If your advisor has decided to own individual stocks rather than either mutual funds or ETFs (Exchanged Trade Funds) for your portfolio, I think you need to ask Why?  To justify the fees he is charging is a cynical (and likely truthful) answer.

The costs to do it well.

Large firms spend large sums of money to hire analysts specializing on understanding the drivers of an industry, the key players within it, the subtlety of a management team’s focus and drive.  As I was one of those guys, I traveled quite a bit to meet face to face with management teams.  Riding in the delivery trucks to meet customers, speaking with suppliers, etc.  All with the idea to develop a deeper understanding into the means a company drove value creation… or destruction.  I was trained by ex-CIA interrogators on methods to question management teams to detect deception.  We retained forensic accountants to go through companies’ financial statements.  These are the actions of the large mutual fund complexes, institutional asset managers and the established specialized hedge funds.  It must be viewed with a skeptical eye when someone attempts to invest in single securities without this level of detail.  Their competition is doing it.  If they are not, I suspect that they may be at a disadvantage.

Reinforced with empirical evidence

This is not to say it’s impossible to outperform these large complexes.  I will be the first to suggest that the large institutions have their own problems that harm their chances to outperform on a consistent basis.  But one must be cognizant that a a manager in the suburbs with limited resources has considerable headwinds.

To make matters worse, considerable evidence suggests that between 63% – 95% of professional managers underperform their mandates.  This has been shown to be true across investment styles, market caps, and economic conditions.  So, the net effect is that you need to believe that your manager is in the top 5%-20% of all managers around the globe to justify his desire to stick you in individual securities.  Those aren’t great odds…

The elephant in the room

To make matters even worse, stock picking may not even be that important compared to other factors.  In repeated studies, it has been shown that over 90% of the variation in individuals’ historical returns can be attributed to two factors; market participation and asset allocation.  That would indicate that individual stock selection has a very minor impact on your long term returns. Combine that with the fact that most managers underperform, it’s hard to understand why you should pay them for their skill at all.

All is not lost

It may sound like I am being harsh towards active managers.  I am.  Most deserve it.  Not all of them, but most.

The above studies’ results have most definitely influenced the architecture and processes of Auour. From a rational review of the current research, we have decided to approach investing by attempting to control the factors that drive performance; market participation and asset allocation.  And to do so with an eye on costs.

The above is not to say that all active managers are poor.  We are true believers that great investors exist.  Our experiences suggest that they focus on small companies or more esoteric investments where information inefficiencies tend to be larger.  Auour looks to identify those that have demonstrated skill over the long term and over various economic conditions and integrate them into a cohesive investment plan to drive stability in philosophy, durability in process, and performance in our clients’ assets.