Delegation or Dereliction ?

I have been thinking about this idea for quite some time, but only recently did I decide to blog about it. This title basically addresses the issue of whether one should be an active or passive investor. An active investor is defined as one who constantly reads up on business news, reviews and analyzes macro-events and company-specific events and generally is interested in the entire investing process and the hard work that comes with it. A passive investor is one who does not take an active role in managing his investments, and may delegate part of or all of it to another party. Note that passive investing also includes index investing, and throughout this entire article I will call passive investing a form of “delegation”, and discuss if it amounts to dereliction (forsaking of duties).

Value investing is a form of investing which involves a significant amount of active involvement, whether it be in the investing process or analyzing the companies in which one is interested in investing in. On the other hand, buying into mutual funds (unit trusts) or doing index investing is a passive form of investing, as it requires the investor to hand over the control of his portfolio to the “experts” who deem to have more knowledge than the common man on the street. Such delegation may or may not be a good thing if one considers the fact that fund managers may not have the requisite skills or knowledge to consistently do better than the market index. But does this necessarily amount to dereliction ? First of all, the most important question is how to define the term, and see if it impacts positively or negatively on the investment decisions which one makes.

For a passive investor, he prefers to delegate part of the investing process to another professional, usually an expert on certain industries or countries, in the hope that the returns generated can beat the market average. Most investors would use the market average as a benchmark to gauge their performance, and the fact is that sometimes delegating one’s investing (whether to a friend, a relative, family member or fund manager) just may not give the comfort level that the person can beat the market average. Warren Buffett actually recommends a “sloth-like” approach to investing, whereby an investor (after selecting the right companies) can just sit back and watch the value of his holdings grow instead of fervently trading in and out in order to “maximize” his returns. The problem lies with the fact that for most delegators, they have yet to build up a decent portfolio of good companies, yet they choose to take their hands off the investment process, hoping that somehow, the person who has been delegated to invest on their behalf can achieve supernormal returns. So far, this has happened only 5% of the time as 95% of professional funds managers under-perform the index due to high churn rates and frequent transaction costs.

Thus, I would still consider delegation a form of dereliction (I know this sounds controversial) as I believe that no matter how much you think you do not know, or how lazy you are, it is still YOUR money after all and you have a responsibility for ensuring it grows at a rate better than inflation rate. In fact, the only form of passive investing which can give you market returns is index investing. Although passive investing prevents you from losing big, it also prevents you from achieving exceptional returns.

Unit Trusts – 80% of Unit Trusts Under-performed the market from May to August 2007

Interestingly enough, an article in The Edge Singapore this weekend (in the pull-out Personal Wealth section) talked about the returns on unit trusts and how they have been battered left, right and centre by the recent market turmoil. Also on Friday, I was having lunch with two friends who expressed their views on the unit trusts market and one of them, incidentally, was heavily vested in unit trusts. I would like to comment on funds in general and also incorporate some of my friend’s personal views on unit trusts and how they have helped her in growing her money.

In the article, nearly 80% of the 700-odd retail investment funds (i.e. mutual funds) have lost money in the past three months up till August 17, 2007 (the day of the big rout and subsequent recovery). That’s about 560 funds in total, no small number by any measure ! The reason for this under-performance can be traced to the fact that during the correction, all asset classes such as equities, bonds, properties and commodities were hit, sparing no one and nothing. Thus, even a well-diversified investor who held on to equity funds, bond funds and real estate funds would be hard-hit. As an example, my friend had a 13% overall gain from her 8 unit trusts before the major correction, but this dropped to as low as 3% (fees inclusive) during the severe correction. Clearly, these funds could not withstand the battering and most were not prepared for this kind of “storm”.

To be fair, to expect mutual funds to consistently out-perform the benchmark index is a little too much to ask. Mutual funds usually show their performance over a stretch of time and this may include periods of under and over-performance; which in the end translate into an average which is then shown to the potential investor. What I would like to add is that funds have a tendency to be a little over-diversified at times, thus eroding any good gains from any particular investment within the fund. After all, owning just 5 excellent companies is much better than 5 out of 30 when the other 25 are just mediocre. But the problem with funds is that the fund manager is forced to (not literally, but in a manner of speaking) make investment decisions on a daily or weekly basis to increase the investment returns for the unit holder. In the end, transaction costs will pile up as the fund manager tries to get into the better investments and bail out of the worse ones. It’s more like fire-fighting in such cases rather than a case of good investment acumen.

