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How a Fiduciary Answers the Individual Stocks vs. Mutual Fund Question

How a Fiduciary Answers the Individual Stocks vs. Mutual Fund Question
May 22
01:14 2018

Here’s an important fiduciary question we don’t see people asking as much anymore: At what point does it make sense to switch from investing in commingled products (like mutual funds and ETFs) to investing in individual stocks and bonds? This is a classic “best interest” question. It obviously makes sense for investors with small asset sizes (say $100) to invest in mutual funds and investors with large asset sizes (say $100 million) to invest in individual stocks/bonds/etc… Many investors, however, fall somewhere in between these extremes. At what point does an investor achieve “critical mass” to begin investing in individual stocks and bonds?

Let’s start out with this annoying spoiler alert: there is no single answer as it all depends on the individual investor’s specific circumstances. (Don’t you hate it when you hear an investment professional hedge like this. Still, it needs to be emphasized as too many people looking for an easy answer are far too willing to accept one that’s handed to them, even if it’s not true.)

Before considering the possibilities, it’s important to review why it makes sense for investors with few assets to use mutual funds (or ETFs) and why it makes sense for investors with a large stash of assets to forgo mutual funds. We’ll frame this discussion within the context of diversification. It is the underlying goal we’ll assume all investors must have. “Diversification/asset allocation is the key driver of risk management in any type of account,” says Philip H. Weiss, a principal at Apprise Wealth Management in Phoenix, Maryland.

What is a “diversified” portfolio? Believe it or not, from the SEC compliance perspective, mutual funds “are further classified as ‘diversified’ or ‘non-diversified’ funds based on the composition of their assets. See Section 5(b) of the Investment Company Act.” For those not interested in going down the rabbit hole of that link, here’s the relevant text from the Investment Company Act of 1940:

(1) ‘‘Diversified company’’ means a management company which meets the following requirements: At least 75 per centum of the value of its total assets is represented by cash and cash items (including receivables), Government securities, securities of other investment companies, and other securities for the purposes of this calculation limited in respect of any one issuer to an amount not greater in value than 5 per centum of the value of the total assets of such management company and to not more than 10 per centum of the outstanding voting securities of such issuer.

(2) ‘‘Non-diversified company’’ means any management company other than a diversified company.

Doing the SEC math, to be declared “diversified,” at a minimum, one position can take up 25% of the portfolio while all other positions can consume no more than 5% of the portfolio. Since 15 times 5% equals 75%, that means the SEC requires a fund to hold at least 16 stocks in order to be considered “diversified.”

Lest you think this a radical proposition, for many years academic research supported the idea investors could effectively diversify their portfolio with little more than a dozen stocks. Today, based on the research of Meir Statman and corroborated by others, that number has grown to between 30 and 40 stocks (see “A Trip Down Memory Lane – Revisiting Portfolio Optimization,”, October 26, 2011).

Once we accept diversification as our premise, the answers to our questions become obvious. To achieve an acceptable diversification, smaller sized portfolios would need to buy very small odd lots of individual stocks. These odd lots are so small, even discounted brokerage commissions would significantly raise the cost basis of these holdings. “Commissions fixed at roughly $5 a trade for stocks can add up for smaller accounts,” says Andrew D.W. Hill, President & Co-founder of Andrew Hill Investment Advisors, Inc. in Naples, Florida. That’s why small investment accounts are better off buying funds rather than individual stocks.

In addition, it’s nearly impractical for smaller sized portfolios to reasonably expect to purchase stocks with very high prices. “With expensive stocks such as Apple, Amazon and Alphabet/Google, an investor with a $100,000 portfolio would be in a much better diversification position by investing in a stock fund rather than in individual stocks,” says Blake Christian, a partner at HCVT, an accounting firm located in Long Beach, California.

Of course, the drawback for most funds is that they must hold far more than Statman’s ideal portfolio size of 30-40 securities. In fact, it’s rare to find funds with as few as a hundred stocks, let alone 30-40. The reason for this overdiversification is simple. Most funds are simply too big. If you go back to the SEC’s definition of diversification, funds wishing to be defined as such cannot hold more than 10% of any particular security. As the fund’s size grows, it becomes increasingly less concentrated and therefore begin to assume the risk/return profile of an index fund.

