🌰In a nutshell: One easy method to have your portfolio diversified and regularly rebalanced is to get help from professional investment management. However, you need to carefully consider fees and risk involved with each option as slight change can alter the long term return by a lot.
So far, we looked at how important it is for you to diversify your portfolio to minimize the risks and to meet your financial goal. However, it is quite a feat for individual investors to composite a diversified portfolio and have them rebalanced regularly. Why? First, you would need quite a large capital to include diversified assets. Then, there is the tedious work that goes into having your portfolio rebalanced constantly, especially if you aim to mirror an index. Are you pursuing alpha and want to buy just unicorn stocks? You would need a tremendous amount of market research. Even so, the risk is very high.
Before moving on, if you are asking yourself a question like “what is this about mirroring an index?”, I advise you to take a quick read at the article, “The $1 Million Bet? Active Investment vs Passive Investment“
There are a lot of you out there sharing the same concerns. They all want to mitigate these issues. Out of the demands, companies created services where individuals can garner benefits from diversified portfolios within their means. We are going to take a look at one broad category of them, and it is called “pooled funds”.
With a pooled fund, investors combine their money into a fund, then it is used to invest in multiple securities. The returns will be shared among the investors proportionally to the size of investments one puts into the fund.
For every fund, there is a designated fund manager. The goal of the manager is to meet the objective of the fund. Depending on the objective, the fund may be invested in cash, stocks, bond, gold, or any other assets and their combinations thereof.
Let’s look at some of the basic pros and cons of joining pool funds.
Now that we know the pros and cons of pooled funds, let’s also look into the option between active and passive management. To know more about active and passive management, click here.
In broad terms, investment funds are managed in either of two ways: active or passive. For the very obvious reason of pursuing the excess return, active managers are often more expensive to retain than the passive ones. With that in mind, let’s look at the differences between the two.
Active managers: they are seeking the alpha. This means they want to beat the market benchmark and generate excess returns. To do so, they are taking either of the following two approaches:
Top down managers: they move from the forest into the tree. They first look at the market trend and predict which sector will perform well in the future. Then they narrow down to a particular industry. Finally, they look for the companies that would perform better than the average.
Bottom-up manager: They do not care much about the big trend. Rather, they are looking for the unicorn that would perform exceedingly well regardless of the circumstances.
Index or passive managers: they aim to mirror the market trend. This strategy works especially well in the long stretch of the bull market. They mirror an index by either purchasing all the shares in the chosen index or a representative sample of securities.
As active management are supposedly spending more resources on beating the market average, their fee is much higher as well. How high? Let’s take a look at the following.
Management fee: this is a flat fee that is charged by both active and passive managers. Regardless of your portfolio performance, this is charged to you. On average, active managers charge 2% of the management fee, while the passive manager charges 0.5%.
Profit sharing: this applies mostly to active managers. Active managers customarily charge 20% of all profit earned.
Hedge fund management fees structure are commonly referred to as “two and twenty”, indicating the 2% management fee and 20% profit sharing structure.
Recently, the performance of active managers is under scrutiny. Empirical data have shown that only a few active managers are performing well enough to justify the higher fee schedule. Sadly, many others are just hitting the benchmark average and fail to distinguish their performance from passive investment managers. In fact, many self-claimed active managers are closet trackers.
Before moving on, let’s learn a word: closet tracker.
A closet tracker is a fund that is claimed to be actively managed, but in fact is managed to make returns akin to those generated by real passive managers (index trackers).
As such, people have been arguing that investors should only pay high fees on the actual alpha the manager generated, not on the entire portfolio that includes the market beta. An idea to measure the actual alpha is to look at the “alpha share”. Alpha share refers to the portion of one’s portfolio that differs from the benchmark index. The idea is to measure how much is your alpha portfolio different by weight when compared to its passive counterpart. However, this method is thought to be valid only as a theory as the management skill of the actual manager plays like the biggest variable in determining the size of the alpha.
The possibility of making a significant gain is good. If an active manager beats the market by 1%, they need to achieve about 2-3% percent performance for it to be lucrative after taking the high management fees and profit share. This is a very difficult feat to achieve. Having said that, it can very well be even harder for you to meet an active manager with that kind of high caliber of management edge. Therefore, passive investment can be a better option for investors for the purpose of saving time and stable long-term management at an affordable cost.
Before closing on this subject of pooled funds, let’s briefly share key findings from a study done by Nerdwallet.com
Nerdwallet.com did a scenario study: a 25-year-old individual with $25,000 in the retirement account, adds $10,000 to the account annually, and earns a 7% average return and plans to retire in 40 years. Now, the individuals were placed in multiple scenarios to find the best-case scenario for the investments.
That’s right. Choosing the right type of investment management can bring a huge difference in the long run. While having a high reward plan is great, you would be well advised to consider low-cost options.
“Active Vs. Passive Investing: What’s Best For You?”. Investopedia, 2020, https://www.investopedia.com/news/active-vs-passive-investing/
“How A 1% Fee Could Cost Millennials $590,000 In Retirement Savings – Nerdwallet”. Nerdwallet, 2020, https://www.nerdwallet.com/blog/investing/millennial-retirement-fees-one-percent-half-million-savings-impact/.
Mariathasan, Joseph. “Active Management: The Question Of Fees”. IPE, 2020, https://www.ipe.com/active-management-the-question-of-fees/10011324.article.
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