Individual Equity Basket vs. Index Fund

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SmallPotatoes
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Individual Equity Basket vs. Index Fund

Post by SmallPotatoes » Thu Nov 11, 2010 12:12 am

I was talking with a financial advisor today at work about the future, the trends, the bubbles, the hidden values out on Wall Street and one thing he said to me stuck: hand-picking an individual basket of equities instead of a broad based index fund like the S&P500.  His reasoning, and probably the only reason I listened to him, is that there's significant volatility in a basket of say 50 equities, whereas a index of 500 weighted companies tends to be a bit smoother.  Since the PP takes advantage of volatility it seems that a more volatile, smaller basket might indeed be inline with the PP.

I'm not saying that one should try to pick the hot stocks or that I know beans about how a company will do in the future, but rather just pick the top 10% of the S&P 500 for instance and go with that.  Thoughts?
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Re: Individual Equity Basket vs. Index Fund

Post by craigr » Thu Nov 11, 2010 12:14 am

Volatility cuts both ways.

Stocks are risky enough without concentrating the bets. The best way to own the stock market is to own the entire market. IMO. It's the most efficient way to capture the returns the market has to offer with no regrets.

EDIT: Also I suspect his hand picked basket of stocks is much more expensive to operate than an index fund. Probably will have more turnover as well which generates transaction costs.
Last edited by craigr on Thu Nov 11, 2010 12:22 am, edited 1 time in total.
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Re: Individual Equity Basket vs. Index Fund

Post by Storm » Thu Nov 11, 2010 7:24 am

Just a guess here, but this guy probably makes a higher commission on someone that rebalances a basket of 50 equities than someone that just buys and holds a single index fund.
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Re: Individual Equity Basket vs. Index Fund

Post by melveyr » Thu Nov 11, 2010 4:01 pm

Volatility is only worth chasing if you are rewarded for chasing it.

Some people load up on emerging markets and SCV because some academic literature suggest you get compensated for taking on this risk. This might be true.

However, most academic literature suggests that you don't get compensated for taking on individual company risk. That's why diversification is often called "free lunch." By diversifying into an index we are cutting down on risk while still capturing the risk premium.

Perhaps picking a basket of stocks that are more cyclical than the SP500 would reward for the extra cyclical risk you are taking, but why bother? More taxes, more management, more emotion, and more commissions.

I just buy an index and relax.
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Re: Individual Equity Basket vs. Index Fund

Post by BobS » Thu Nov 11, 2010 8:45 pm

I've spent the last few months putting together test portfolios using individual stocks, various mutual funds, and etfs.  In doing so, I set a few rules -

For stocks, they had to have both a DSPP (Direct Stock Purchase Plan) and a DRIP (Dividend Reinvestment Plan), as well as being established
companies.  I eventually used the mutual fund - LEXCX, as a starting point for the stocks as it's been around since 1935 and is passively managed.
The return for LEXCX averages 15%.  By the time I was done, I ended up with one stock from the fund - UNP and tossed the rest.

In looking at etfs, VTI, tends to be more consistent, regardless of how it's used.

In the end, ignoring the mutual finds in my 401K (not much choice), for the stock portion of my IRA, I'm doing the following -

33% VTI Total Stock Market etf
33% PRFZ FTSE RAFI US 1500 Small-Mid cap etf
33% AMANX Amana Trust Income mutual fund

Using just VTI will produce more return.

Personally - my irrational reasons are, VTI doesn't have enough small/mid cap exposure and AMANX has great set of value selected stocks from
companies that are not highly leveraged and do well, even when the market is down.

Of course, this means the overall return of the stock side will lag and not be as great as simply using VTI alone or getting lucky with stocks like
EMR - 145% gain over 1.5 yrs, CSX or UNP - 200%+ gains over 1.5 yrs.  But I feel better using the above than I would using any one etf or fund.

Perhaps I'll add UNP if the stock price drops, I'd like to bet on rail doing well over the next decade.
Last edited by BobS on Thu Nov 11, 2010 10:05 pm, edited 1 time in total.
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Re: Individual Equity Basket vs. Index Fund

Post by BobS » Sat Nov 13, 2010 11:21 pm

I should have given a coherent answer...
SmallPotatoes wrote:
I'm not saying that one should try to pick the hot stocks or that I know beans about how a company will do in the future, but rather just pick the top 10% of the S&P 500 for instance and go with that.  Thoughts?
The top 10% is what smooths out the S&P 500.  Adding small caps would add volatility.  In an earlier Harry Browne book - "Why the Best-Laid Investment Plans Usually go Wrong", Harry had a requirement that the beta had to be greater than 1.  If you take the S&P 500, starting at the top -

Exxon - Beta: 0.48, then Apple, Microsoft (barely above 1), General Electric, then Johnson & Johnson - beta 0.58.  Thus while possible, one has to
know what to select.  And, in doing so, some diversification will be lost - energy companies, health care, NO utilities.

