Monday, February 18, 2013

What the Pro's do, that you don't

In my last post smarter-investing-by-watching-the-pros, I talked about how there is a clear difference between the way that retail investors (regular Joe’s that are investing their own money) and institutional investors (businesses that invest for others’ including pensions and large municipalities) go about investigating a particular investment style.  And this difference in my opinion has a huge impact ultimately on how much money they make or retain (with a bad investment) over time.

I wanted to provide some specific examples to show the clear difference between both of their approaches …

Retail Investors are wowed by performance numbers – the higher the number, the more frothy and excited they tend to get.  As much as we say we don’t … we still all buy into the get rich quick ‘scheme’, and are willing to overlook certain red flags in pursuit of this.  The biggest “red flag” is to consider how the advisor fees will ultimately impact the performance.  Finding out the fee is easy to do, but looking at the historical performance and calculating the ACTUAL NET return on investment (after fees) is something that isn’t provided by Advisors. 

Institutional Investors on the other hand don't care about Gross Performance numbers, they phrase their questions to identify the bottom line AFTER FEES.  

So many Investment Advisors show market beating returns to a prospective client, and simple analysis will show that after fees the majority of all Investment Advisors underperform the general indexes substantially.  Institutional Investors will insist on AFTER FEE performance numbers, because again, they are concerned only with determining what is THEIR bottom line, not the theoretical bottom line.

How to get around this … again … a little math and you can figure out the after fee performance yourself, but an institutional investor will directly ask the Investment Advisor to provide the numbers, and I think this is a great idea.  The reason … it sheds some light into how forthcoming the Advisor is with you.  He should have nothing to hide and shouldn’t have a hundred excuses as to why he underperformed in a certain period.  He should be willing to show you without any effort on your part … and if he hesitates … you should take this as a red flag and invest elsewhere.

Sounds crazy but because of what I said above, Insti’s don’t get hung up on a higher fee structure.  Because they are only concerned with the AFTER FEE performance … it really doesn’t matter what the fees are, as long as AFTER FEEs the returns are market beating.

I’ve seen many retail investors just close down when they hear a large fee structure and don’t stop to consider the real performance after fees.  They’d rather pay a 1% fee on a strategy that returns 5% a year, than 2 or 3% on a strategy that returns 15% a year … doesn’t make sense but I see it often. 

The reality is that there is probably a reason for the higher fee structure.  Most Investment Advisors invest their clients’ money in simple Buy and Hold approaches which take very little time to implement, but are prone to large downside risk during market declines while strategies that are more defensive in nature tend to take significantly more time and resources to implement, and therefore are justifiably more expensive to run.  I know in our case, our overhead is quite sizeable, because we are analyzing the market and potentially taking protective actions with their client portfolios’ every single day. 

I’m obviously not implying that you should be happy to pay higher fees, or that you should assume a more expensive fund is better at their analysis, but just be smart in your due diligence … don’t get hung up on the fees by themselves, without considering the bottom line.

The same principle applies to paying taxes - so many of us get hung up on paying taxes, that we immediately dismiss a short term strategy that results in higher taxes than a longer term strategy ... this is silly to me.  Again, you need to weigh the impact ... as an example in 2012 Resnn Investments returned over 26% AFTER FEES for our clients ... these were short term gains which is taxed at a higher rate than a long term trading strategy, but ... if you do the math it is still significantly better than the 13.4% return the S&P 500 returned for the year and therefore significantly better than 99% of all Investment Advisors performance for the year.  In a worst case scenario, you have a 20% tax difference between short term capital gains and long term capital gains ... so take 20% of the 26% return (5.2%) and then deduct that from the return (26% - 5.2% = 20.8%) ... you still earned 7.4% better than 99% of all others out there.

Again, you need to consider the tax impact on your investing decisions, but don't throw out the idea of using higher tax strategy just because ... weigh the impact before making your decisions.  Remember ... look at the bottom line after paying ALL fees (including taxes).

