Hands-On Investors: Don't Make These Mistakes

Christine Benz: Jason, great to be here.

Stipp: So, I want to start at the portfolio level. Our Portfolio X-Ray and Portfolio Manager offers a lot of detail about investors' portfolios. We know a lot of our power users check this X-Ray report out and sort of see how they are allocated. It's good to be hands-on and to know where you are, but there are also some potential pitfalls that you can fall into.

Benz: I think, there are, Jason. One of the big ones is looking at how your portfolio is arrayed across the Morningstar Style Box and thinking that you need to have equal distribution in the style box squares. One thing that even sophisticated investors might fall into is assuming that they need to have an equal distribution between value, blend, and growth.

Investors might naturally end up with some biases, and those are OK as long as you buy into them and you know what they are. So, I know we have a lot of avid value investors on the site. Certainly a lot of our stock analysts are value investors at heart, and that's OK. If that's your strategy and that's your style, there is no need to artificially force your way into some growth exposure that you don't really believe in. But if you do have a portfolio that's really listing toward one side of the style box or the other or into small caps just understand that you will have periods of time when your portfolio will underperform other parts of the market or maybe even the market at large. It's OK to have those biases, but just know what they are.

Stipp: So, make sure you know your tilts, but also make sure you know why or why you're not comfortable with those?

Benz: Right, and the same goes for sector exposure. So, there is no need to jam all of your sector exposure to that it's exactly equivalent to what, say, a broad market index fund is. It's OK to have those sector bets, but just be aware of what they are.

Stipp: So, Christine, I know, a lot of our power users are looking through our Analysts Reports, and they're trying to pick some of the best actively managed funds. We know that active management sometimes will underperform indexes, but the best managers can perform well, over even longer periods of time. It's also hard to put all of those active managers together into a good portfolio, right?

Benz: It is. One thing that's a lot of people fall into is, they have chosen many strong-performing funds, many funds with great fundamentals, but they've simply amassed too many of them. The net result is that you're kind of drowning out some of the very strong performers. You're ending up with a portfolio that is perhaps overdiversified. You're watering down individual emphases that might appear in some of those portfolios. You're ending up with a portfolio that's very indexlike in terms of its portfolio, but you may be paying active management fees for it. So, that's a pitfall that even very good investors can fall into from time to time.

Stipp: Another thing that when you're looking at actively managed funds. I would think, especially in environment like this where there are a lot of clouds on the horizon, it would be good for investors to give some of their money to someone who is going to actively go out there, avoid the pitfalls, and invest in the right place. But there are a lot of headwinds even for active managers, as well.

Benz: Well, there are, Jason. I think fixed income is a great case in point where, I know I drive a lot of sense of security knowing that I have some of my fixed-income assets, with say, a Bill Gross, and that's good. But you recognise that he still has to invest his portfolio in bonds or cash or some variation thereof at the end of the day. So, even great portfolio managers can't circumvent those headwinds. They are still investing in whatever asset class that they are stuck with. So, they will not be miracle workers and understanding that is an important way to use active funds well.

Stipp: Active funds also tend to have higher fees. If you find a manager that you think you like and a strategy that you think you like, sometimes you're willing to maybe pay a little bit more for that fund. But how do you know when too much is too much?

Benz: Well, it's a great question, and I would say it's when I frequently receive. When I give talks people say, "Morningstar puts such a big emphasis on the importance of low costs. I have chosen X performing manager. He has been a great performer, and my costs are really high."

But I think certainly when you look at the data that we've run over the years that our colleague Russ Kinnel has run, you have to realise that if you are opting for a fund with strong performance, but high costs, that's generally not a great bet to make. You better off in fact probably looking to a fund that's not been as great a performer, but has very low costs. It's odds of outperforming in the future actually beat the strong performer with high costs.

Stipp: So, understand that if you're investing with an active manager, even if he is the best runner, if he has a high-fee fund, he is starting with heavy, heavy shoes or maybe even boots?

Benz: Exactly. The other thing to keep in mind is if we're in for a period and maybe the decade ahead where absolute returns from stocks are relatively muted, you really don't want to be saddled with those high costs. So, if the market returns 6%, do you want to be shelling out 1% in terms of management fees, or do you want to be shelling out half of that much? I would say the latter.

Stipp: Sure. So, another thing Christine that we've seen through some of our data is that for investors who invest in these actively managed funds, it's not just picking the right manager, but also the right time to buy into these funds?

Benz: I would call it the Fairholme effect recently where we saw a lot of folks flocking to Fairholme Fund. I think we still think it's a very good fund, but what made the fund such a strong performer in the past was inevitably going to work against it at some point in the future. So, that's a fund with a high level of concentration in individual holdings, a willingness to make sector bets. Those things that make a fund great can also work against it at various points in time.

So, if you are opting for a truly active fund, recognise that it will hit performance troughs from time to time. Also make sure that you have a nice long time horizon for that investment. And be willing to dollar-cost average in so that you're not sinking a lot of money into the fund as unfortunately a lot of Fairholme investors did recently just in time to see the fund's performance cool off.

Stipp: So, Christine, some of our favourite active funds actually have very simple strategies. They might be difficult to execute, but they are understandable. But we also know that there is a whole group of investments that have more sophisticated strategies. These are funds that might use derivatives, they might short, or they might use some sort of quantitative model. They are doing things that a much more sophisticated investor would try to understand. How do you know if these funds are really going to give you the effect that you want or that they seemingly are promising?

Benz: It's a good question, and you're right a lot of sophisticated investors are naturally attracted to some of these more sophisticated strategies and the diversification benefits that they promise. The first thing I would say is if you are opting for an investment type like this, make sure you really understand it. And I think that that was a pitfall lot of new commodities investors fell into when they embraced some of the futures-based commodities funds. They didn't understand that some of these investments wouldn't perfectly track commodities prices and sometimes be downright out of sync with commodities prices.

So, you want to make sure that you know how the strategy works and how it might not work at various points in time. And also if you are adopting a sophisticated strategy or a fund that uses one, make sure that you're not duplicating some feature that's already in your portfolio. So, one criticism I have of some of the more-sophisticated alternative-type investments that have hit the market is that they are going to deliver a risk-return profile pretty similar to a composite stock-bond portfolio but at a much higher cost. So, if you're layering on some more-sophisticated strategies, make sure that you're overall portfolio, your plain-vanilla portfolio, isn't already delivering some of those attributes.

Stipp: So, make sure you know what you're getting into, what the investment is suppose to do, what the investment likely will do, and also what could go wrong with some of those investments?

Benz: Exactly.

Stipp: All right, Christine. Thanks for joining me today with some tips for the hands-on investor.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.