Fortunately, if the investor possesses enough asset size, there’s no need to continue riding the mutual fund bus. It’s possible to switch to that chauffeured limousine known as a privately managed portfolio. Mind, we’re talking about a chauffeur driven limousine, not a self-propelled vehicle. While investors may have the assets they likely don’t have the capacity to learn everything they need to keep an ongoing eye on their portfolio. “Time to research is a key factor,” says Hill, “Often individuals either assume too much risk, or not enough risk in their portfolios. They may be better served to hire a Registered Investment Adviser to manage their separately managed account.”

There’s another reason to switch from funds and into individual stocks and bonds. As attractive mutual funds may be to smaller sized portfolios, they come with a price. “I would argue that smaller asset sizes will benefit from diversification via stock and bond funds,” says Christian. “The downside of funds is that when a correction takes place, the investor has no control over the liquidation process and can incur unintended economic and tax consequences.”

The need to move away from mutual funds becomes more acute in taxable account situations. That’s why professional trustees generally avoid using mutual funds, if at all possible. It’s also the reason why banks place smaller trusts in collective investment trusts rather than mutual funds. (Bank sponsored CITs do not fall under the same regulatory apparatus as mutual funds.) “Generally,” says Hill, “you can control taxes better with individual securities than funds since usually, you have no influence over the taxation of funds.”

Due to regulatory requirements, fund shareholders may find themselves saddled with taxable income with no recourse to offset those gains. “Mutual funds distribute their income (i.e., net of capital losses and fund expenses) to shareholders,” says Weiss. “This can result in unexpected capital gain distributions for shareholders, which can increase your tax bill. On the other hand, if you own individual securities, you have more flexibility as to when gains are recognized. In both cases, you can use tax loss harvesting (selling securities at a loss to offset gains), but this can be harder to manage when you do not know what your gains are until late in the year. Additionally, if you own individual securities, you will typically have more securities to choose from in terms of recognizing gains or losses than if you own funds or ETFs. This also relates to the concept of asset location, which refers to our ability to hold certain securities in taxable accounts and other in non-taxable accounts in order to better manage our tax liability.”

To taxable portfolios, at least, it’s very clear why there’s a need to avoid mutual funds. “Individual investments in stocks and bonds is generally preferable from a tax planning standpoint,” says Christian. “This allows the taxpayer to control their overall tax consequences better. In the case of fund investments, the investor/ taxpayer is at the mercy of the fund manager as to the tax and economic consequences associated with the disposition of the fund’s investments.”

When it’s all said and done, where should the fiduciary draw the line between investing in funds and building portfolios with individual stocks and bonds? As stated at the outset, it all depends on the specific facts and circumstances of the individual investor. Given this, different professionals can have different points of view on this.

Weiss says, “The general premise can make sense for accounts under around $50,000 in size. For example, with a $50,000 account, you could have roughly 25 positions at $2,000 each. With the right discount broker, the commission cost of purchasing these positions would be reasonable (say $125 – $250 based on commissions of $5 to $10 per trade).”

Many professionals use two numbers – one which anything below it will remain in funds, the other which anything above it will be in individual stocks and bonds. “We usually use ETF’s & funds for portfolios of less than $100,000,” says Hill. “It can be difficult to diversify effectively for our business model below $100,000. While Hill believes portfolios over $100,000 can be adequately diversified, he says “a $400,000 portfolio could be diversified nicely.”

Christian says, “$500,000 is the point at which individual investments starts to make more sense vs. mutual funds and bond funds. $500,000 will generally allow for both asset and geographic diversification. Still, investors need to balance diversification and fee structure – key factors that impact the net return.”

Finally, there’s another trend adding to the push to move away from funds. As fee conscious fiduciaries have become more aware, products like mutual funds have higher operating costs and fee structures than privately managed portfolios. “Unbundling all their products into their simplest forms – stocks and bonds in your own name – always makes most sense,” says Ryan Krueger of Krueger & Catalano Capital Partners, LLC in Houston, Texas. “Except, as is often pointed out, in 401k’s where it is not an option except for growing number of self-directed plans which does allow it. The confusing number of fund choices where participants have no idea what they hold is part of the reason the father of the original 401k Ted Benna has not confessed ‘I created a monster.’”

Portfolios of individual stocks and bonds represents an ideal not all investors can attain – yet.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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