In my opinion, the only reason to hold individual stocks in the PP, is as part of a dividend reinvestment strategy, where the stock compounds
it's growth through re-investment of the dividend.  To do that, requires a DRIP plan that is automatic and, preferably, paid for by the company.
And even with that, a part of the stock portfolio should include the Total Stock Market - VTI.  Or, if you must, the S&P 500.

Stocks suitable for a DRIP strategy need to be held for 10 to 20 years, thus the companies need to be stable and long term.  A list of some
of the suitable stocks can be found at - http://www.dividendgrowthinvestor.com/2 ... g-run.html.

Then it comes back to more than 10 stocks, and one is running a mutual fund.  Even with just 10 or fewer stocks, it's important to at least
be aware of the news associated with the company - did the CEO or CFO suddenly leave (Enron or HP)?  Did an accident occur (Exxon or BP)?
And it's important to, at a minimum, read each companies annual report, though it would be better to listen to the quarterly conference calls.

If you want volatility, use PRFZ, VXF, or VBR, at 50% to 75% in conjunction with VTI.  If you want real volatility, just use VBR with no VTI.
VBR has a beta of 1.24, VTI a beta of 1.03.
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Re: Individual Equity Basket vs. Index Fund

Post by TK3 » Sat Mar 12, 2011 11:19 am

I just switched my equity portion of my PP to 20% PRF, 5% VEU.  Beta of the fundamental index is 1.2 vs the market and I feel better not being weighted so much to the large caps.  Hopefully it will resist the urge to tinker.  My VP is all low beta dividend stocks which temper the higher beta of my index portion.  Works well in my MC simulator.  We will see. 
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Re: Individual Equity Basket vs. Index Fund

Post by longeyes » Sat Mar 12, 2011 11:58 am

Has Michael Cuggino ever explained why he uses individual stocks rather than ETFs in PRPFX?
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Re: Individual Equity Basket vs. Index Fund

Post by MediumTex » Sun Mar 13, 2011 11:32 am

longeyes wrote: Has Michael Cuggino ever explained why he uses individual stocks rather than ETFs in PRPFX?
It's just consistent with the fund's strategy since day one.

As a sort of PRPFX decoder ring, you can follow PAGRX, which normally mirrors the 15% of PRPFX held in "aggressive growth" stocks. 

For those who don't know, the other 15% of PRPFX's stock holdings are in natural resource and real estate stocks.

PRPFX is all about inflation.  Cuggino is just following a recipe that was written 30 years ago (though he does appear to be a pretty good stock picker).
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Re: Individual Equity Basket vs. Index Fund

Post by HB Reader » Sun Mar 13, 2011 10:08 pm

When PRPFX was set up in the early 1980's, ETFs and index funds didn't exist.  The universe of mutual funds was much, much smaller and most were mildly-diversified attempts to be complete ("everything to everybody") funds, much like many of the so-called "balanced" funds today.  Highly-leveraged  funds (like Profunds and Rydex offer now) didn't exist.  In the mid-1970's, HB began suggesting that individuals use warrants, something called "dual purpose" closed end funds, or leveraged stocks as a reasonable way to hedge a portfolio against a major stock market boom -- something that that very few investors in the late 1970's and early 1980's expected to occur. 

Without gettting into details, using warrants and dual purpose funds (which were self-liquidating) was difficult for funds or institutions to do in an effective way, but was possible for individuals.  Conversely, buying a portfolio of leveraged stocks that was diversified sufficiently to ensure participation in a major stock market boom required a much bigger portfolio and more expertise than most individuals possessed. 

PRPFX was (and is) big enough to get reasonable diversification through the direct purchase of growth and natural resources stocks.  As MT points out, Cuggino (and Terry Coxon before him) have been pretty good at picking high beta and resource stocks.  One advantage of this approach over ETFs is that there is one less level of fees, although fess are pretty low in ETFs.

Not long after PRPFX came out, HB became recommending a combination of several growth no load mutual funds (and later, just index funds) for the stock market portion of most DIY permanent portfolios.  I think he probably did this for simplicity sake and in response to all the attractive growth funds that started to appear after the start of the big bull market in August of 1982.  Most ETFs, of course, are of fairly recent (post-2000) vintage.                   
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Re: Individual Equity Basket vs. Index Fund

Post by KevinW » Sun Mar 13, 2011 10:29 pm

Anyone else ever wonder about using a growth index for the stocks?  That'd be more consistent with PRPFX and Browne's earlier writings.  However in Simba's spreadsheet, that change makes both returns and volatility a tiny bit worse.
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Re: Individual Equity Basket vs. Index Fund

Post by longeyes » Mon Mar 14, 2011 12:36 am

With the amount of assets that PRPFX has right now they could easily get much greater diversification within their charter.  A recent schedule of investments shows them owning 15 natural resource stocks, 18 REITS, and about 40 aggressive growth stocks.  That's not that many.