Institutional’s most important criteria is risk control and preservation of capital.  They will quickly pass on an amazing strategy if there is little risk control within the strategy.  They know that it is a lot easier to lose money than to make it … so having proper defensive structures in place to protect their capital is imperative.

retailer’s on the other hand, focus on chasing performance … they are most concerned with “how much you will make me”, and not on “how much could I potentially lose”

Insti’s will ask questions like … “what’s the worst case scenario?”  when do you exit a losing trade?”, “do you have preset levels and preset exit points that are setup ahead of time?”.

Insti’s look for investment strategies that offer TRUE diversification for their portfolio’s, not perceived diversification.  Bottom line, you need to figure out how closely correlated all of your investments are, so that if we have a decline it has minimal impact on your portfolio.

2008 - no safe place to invest
Investment Advisors are GROSSLY guilty of implying safety with diversification to their clients.  I hate to use such strong words, but we’ve all been brainwashed to put 30% into international markets to help reduce the impact in the event of a US market decline, but if you look at 2008 … this type of diversification doesn’t work.  ALL world’s markets declined between 30% and 70% in 2008 … there was no safe market to put your money.

So Insti’s want to find investments that are ‘inversely correlated’ to each other.  They want to make sure that their money is invested in strategies that perform independently from each other .  In fact, this is one of the main reasons why our strategy is so popular with the institutional players … because we are pulling out of the market (going to cash) during volatile times, this inversely correlates with their ‘long only’ (stay in the market) strategies and offers dramatic protection for them.  

Don’t think by having your money in 10 different equity mutual funds that you are safer than if you picked one fund.  Proper diversification is not about picking many different stock market investments, but rather picking strategies or industry sectors that move independent of each other.  A typical Insti investment portfolio looks something like this …

long only US market
long/cash US market
emerging international
currency trading
bond investing (but be careful as many of these correlate with the US market)
oil / natural resource market
long/short US market (this closely correlates to the long only … so they will use these sparingly)
liquid real estate (reits)
distressed investments
some international exposure, but they are careful to note that the long only US market exposure above usually has a large international exposure

Retail Investors want to know what’s the BEST CASE scenario … what’s the biggest return you’ve had … which means Advisor’s and Financial Planners have learned that they can pick and choose graphs that show their hot performance periods and hide their weak performance numbers.  Insti’s are concerned with risk and worst case scenarios … they’re thrilled that you beat the market by 40% last year, but they spend much more time looking at the years’ you didn’t beat the market.  They want to know how often and why you underperformed.

Insti’s want to know what they can expect, and consistency as a result is critically important.  They want to work with people that perform the same year after year after year.  And in fact, would much rather invest in a strategy that returns 10% consistently than one that returns 40% in the first year, -10% the next and 100% the third year even if the second strategy returns more.  In analyzing historical performance, they are looking for this consistency more so than performance.  

This may sound obvious, but most people I know don’t follow this Institutional rule … If you want the best performance, you need to hire the best.  You don't hire your brother-in-law, or your buddy from college, or the financial planner on your kid's soccer team ... you find the best and hire them.  This takes a little work to do this, but the first rule is that you need to find them, vs. them finding you.

An amazing study was done a few years back about people and how they decide on different investment strategies, and amazingly what this study found was that people spend more time picking out their washer/dryer than investments?!  Sounds silly, but think about the long term impact of this.  Most investment decisions once made take little time to maintain … but Institutional’s will take weeks, if not months to make investing decisions to make certain they have identified all the potential issues.  Take the proper time to understand the investment strategy, and if the Investment Advisor you are ‘interviewing’ is making it hard to understand his investment process, it is probably a good sign that you should pass.  The person should be able to explain his process in very clear easy to understand non-technical speak.  You should have a good grasp of what he/she is doing with you money BEFORE you fund the account.

The biggest difference between these two investor types, is that Insti’s leave the emotions out of the decision process.  This is a business decision for them and nothing more.  Retail Investors ‘want to believe’, they buy into the excitement of the strategy and as a result they tend to ignore the red flags.  Related to this, they might invest with a buddy or worse … invest in an advisor just because the person is likeable.  Keep personal emotions out of the decision and focus on the investing process and risk / reward trade off.

Hopefully this post helped you think about how you should approach a very serious decision in your life.  It is more effort to do this the right way, but ultimately getting your money to work for you will have a huge payoff for you over time.  Please feel free to add any comments or questions below …

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