Having been exposed to the investment industry my whole life, and after having a brief career as an equity analyst for a buy side (i.e., money manager not securities broker) investment firm, I feel like I have the knowledge and the comfort level that allows me to feel good about taking control of managing my investment portfolio on my own.  Not having the convenience of being exposed daily to the market news, insider information, analyst reports, etc. anymore, I admit that my level of comfort has diminished slightly.  How do I combat that feeling and still maintain my investment portfolio?  I follow the advice that I give my friends when they are thinking of taking the leap from paying for a financial manager (e.g., Merrill Lynch, Citigroup, etc.) and being their own manager, setting up accounts at Schwab, eTrade, etc.:

If you don't have the time to invest in doing your due diligence to research a company and do a complete financial valuation to discover its intrinsic value in comparison to the current market price, then spend what time you do have discovering smart people who make it their business to do the research for you and have a proven long-term track record of success.  In other words, find a few mutual funds you like that fit your risk preferences, investigate the manager's performance, and do some research into their top holdings and trading patterns.  But before you do that, I suggest reading up on the basics of personal finance and investing.

There are hundreds of books out there professing that they have the answer to get rich quick.  Well, the reality is that in today's world, winning in the market is extremely challenging because of the volume of trading being done on a daily basis, the speed at which information is being delivered, and the unpredictable momentum shifts due to news events -- rational and irrational.  It is very difficult to find a competitive advantage as an individual investor!  Especially when you're busy working your own job trying to make the money you plan to invest, right??  The best thing to do is to give yourself a little leg up by simply knowing what you're talking about, even on an entry-level basis.  I suggest that you consider reading some of the original books written by the Motley Fool - an Alexandria, VA based company started by two brothers, David and Tom Gardner.  Specifically, I suggest the following two books:



The Motley Fool also runs a good website with insightful commentary.  This is a great way to get close to the institutional-level equity analysis available to Wall Street money managers, often times without the bias.  My favorite aspect of these books and the website is that everything is written in layman's terms as much as possible, so you shouldn't feel intimidated by the topics.  There are other great books out there too - The Warren Buffet Way by Robert Hagstrom was one of my first and favorites!

So now you have the basics, or maybe not, but you're better off than you were before, right?  So here are some facts and definitions.

Definitions from Investopedia interlaced with my own comments:


Index Fund  - A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. "Indexing" is a passive form of fund management that has been successful in outperforming most actively managed mutual funds in the long run. 

Actively Managed Mutual Fund - A portfolio of stocks that are maintained by a single manager, co-managers or a team of managers, to actively manage a fund's portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell.  In general, funds typically charge an annual fee for assets under management (a management fee) that may range from 0-2%.  In addition, some funds may charge an upfront fee, or commission (load fund) at the time of purchase, or a back-end fee (back-end load) upon sale of the investment.  Performance fees are usually only found on hedge funds, for example a "2 and 20" or 2% annual fee for assets under management plus 20% of profits over the last high watermark.  Too many terms to remember in that last piece of info, well don't worry because unless you're a high net worth client, you're opportunities to invest directly in a hedge fund are limited due to very high minimum investment requirements.  One final note for mutual funds are the "hidden costs" due to active management of a portfolio - or turnover.  Just as you would incur a fee every time you trade a stock on eTrade, mutual funds pay their brokerage fees, albeit at more discounted rates for volume.  Turnover is very important because if a portfolio is being bought and sold frequently - anything over 100% to me is a red flag - then all those brokerage fees are cutting directly into your fund performance.  These are not costs absorbed by the management!  So be careful!  Historically, only a small percentage of actively managed funds have beat the market in the long term, so it pays to do your research and find a manager that has a demonstrated track record for returns, buy, and hold.

Exchange Traded Funds (ETFs) - A security that tracks an index, a commodity or a basket of assets like an index fund or portfolio of stocks from a particular industry, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. Because it trades like a stock, an ETF does not have its net asset value (NAV) calculated every day like a mutual fund does.  By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order.  ETFs are a great way to buy an index fund with the flexibility of a stock!  In particular, I like that there is a way to purchase a group of stocks, for example Property & Casualty Insurers, identified by a particular industry if you feel particularly bullish on that industry.   The recent news can't stop talking about the price of gold going up and up and up!  Of course this is due to people retreating from cash and securities, replacing it with the safety and security of a tangible commodity during recessionary times.  Well, if you had purchased a Gold ETF, such as the Gold SPDR (GLD), your 5-year return against the Dow and S&P indexes would have looked a little like this:



Hindsight is cruel!  But now you know that the option is out there to create a "concentrated diversification," if there is such a thing because I just made the term up, by buying this basket of industry or commodity-based stocks.  Just note that any form of concentration adds risk. 