Fund managers are trained professionals with a wealth of knowledge in investing, financial products and financial markets. I have the utmost respect for them because after all, it is not easy to handle large sums of money which are not yours and to be accountable to so many people. Herein lies the problem: Warren Buffett mentions that as a fund manager, you are constantly “forced” to make moves in order to grow other peoples’ money; and this is like being a baseball player who is forced to swing at every pitch, even if it’s a bad one. The analogy is apt because in the investment world, there cannot be that many good investments out there for everyone (otherwise, we would ALL be very rich by now). In fact, after doing several months of independent research on the Singapore Stock Exchange, I dare say there are only a handful of truly outstanding companies with capable management, good earnings growth and an endearing product/service. The fact that fund managers have to take action all the time or be labeled as “lazy” or “inefficient” is sad because all it takes is one really good investment to reap all the returns; instead most funds buy/sell constantly (eroding gains through transaction costs) and they also buy/sell into mediocre companies or investment products, further stunting performance. This is why there are only a few truly outstanding funds in this world (which, incidentally, are managed by fund managers who have a value investing mindset).

So I tell my friend: “Why don’t you invest in equities in order to enjoy a higher return ? Fund managers regularly under-perform the index plus you have to pay them an annual management fee even if they fail to perform !” Her reply was that these fund managers “know their stuff” and it was important to “diversify her risk” by investing in a myriad of asset classes. The sad fact is that the entire fund industry likes to convince retail investors that it is difficult and tough to invest on their own and thus the services of such professionals are required. The truth is that even though it is not simple to invest on our own, it is also far from being rocket science ! What most people don’t realize is all it takes is a keen interest in business news, basic accounting knowledge and an understanding of businesses and companies. I have a previous entry on the pros and cons of unit trusts so please refer to that posting for more detail.

For diversification of risk, apparently it also comes with a condition that you also “diversify” your returns ! Wide diversification is necessary if the retail investor does not know what he or she is doing, and even though diversification helps you to “weather” the storm, the flip side is that it cannot guarantee superlative returns. Most of my friends who are heavily into unit trusts report an overall gain of at most 15-20% for their entire portfolio (and that’s for the very outstanding individuals who have picked almost all the out-performing funds). For most value investors who regularly do their homework and research, focusing on just a few excellent companies can help weather storms much better and give much better returns as well.

Note: Kindly feel free to comment on this post as I know the issue is rather contentious (there will be people in strong support of UT, like my friend is). Rather than skew my discussion towards pure equities, I invite views from readers as well.

Also Note: From the feedback of readers, I have organized my blog into sections using labels so that it is easier to navigate and to read up on specific posts (e.g. on Ezra, Swiber or research series). Kindly use the right-hand toolbar called "Categories" to navigate through my blog's older posts. In future, I will "tag" each posting with a label for easier reference. Feel free to leave comments on ANY posting and I will attend to it when I have time.

Unit Trusts – A Candid Discussion on the Pros and Cons

Unit trusts (also called mutual funds in the USA) consist of a basket of stocks, bonds or other financial securities. These are packaged together according to a theme (e.g. industry theme such as property plays, oil and gas plays) or a country theme such as India, Vietnam or Thailand Fund. Unit trusts are marketed and managed by companies such as Aberdeen, and are also “sold” by banks such as UOB Asset Management. This class of assets allows investors to have an alternative to pure equities, which many may see as being uncertain and volatile.

My post today seeks to explore the pros and the cons of unit trusts, and the place it has among different investment products. First, a disclaimer: Please note that all the following comments are personal and are not meant to encourage or discourage readers from investing in unit trusts. Ultimately, we have to rely on our own research and fact-finding in order to make an informed decision. As investors, we all seek a reasonable rate of return on our investment which is higher than inflation (see previous post on research series part 2). Unit trusts, if chosen properly and correctly, have been known to give steady returns over time plus good dividends to boot.