While ETFs didn't exist back in 1982, they do exist now.  Vanguard had a S&P500 index fund available for retail investors in 1976.
Last edited by longeyes on Mon Mar 14, 2011 12:38 am, edited 1 time in total.
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Re: Individual Equity Basket vs. Index Fund

Post by HB Reader » Mon Mar 14, 2011 3:37 pm

I don't think PRPFX needs more diversification in it's stock portfolio.  That is a sufficient number of stocks.  As a shareholder, I hope they keep it this way.

Vanguard's S&P500 index fund did come out in 1976, but "index investing" was a new and unproven concept at the time. It would not have been useful for PRPFX then or now.  HB warmed to the idea of using S&P500 index funds instead of leveraged stocks or funds only after index funds had proven themselves in the post-1982 bull market.  He did it both for simplicity sake and because he realized there was probably more leverage inherent in the overall market than he had previously thought.  But that doesn't necessarily invalidate using a portfolio of well chosen leveraged stocks for your stock market exposure.       
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Re: Individual Equity Basket vs. Index Fund

Post by moda0306 » Mon Mar 14, 2011 3:58 pm

HB Reader wrote: I don't think PRPFX needs more diversification in it's stock portfolio.  That is a sufficient number of stocks.  As a shareholder, I hope they keep it this way.     
Here's my general problem with stock-picking:  Even if it can be done, it has to be done with enough effectiveness to overcome the tax-inefficiency of moving out of stocks as the become overpriced (or fairly priced) and into stocks that are supposedly underpriced.  If one says "well we pick them and hold them for a very long time" then I'd say back, "then you're not really that great a stock-picker are you, if it takes 15 years for the market to realize that your stock was underpriced and come up to fairly priced."

More or less, taxes make stock-picking even more difficult than it already would be by a long shot.
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Re: Individual Equity Basket vs. Index Fund

Post by HB Reader » Mon Mar 14, 2011 8:09 pm

But they aren't picking stocks based on whether they are "underpriced" or "overpriced" like value investors.  They merely want stocks that have high betas (i.e., move more than the overall market).

I'm not trying to debunk or devalue the index approach, but to point out that the leveraged stock approach is consistent with the overall strategy.  HB was looking for investments with some inherent or built-in (but not from debt) leverage.  He discussed both gold and LT Treasury bonds as having this characteristic.  As I said, he eventually concluded that index funds probably give you close to the same long-term movement, but without the added work of researching individual stocks or growth mutual funds.   

They may have to occasionally buy and sell some of the leveraged stocks, but I doubt it results in much tax-inefficiency overall.
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Re: Individual Equity Basket vs. Index Fund

Post by longeyes » Tue Mar 15, 2011 3:33 pm

There are plenty of high-beta equity ETFs that PRPFX could use to get the same juice with much higher diversification.  Cuggino could certainly use sector ETFs to cover natural resources, REITs, and "aggressive" growth stocks.  I'm in PRPFX also but I also think the fund's under-diversified given its asset base.
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Re: Individual Equity Basket vs. Index Fund

Post by SmallPotatoes » Fri Mar 18, 2011 12:09 pm

Great feedback everyone.

I might be wrong in picking a few stocks to add to my PP, but I just consider this my VP. Bought some BP for my VP back several months and it's done well. Of course if I'd owned before it would have hurt. That's why I have VTI. This is the PP that I rebalance in and out of.

Surley, picking a fee stocks for VP or to add to a PRPFX holding can't be that determental to the PP as a whole.
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Re: Individual Equity Basket vs. Index Fund

Post by BobS » Sun Apr 03, 2011 9:22 pm

As I've been slowly moving the portfolio into a slightly altered version of the PP, I split the equity portion in half -

- one half consisting of - world allocation and natural resources mutual funds
- one half dividend paying stocks
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Re: Individual Equity Basket vs. Index Fund

Post by fnord123 » Tue Apr 26, 2011 1:45 pm

BobS wrote: As I've been slowly moving the portfolio into a slightly altered version of the PP, I split the equity portion in half -

- one half consisting of - world allocation and natural resources mutual funds
- one half dividend paying stocks
This seems like a pretty significant variation - the natural resources part will likely correlate with gold.  The world allocation will correlate with nothing in the regular PP.  The dividend paying stocks will reduce the volatility of the stock portion.

Not saying this is a bad idea, but it seems like it could behave quite differently than the PP at any rate.
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