SCOTT REED: Don’t be average, diversify portfolio

SCOTT REED

SCOTT REED

In my last column, I wrote about the difference between active management of mutual funds and passive management of mutual funds.

Active management is easy to like. The idea of having a smart person that is considered an expert in the field looking after your investment portfolio makes a lot of sense.

All things being equal, it may be a smart thing. Certainly, there are still some areas where I think active management has an advantage.

So the question that begs to be asked is, “Why passive?”

I previously put forth the argument that active management costs more than passive management.

A number of studies indicate that, even if active managers are better than the index with which they are compared, they aren’t better enough to overcome the extra expense of hiring them. At the end of the day, it doesn’t matter how well they do – it matters how well you do.

One of the questions I have is, “Why can’t active managers overcome the extra fee they charge?” I think the main reason is that they are working in an environment that is set up for failure. The investment world does not wait very long to cut its perceived losses.

The average investor, in my experience, cannot stand to fall behind for even the shortest period of time. If a mutual fund manager falls behind his market for even a quarter, investors start to leave.

The problem is that even the best managers fall behind for extended periods of time.

So how do active managers protect themselves against the inevitable underperformance that they cannot avoid? It seems to me that the way to keep investors in the fold is to minimize that underperformance.

The best way to do that is to make sure you look like the index that you will be compared to. And the best way to make sure you look like the index is to diversify your portfolio throughout the securities in your index.

That’s where the investor incurs one of their biggest roadblocks to outperformance. Diversification is the enemy of outperformance.

The general rule for quite some time is that eight to 10 securities in any asset class can give an investor about 90 percent of the benefit of diversification and will still give a manager the opportunity to do significantly better (or worse) than their index.

The more securities you buy, the more watered down the return and the more you look like the index.

There is less chance that investors will leave you and there is less chance that you will significantly outperform.

Logic 101 tells you that if most active managers are over-diversified and over- diversification leads to average performance, why would you pay for a manager who is destined for average performance?

Why not just buy the index and get your average performance at a very cheap price?

Exactly.

Scott Reed is CEO of investment advisory firm Hardy Reed in Tupelo. Contact him at (662) 823-4722 or sreed@hardyreed.com.