7 Key Lessons To Make Your Investment IQ Skyrocket

January 26, 2018
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If you are a portfolio manager or fund analyst I feel for you. You are under attack — some of it is justified, some of it is ignorance. All you read about these days is how bad your mutual fund manager is. You can’t even beat a Vanguard ETF. Unfortunately, I am not here to defend you as I am not writing this for professionals.

I am writing this for regular people too busy in their normal lives to pay much attention beyond the headlines — all of you non-financial people, you know who you are.

  • The Gen X couple investing in their 401K’s without much guidance and sweating it out during periods of market turbulence.
  • The baby boomers wondering if they have saved enough to enjoy a dignified retirement.
  • The young parents stretching their finances to fund their kid’s college education.

Just to be clear, I am not writing an expose on the active fund management industry. If I had National Inquirer pictures, I would. But in my 3 decades in the business I have not come across many Harvey Weinstein’s.

For now, I am going to share with you several off-the-beaten path insights gleaned from my 3 decades in the investment business.

These insights will not make you rich on their own but will raise your financial IQ.

You will better understand what you are getting yourself into when, say, picking funds.

Without a doubt, you will learn to avoid making investment decisions based on some preconceived ideas that don’t hold water.

I love my work as an investment professional. It’s a craft I have been perfecting for a long time.

I have learned a lot about capital markets, investment strategies and above all else human nature especially the oftentimes complex relationship that otherwise normal people have to their own money.

One of the most difficult emotions that people struggle with is buyer’s remorse. In today’s world, most people have are left to their own devices when say picking funds in their retirement accounts. A lot of individuals are ill equipped for this task as they often rely on a set of assumptions that often do not conform to reality.

Naturally with so many people bashing mutual fund managers these days you might be having some second thoughts about your own investments. Am I doing as well as I should? What am I even invested in?

Especially when markets get volatile people start having buyer’s remorse — why did I put my 401K in this and that investment strategy? I could have done so much better if I had just picked that growth fund recommended by my neighbor. She seems smart!

Everybody is doing well so why is my portfolio not growing? It must be that the funds I picked are terrible. Dam, I should have never listened to my cousin Vinny!

Sure, there is a deluge of information online with fund factsheets and all kinds of pretty charts but without being on the inside how would you know what happens in the factory? Who has time for this?

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You might have an idea, but there is always a bit of distortion when looking from the outside in. You can see some things with clarity but your view is often obstructed or the light too dim to make out much of anything.

Most individuals are not financial experts and often hold a lot of misconceptions about their investments. These misconceptions can have long lasting negative effects on people’s financial well-being

Becoming a financial expert does not happen overnight and it certainly does not happen by osmosis. You are probably already over-booked with work, kids, a new boss, fixing that kitchen, aging parents, … and now you also have to worry about picking the right funds in your 401K or you will end up eating cat during your golden years in Pensacola?

We all have these gaps in understanding and fears when dealing in areas beyond our expertise. The vast majority of people are not financial experts, but for some reason many have opinions that are often at odds with reality.

From the idea that investing is easy and anybody can do it. To the idea that everybody in the financial industry behaves like Charlie Sheen. Wall Street versus Main Street, bulls versus bears, …

I would like to share with you some of the lessons I have learned as a fund manager over the last 3 decades.

None of these insights will make you immediately rich — for that try Bitcoin or Mega Millions if you don’t mind blowing it all at ounce.

But my insights will allow you to make more informed investment decisions that will have long-lasting positive effects on your financial well-being.

Here it goes — my 7 key lessons to make your investment IQ skyrocket and allow you to gain greater control over your financial future

1. Portfolio managers in large investment houses are highly educated and smart but unfortunately the market does not care

Everybody is smart and that is the problem. Out-performing is hard precisely because of how smart and informed portfolio managers are. Everybody is competing harder and harder. For every winner, there is a loser. Net, net the competition has become fiercer as more people have entered the investment business.

When funds under-perform the blame is on the portfolio manager and when the fund out-performs it is all about the genius running the money. But if you talked to the portfolio manager of losing versus winning funds you probably would find both highly educated, smart and well informed.

Lesson — don’t pick managers based on how smart they appear on TV or the number of degrees on their resume. The proof is always in the pudding — performance matters, looks and book smarts don’t.

2. The expense structure of many mutual funds makes portfolio managers look bad

Why? Because the average expense ratio for most funds is north of 1%. Some fund categories such as foreign stock funds are even higher at 1.5% according to the Balance.