The pros of unit trusts are as follows:-

1) Unit trusts are able to gain exposure to stocks in countries which may not be accessible to most investors. For example, some unit trusts benchmark against shares in the Shanghai “A” shares market which can traditionally only be traded by Mainland Chinese residents. Also, there is a Lion Capital Vietnam Fund which allows investors to gain exposure to the booming Vietnamese economy, as the fund ties its performance to the performance of the Vietnamese stock market indices.

2) Funds also allow investors access to various classes of securities and financial instruments which normally would not be accessible to the retail investor. Some funds are index funds which benchmark against an index, while others are bond funds which allow investors to invest indirectly in the bond market. There are also funds set up for commodities and other classes of assets such as precious metals; thus investors can choose from a spectrum of asset classes to invest in through funds.

3) One aspect of funds which differ from equities is that funds are managed by professionals with good knowledge of the economy and the market. Thus, investors who feel that they are not sufficiently knowledgeable can simply sit back and rely on their fund managers to show results. Fund managers also take care of all aspects of the fund for investors, including giving advice on investment time horizon as well as expected returns depending on whether investors are aggressive or conservative. In fact, I would say fund managers also have a minor role to play as financial advisor to clueless investors.

4) Funds are well-diversified, meaning that the risk of a very large and sharp decline in the price of the fund is minimized as it usually has a basket of 20 to 50 stocks, or is diversified across several industries or asset classes. This helps to buffer the investor against sudden shocks in the system should they arise. Conversely, this could also act as a con in that superior performance is mitigated because the fund may be too diversified, thus eroding gains.

5) Some funds are also tailored to give investors a stake in private equity firms which are poised to go for listing, or which are generating good returns on their own. Investors can thus invest in unlisted companies whose shares are not freely traded on an exchange.

The cons of unit trusts:-

a) There is no chance for an investor to decide on how to alter the constituents of the fund, as the fund is entirely in the control of the fund manager. This means that the investor has no say to dictate what the fund manager should buy or sell, or even how many times he should buy or sell; as long as the fund manager keeps to the original investment objective. This could create a lot of transaction (frictional) costs which eat away at investment returns.

b) Funds are generally too highly diversified to be able to eke out exceptional gains. When I say exceptional, I mean multi-baggers where the you get to multiply your wealth by 3-4x for example. When investing in equities, this is possible due to the fact that the share price is correlated to the earnings and valuations of the company. For well-performing funds, most of the time I hear of good funds bringing in 40 to 80% gain for investors over a year. While this is considered a good (but not great) return, most of the time it is not consistent as the best-performing fund this year tends to under-perform in future years.

c) The costs of owning a unit trust also serve to eat away the gains. Most fund managers charge a flat 3-5% management fee per annum on the value of the fund irregardless of whether it is doing well or not. This literally means that you still have to pay your fund manager even if he under-performs ! Some funds also have also implemented a performance fee which means the fund manager gets paid additional fees if the fund performs over and above a set criteria. These measures all serve to erode the gains for the investor.

d) Even though the prices of funds are publicly available on websites such as Fundsupermart.com and publications like the Business Times, it somehow still puzzles me that when one sells his unit trust, the transacted price is always 2 working days late. This means that even though you place a sell order today (say, at the spot price of S$1.00), the order only gets executed at the spot price 2 trading days later (which means the transacted price may be higher or lower than S$1.00, or even S$1.00 itself). The point is that one will not know if markets may crash the next day, thus I find this T+2 rule very disturbing and inconvenient for investors. Why is there a need to settle the price only T+2 days later ? For shares, the transacted price is simply the price entered for buy or sell, even though the actual payment or receipt takes place T+3 days later.

Conclusion

The reason why I don’t invest in unit trusts is mainly due to the cons mentioned above. I do not see a need for me to expose myself to other markets when I can make a good return investing in SGX. Furthermore, value investing works better for me as it allows better gains to be obtained through a concentrated portfolio. In addition, I don’t have extra costs such as Management fees and performance fees to erode my gains when I invest in equities. As for researching which company to buy, I use simple industry analysis and financial statement analysis to determine this, as well as a knowledge of business conditions. This approach has worked for me so far, and I am comfortable with it.

Please feel free to post comments on how you feel about unit trusts versus equities. A more balanced view is desired as I know my views are rather biased towards equities.