all the underlying forces and variables that determine their fair value. Some assumptions might change with time and managers want to exit or reduce their position in a specific company.
Each fund has internal rules for each investment: for example, the maximum weight of a specific holding can not exceed 5% of the total portfolio, or at least 95% of the holdings must be within the USA, etc.
In terms of costs, sometimes you would have to pay for an upfront fee and the regular fee that could be on average between 1% and 1.50%. You will find funds that reinvest the dividends or other that will give them to you.
ETFs (Passive Managers): An investment vehicle that replicates the composition of a specific index. For example, If you would like to buy the companies that are part of the 500 most representative companies in the US (S&P 500), one of the ETFs (Exchange Traded Funds) that follows this index is the SPY (ticker name in trading platforms). It means that it is a computer mirroring the composition of an index, it is an automated process leaving aside human interaction. ETFs are usually replicating indexes based on market capitalization.
Technological advances have helped ETFs to narrow the options and determine more restrictions or rules to find the top stocks in that specific universe. Now, we have what is known as SMART beta ETFs, which incorporate different features such as dividend yield, momentum, volatility, earnings, EBITDA. Some of them are even hedging the currency in case you want to invest in another region (i.e. Europe or Japan).
As in the case of mutual funds, you can find a wide range of ETFs depending on the region, sector or size.
The cost (management fee) associated with this type of vehicle might vary between 0.40% and 0.80%.
Stock Picking: You can enter the market by purchasing stocks in a specific company. Simple as that.
What is the best strategy?
The answer to this question might be the one with the highest number of documents, research, and papers across the universe of investment; some supporting the active management and some others supporting the active managers.
I won’t bring to discussion the stock-picking as I consider this option to be good for people with an understanding of finance or people passionate enough with a company to have some portion of their investments in a specific company. Let’s consider different aspects:
Performance: Many managers will argue that they are in the top quartile performers. And that may be true. However, look twice. Some of the performance comparisons take periods when it was better for the managers. In my experience, I never found a manager that beat in the 100% of the occasion the performance of ETFs.
Some of the performances shown only bring the last decade. Consider that there was a bull market for the last 10 years. It is very challenging choosing a fund without understanding how the fund will behave in a downturn.
In my experience, there are more cases of ETFs over performing the market than the number of mutual funds.
Costs: Here, there are no grey areas. ETFs are much cheaper than mutual funds.
Velocity: You would think that a manager can incorporate faster and more accurate changes in his portfolio. However, having the capacity of doing so, does not mean doing it.
Efficacy: The more developed the market, the easier for ETFs to overperform a mutual fund with the same strategy. A less developed market translates into less information, a considerably small number of companies, which means that the models trying to predict the future price/earning/growth might be challenging.
Management and team: Most of the people involved in a mutual fund won't last forever. That means that you will not find the same talent doing what they proclaim they are good at.
In my opinion, there is not a definite answer. This is the reason why I used to have 50% of the equity portfolio in mutual funds and 50% on ETFs. Although the weight on ETFs was taking over, especially in the US and Europe. Now that you know what types of management are, you will have to look for the best-in-class, and try to understand some of the economic outlook of the region you want to be invested in.