Right off the bat, portfolio managers have to out-perform by at least their expenses (say, 1%) to break even compared to market indices such as the S&P 500 or the Down Jones.

It might not sound that hard but keep in mind that the average historical equity market return is 10% a year. Making up that 1% cost differential is hard in relation to market returns.

Lesson — fund expenses matter a lot. Fund expenses are disclosed upfront so there is no excuse for picking high expense funds unless the return is commensurate.

Fund expenses are determined way up the food chain and the portfolio manager does not have any control over the matter. As the say, don’t hate the player, hate the game. Pay attention to fund expenses and costs.

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3. Most fund companies do not allow portfolio managers to hold much cash in reserve

For an equity manager the number is in the range of 2 to 4 %. In my own experience, anything higher results in a call from the internal compliance police.

It is rare to see equity or bond funds hold much in cash. When you do it is usually in a smaller fund or a privately held fund company. For most of the industry the amount of cash held in funds is minimal.

According to Morningstar the average US equity fund currently holds 3.2% of assets in cash.

Why does this matter? The easy answer is that the ability of portfolio managers to play defense during difficult market environments is limited because they can only hold a very small percentage of fund assets in cash.

For example, lots of fund managers complain about equity markets being over-valued and at risk of a correction. But if you don’t have the ability to place a good chunk of fund assets into cash how can you protect the portfolio from falling along with the rest of the market during a correction? If you don’t believe me look at how many funds fell apart during the 2008 Financial Crisis.

Lesson — don’t expect your fund to play defense unless it is explicitly part of their strategy.

Some funds are designed to offer downside protection but these funds are seldom found in say 401K investment menus and represent a tiny fraction of the fund universe. Most of them have failed to deliver or they lag some much when markets recover making them at best short-term tactical holdings.

The best protection against periods of market stress is an asset allocation strategy designed for you– do not expect your equity or bond fund to save you during a market meltdown

4. Fund managers are not incentivized to care much about your tax bill

I have never seen a fund management compensation structure that rewards portfolio managers for saving taxes.

Who’s taxes anyway? The tax picture of a 75 year old retiree in Florida is very different from that of an up and coming biotech researcher in California.

Very few portfolio managers get rewarded based on their after tax performance. Some funds are designed to minimize taxes, but the universe of such offerings is small. If interested search for “tax-managed” funds in Morningstar.

Lesson — if taxes are a serious concern for you, do two things.

First, optimize your asset location. What does this mean? You should hold funds with higher potential tax obligations in tax-advantaged accounts such as 401K’s. If you are already maxed out in your tax advantaged accounts, put funds with lesser or minimal tax exposures in taxable accounts.

Second, some fund structures are inherently more tax efficient than others. For example, the taxation governing mutual funds is less advantageous than that of exchange traded funds (ETF’s).

ETF’s, in general, are more tax efficient than mutual funds. Assuming similar strategy risk and reward, pick a fund structure that is more tax efficient. The tax savings will compound nicely over the long-term. More money in your pocket. Who doesn’t like that!

5. Actively managed mutual funds used to be the only game in town but ETF’s have joined the party

Mutual fund managers have been under attack for close to 2 decades. The heyday of the active equity fund dates back to 1999 when the Technology, Media and Telecom bubble was in full swing.

From an investment perspective, the key difference between mutual funds and ETF’s hinges on the role of the portfolio manager in selecting securities for the fund.

The vast majority of ETF’s mimic the holdings of an index such as the S&P 500 or the FT 100. An index is nothing more than a listing of stocks with associated weights. Unbiased service providers such as Dow Jones or Russell use a defined set of rules to arrive at such a list.

In theory, anybody can replicate an index. That is what ETF managers do — nothing more and nothing less than build a portfolio with the exact stocks in the exact proportions. They do not deviate. There are no sex symbols in the ETF industry!

ETF’s are un-managed in the sense that there is no stock picker or bond manager making active decisions. Because of this, the fees are typically several orders of magnitude lower than those charged by mutual funds. For example, the SPY ETF which mimics the S&P 500 has an all-in expense ratio of 0.09%. Most active mutual funds are over 1%.

In contrast, an active mutual fund manager will consciously deviate from the index in an attempt to out-perform. They may, for example, emphasize cheap stocks or try to find the next Amazon or Google.

