Woodstock Financial Advisor – Third Act Retirement Planning —

What are the best stocks to invest in for retirement? – Part 2

When it comes to investing and which stocks are best, Rule No. 2 is to employ a high active share account as part of your strategy. So, what exactly is an “active share account”? This term represents the percentage of stocks inside any given mutual fund or stock investing strategy that are not matched to the index it’s tracking. For example, if you utilize a US large-cap blend stock investing strategy managed by a separate account manager, and the active share account is 20%, that means only 20% of stocks inside that strategy—whether mutual funds or separately managed accounts—differ from the S&P 500. On the other hand, if you have an active share account of 80%, this means that 80% of stocks in this large-blend US stock strategy differ from those stocks contained in the S&P 500.

Rule #2 High Active Share Count

Let’s consider a 10-year study (from 2007 to 2017) that spans the financial crisis, stock market crash, and when the S&P 500 dropped 57% from October 2007 until March 2009. During that 10-year time period, stocks with the highest active share account—those with 80-100% of stocks that differed from the index being tracked—outperformed the lowest ones (0-20%) by about a full percentage point. Concurrently, stocks that were tracking indexes performed about 8.9%, while others that were 80-100% different than the indexes they were compared to performed at about 9.9% during that 10-year time period: a full 1% difference. Gaining that 1% alone—simply by using this strategy along with others we discuss in this article series—would more than compensate your investment advisor so you can enjoy advice not just on stock selection but also with respect to your financial plan, tax planning, and anything else a comprehensive, holistic fee-only financial planner can help you with.

The other thing to remember—and another study I examined—revolves around how high active share funds also outperform their benchmarks, which is another very important consideration. This particular study was executed by Western & Southern from 1990 to 2003. Net of fees and transaction costs for all equity mutual funds during this time period, we see that the first quintile (among five segments, of course) outperformed benchmarks by almost 1% a year during a solid 13-year time period. The lowest performer, with the greatest number of stocks that equaled their benchmarks, underperformed their benchmarks by just over 1%.

One of the issues we encounter with these low active share accounts, meaning a mutual fund or separately managed account stock strategy, is that you’ll have costs and fees to contend with. If you have a mutual fund, all it’s simply doing is tracking an index (with 80-100% of stocks aligning with the corresponding index) and unable to keep up due to trading costs and additional expenses associated with a separately managed account or mutual fund. So, this is yet another thing to keep in mind and one more reason why if you set out to engage in indexing, you want to make sure it’s as low-cost as possible so you can closely mimic index performance without underperforming too much after fees.

The other thing we have to remember is that over the years since mutual fund managers have been tracked so closely—going all the way back to 1980—the average mutual fund had 60% of stocks that differed from the index or benchmark it was compared against during that time. So, 60% is a pretty solid number that differs from the index tracked. However, as time has marched on, by 2009 that number dropped for the average mutual fund all the way down to about 20% differing from the index or benchmark it was tracking—meaning that during this time period, only one out of five stocks inside of the average mutual fund differed from the index it was compared to. Now, the average mutual fund holds about 518 different equities, which is very high. This gets into the related discussion we had—Rule No. 1—regarding the overlap that occurs when you hold so many stocks, and the strategy begins to just perform like the general stock market, on top of a very low active share count.

Rule #3 – Active Management

Now, let’s move to Rule No. 3: any active management strategy must use concentrated managers. “Concentrated” means you’re using less than 40 or 50 stocks. The reality is that you only really need about 15 to 20 stocks to reduce company risk by 96-plus percent, so that you’re left with just the market risk of the stocks you have and not exposed to any one particular stock if you just have 15, 16 or 17 stocks (for example). However, most managers, mutual funds, and separately managed account strategies do not offer approaches with only 17 stocks, so this is very rare, if not unheard of. However, we do see concentrated equity managers with around 40 to 50 positions—which is something we can have access to and use.

One Lazard study I reviewed from a 15-year time period that ended December 2014 (and began in 1999) examined concentrated equity managers and how they performed against the S&P 500. During this time period, the average 5-year rolling S&P 500 returns were lower—a lot lower, more than 2% lower—than concentrated managers. The 5-year rolling average for concentrated managers was 9%, wherein the S&P 500 was around 6%. Hence, concentrated managers performed about 3% better per year during those same 15 years. Similar findings were uncovered for 3-year rolling returns, the average of which were about 10% for concentrated managers. For the S&P 500, this came in at about 7% per year. So again, it’s about a 3% difference when we zero in on concentrated managers that boast between 40 and 50 stocks—rather than the 500 stocks contained inside of the S&P 500.

Another key piece to consider are concentrated managers during market downturns. During the 2008-2012 slump, for example, less participation was observed—capturing only 98% of the downturn, including managers with fewer than 40 stocks. Conversely, strategies with anywhere from 80 to more than 250 stocks captured about 106% of the downturn. Guardian Capital reported these numbers at the end of December 2017.

As mentioned, holding fewer than 40 stocks basically only captures 98% of the downturn. So, whatever that 2008 downturn exactly was, probably in the high 30s—let’s say 37%—concentrated stock managers only suffered an approximately 36% loss (whereas other managers with many more stock positions faced a 39% loss because they averaged roughly 106% in the participation of that particular drawdown).

By now, we’ve gotten through the first three rules of selecting stocks and designing a stock portfolio. In reviewing over 5,000 different investment accounts and performing extensive audits, my team and I clearly understand that the No. 1 rule is to avoid overlapping—which you can review in the first article in this series.

Rule No. 2 is to engage in stock investing strategies with a high active share account. Finally, rule No. 3 is to employ best practices and go with concentrated managers containing 40-50 holdings. Take the time to research each company carefully before making a selection, and therefore, you can enjoy owning higher quality stocks and a better likelihood they will perform well in the long run.

Rule #1 – Avoid Overlapping. Rule #2 – High Active Share Count. Rule #3 – Active Management

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