Let’s begin by using our imaginations a little bit. Imagine for a minute that we are starting a mutual or electronically traded fund (ETF). Pretend we are someone like Jack Bogle, the founder of Vanguard. We have decided to collect money from people and invest it in stocks. We are going to create a very large fund company and charge a percentage of the assets we manage. The more assets we have in our funds, the more money we will make as a company.
Owning a fund will work like this: people will give us their money, we will buy stocks with their money, and when they want to use their money later, we will sell some stock and give them back their money. As more and more people give us money to manage, our fund will get larger and the fund will own more and more stocks.
If our fund gets large enough, we will have very large holdings of many companies. We may even become the largest owner of some small companies. However, as our fund gets bigger and bigger, there will be fewer and fewer companies or funds that we could sell our entire holdings of a stock to. For example, if we own 50 million shares of Apple, there won’t be many buyers out there that could buy 50,000,000 shares of that stock. At current prices, that would require $8,600,000,000!!
Now what if lots of people were to ask for their money back, all at the same time? If we have many people asking for redemptions of their shares, we need money on hand to refund them. In order to raise the money, we must sell shares. As a huge fund company, we would have to sell to another huge company. But when the market is going down, the other companies are also having stockholders withdraw money. They don’t want to buy. They want to sell.
In order to avoid the problem of giving lots of people their money back, it would be in our interest as a fund company to convince them not to sell their shares. How can we convince them to hold on? Well, we could tell them to invest for the long term…
- “Stick with it through the down times.”
- “It always bounces back.”
- “You can’t beat the market, so just be an index investor.”
- “It’s better for taxes.”
- “The average active manager doesn’t beat their index.”
Perhaps if we spread these ideas, and investors start to believe us, they won’t ask for redemptions. The issues of selling large orders could therefore be avoided. Fewer redemptions makes it easier for us, the fund company. Who cares about the little investor. We are in this to make money for ourselves.
Does this sound plausible? Well, this is exactly the situation the American investment industry is in now. Blackrock is the largest investment company and its funds hold a total of almost $6 trillion. Vanguard is second with $4.5 trillion. How do you stack up? Even if you have millions to invest, you are small potatoes. Think the funds care about your interests?
Next, we will take this a step further and ask why are investors playing by the fund’s rules?
Nick Saban, the multiple national title winning head football coach at the University of Alabama, was interviewed on the Feherty Show on Golf Channel. He made a very interesting comment about the reason he likes being a college coach. He said that he can recruit the best players.
In college football, it is entirely within the rules to recruit the best high school players. By stacking his team with the best players at every position, it becomes highly likely he will win the games. The NFL (where Saban was an unsuccessful coach of the Miami Dolphins) has salary cap rules to try to bring equality amongst the teams. Saban’s strategy of getting the best players was not possible under the NFL rules.
How does this relate to investing? Well, investing has a set of rules, laws actually, that are set by the government. There are also a set of “rules” that the investing industry plays by that are designed to increase their profits and not necessarily the investor’s return. These industry practices, or “rules”, are often a result of how the investment world has chosen to do business to make it easier and more profitable for themselves.
We can’t break the laws obviously, but we can use the industry’s practices to our advantage. We can do something similar to Nick Saban and align our strengths as individual investors with our strategy, so that we have a greater chance of winning.
The biggest common practice the mutual fund industry uses that we small investors don’t have to follow is their practice of always being invested. Some mutual funds manage hundreds of billions of dollars. They may have position sizes in the hundreds of millions. It is very difficult for them to sell a hundred million dollars of stock to another investor. There just aren’t that many investors out there that would want to buy that much. It would therefore take them several if not many trading days to get out of a large position. Due to this difficulty, they remain invested at all times.
Small investors don’t have this issue. We small investors can easily find someone to buy our shares on the open market. To take advantage of this, we need to realize it is okay for us to sell our shares. Remaining in a stock that is decreasing in value is not something small investors need to do! Large institutions might have to stay in a losing position because they have difficulty getting out, but not we.
For maximum advantage, we should move in and out of funds at the correct times. We are nimble, we can be quick. Liquidity is the small investor’s friend. It’s more of a guerilla style of warfare versus lining up like the British Redcoats. Lining up and shooting each other gives the advantage to the larger army. Staying invested and waiting through the stock market declines is playing by the fund company’s rules.
What we should be doing is playing to our advantage. We can sell a position and move on to our next investment without any worry about being stuck in a position. This is especially advantageous if an investment has started losing value. We can cut our losses and move on to a better investment.
Another thing we can do is sit in cash until the market is in our favor. Institutions are pressured into always being invested. Their managers are being paid to invest, so they must invest. Even if it’s not the best time.
If we could avoid the huge drops the stock market routinely goes through, we will have far better investing returns. As small investors, we can make trades that are timed properly. Mutual funds don’t have this luxury. The small investor has an advantage by using a more active, nimble strategy.
At Andrew Marshall Financial, LLC, we use an investing strategy that creates an advantage for the investor. We use the fund companies for their low fees, but we don’t sit around while our investments lose money. For more information click here.