Active management funds charge higher fees in return for the prospect of higher than index performance. When active funds outperform the index, the extra costs of these funds are worth it and everybody is happy.

When active funds under-perform, buyer’s remorse sets in and you have the same feeling as during a long winter in Seattle! Very low…

Up to the mid-2000’s ETF’s were small fry in the industry but the growth especially in the last ten years has been spectacular. Investors have been moving aggressively out of actively managed funds into ETF’s.

The most recent Investment Company data shows ETF’s in the US with $2,524 Billion in assets while mutual funds held $16,344 Billion. Mutual funds still dominate, but ETF’s have joined the party.

Lesson — ETF’s are legitimate alternatives to mutual funds and you should consider them. You should also measure the performance of your mutual fund versus the appropriate low-cost ETF.

For example, if you have a large cap US equity mutual fund in your 401K compare its performance versus the SPY ETF. If you own an emerging market equity fund compare its performance versus the IEMG ETF.

Mutual fund rankings relative to peers only confuse the issue. The number of Morningstar Stars or the latest Lipper rankings are niceties. If you have the option of owning an ETF similar in strategy to that of the mutual fund, the comparison should be relative to the ETF. Find that clarity!

6. The fund name is not always a good descriptor of what the fund owns

This happens when the securities that the fund owns are no longer representative of the stated aim and strategy of the fund.

How can this happen? We have something that people on the inside call style drift. Style drift happens when the characteristics of the securities held in the fund have changed.

For example, the EJW Small Cap Value Fund (purely hypothetical) may have been so successful that its stocks appreciated wildly. All the stocks went from small to large capitalization (capitalization refers to the size of the company).

At the same time assume that the stocks went from being cheap (hence the word Value in the fund name) to expensive. There is a dis-connect between the name of the fund and the type of stocks that the fund now owns. Your fund has become the victim of style drift!

Lesson — always know what your fund owns. Do your basic research by going to, say, Morningstar to get an updated view of your fund holdings.

At the very least you should understand your fund’s economic sector and geographic exposures, its capitalization (large, mid or small), and its style characteristics (value, blend or growth). Why? Because these characteristics can have a huge influence on returns.

Does your understanding of your fund’s strategy match up to what the numbers are saying? If yes, you have done your basic homework. If not, sprint away and choose a fund that you understand.

And if you don’t understand any of this, buy a low cost ETF such as SPY (US Stocks) or AGG (US Bonds).

If you can’t tell a stock from a bond go even simpler and buy an ETF that combines both such as the AOM ETF.

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7. Fund selection should be done only after you have figured out what type of overall portfolio best matches your goals and risk profile

A mouthful, I know. But actually the most important insight that I can share with you. Your financial health is at stake.

Smart investment decisions are not just about picking this or that fund. Low cost does not matter if the fund or ETF you picked makes you wake up at 3 AM in a pile of sweat. Similarly, being too cautious may be doing you more harm than good if your retirement nest egg fails to keep up with inflation.

Picking funds or ETF’s is a significant component of your financial health, but it is a distant second in importance to first figuring out what you are trying to accomplish with your money and how you feel about the inherent risk of investing

Everybody is unique in this regard. Even long-term partners can sometimes find themselves at odds when first discussing their goals and expectations.

And, it doesn’t get any easier when the discussion involves your feelings about the inevitable ups and downs created by market swings.

Lesson — before you pick any funds or ETF’s know yourself and your partner.

What are you trying to accomplish? How comfortable are you watching the fluctuations in your investment account? Are you confident of making informed financial decisions on your own?

At a minimum, figure out what proportion of your portfolio should be in stocks, bonds and cash reserves. This is a process called asset allocation and accounts for over 90% of the fluctuations of your portfolio. This is really, really IMPORTANT!

You can start with a free online tool such as that from Vanguard, but if your financial situation requires a bit more fine-tuning or some complexity the best starting point is to see a fee-only financial advisor.

Make your money work for you — your goals, your aspirations — it’s your life after all!

Be proactive about your financial health — it’s a big part of your life.


None of this shall constitute an investment recommendation. Consult your wealth manager if you need help.


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About the author

Eric Weigel

My goal is sharing my experience as an investment manager, certified retirement coach, and fellow Baby Boomer to enable people to design the life they want and that matters to them in their next phase in life. We all want to live longer, but we also want to lead a life of meaning, joy, and fulfillment.