Alright, so now you are armed with some key definitions.  Here are the 3 steps you may want to take to assess money managers when you've made the decision to add an actively managed fund to your portfolio.

(1) Know who you are buying: Two fantastic websites are Morningstar and Guru Focus.  Guru Focus compiles the activities and performance of some of the BEST money managers in the industry with a wide variety of investment styles -- Buffett, Nygren, Soros, Berkowitz, Russo, Klarman, etc.  I like to go on the site to see what these guys have been up to with their new buys, portfolio adds, and portfolio reductions.  The great thing about this site is that it provides you with a list of successful fund managers that you can use to begin researching on Morningstar because many of these funds are available to purchase and have low barriers to entry (or minimum investments), unless of course you're desire is to purchase a Berkshire Hathaway Class A share!! (Pssst...BRK Class B shares are the same thing, just approx. 1/1500th the value of a Class A)

(2) Do your homework:  Just because you're buying a portfolio of stocks managed by someone else doesn't absolve you from doing some work.  Go into Morningstar and run a search or find a specific fund by it's ticker symbol.    For example, let's look at Fairholme's (FAIRX) front page:

 
Things to consider: 
  • Yield:  What is the portfolio's dividend yield from it's assets under management?  If you are looking for investment income, this may be a deciding factor.  Dividends are taxable, in most cases.
  • Expense Ratio:  Here is how much you have to pay, annually, for the privilege of receiving the management services of Mr. Bruce Berkowitz.  In this case, the management fee is 1% of assets under management, or the value of your investment in the fund.
  • Turnover:  How often are stocks being bought and sold?  Higher turnover means higher expense to you!  Also, a high turnover hints that there may be some momentum investing taking place, capitalizing on short-term movements in the market, and that the manager may be skipping some steps in the due diligence department in order to grab on to this momentum.  Hedge fund managers like to play with their money this way, with turnover rates that could exceed 1000%.  That means they have bought and sold 10x the value of their portfolio!!  All on your dime!  Thank you Mr. Berkowitz for not playing with my money, with your sensible 27% turnover.
  • Minimum Investment: Self explanatory.
  • Category: Weighted average market cap of the fund and investment style.
  • Performance: LONG TERM returns!!!  Make sure to look at the long term, or 10-year return, for the fund.  Short term returns have so many other factors that may not accurately reflect the fund manager's abilities.  For instance, the fund may have had one of it's top holdings collapse due to an unpredictable event - think AIG, Bear Stearns, Lehman Brothers, Enron, etc.  The fundamentals may have been there, the extensive due diligence may have been performed, corporate management may have been interviewed personally, but there was that one trigger and a market momentum (mania) took over that completely killed the fund's performance one year.  
  • Risk Measures:  Is this in line with your risk preference?  Usually people who are some distance from retirement can tolerate a higher risk portfolio
  • Style Map: What is the makeup of the portfolio?  Is the fund particularly exposed to a market cap group or investment style that may indicate a risk spectrum preference (e.g., deep value, core value, core, core growth, high growth), where growth suggests higher risk compared to value.
  • Top Holdings:  What are you getting for your money?  How much of the portfolio is exposed to the performance of the top 5 holdings?  What are these companies?  Do you recognize them?  Maybe you should do some quick research into them because, after all, when you buy the mutual fund, you are essentially becoming part-owner of these companies.
  • Top Sectors: Is the portfolio concentrated in one particular sector that may put overall fund performance at risk if the sector was to underperform?
  • Asset Allocation: How is the money being invested?  Is it balanced with a good portion in cash or bonds?  Is the portfolio exposed to non-US securities?  
  • Management:  Who is the fund manager?  How long has he been associated with the fund?  Can you attribute the 10-year return to the manager?  In the case of FAIRX, Berkowitz has been managing the fund since 1999, so the answer is yes!

(3) Continue doing your homework:  It doesn't hurt to learn more!  Keep researching, find other funds you like, treat your investment portfolio like you do your teeth -- make it a habit to be involved in maintaining its health.  Unless, of course, you think Austin Powers is sexy...yeah, baby!

So there it is!  My thoughts on basic investing on your own, without a financial advisor.  Of course, everything here was written with the caveats that: (a) I am not a professional investment advisor; (b) I am not certified in giving advice on financial planning; (c) I do have a background in finance,  and I performed equity analysis and delivered buy/sell recommendations for stocks in the consumer discretionary and healthcare industries in my prior career; (d) while I may or may not own shares of FAIRX, for the purposes of this blog it was only used it as an example of how to read a fund statistics page off of Morningstar and not as an investment idea - do your own research, geez!; and (e) everything else I missed that could get me in trouble.  Fortunately, I don't think many people will read this, and those that do are my friends who have probably already asked me the question I'm trying to answer with this blog.

Finally - good luck!

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