By Todd Hoffman
The way I manage portfolios is different than the direction I believe most advisors are moving. I believe buying the stock of individual companies or owning individual equities in my managed discretionary models is a better tool for clients for five reasons. It’s important to understand that individual equities can be riskier than some other investments because equities can be volatile and owning individual stocks increases the potential to own a greater concentration of sectors or individual companies which can lead to lower overall levels of diversification. Individual equities also may not have guarantees offered by other investments and can lose money, particularly if held for short durations of time. Despite these characteristics, I believe when managed properly for suitable investors, owning shares of individual companies’ stock as part of a diversified portfolio may have the following advantages.
Cost and Transparency
I often hear from prospective clients their advisor or portfolio manager charges X percent and they usually have no idea they may be paying another 1 to 2 percent in additional fees over and above this management fee. These additional layers of expenses must be added to the fee the portfolio manager is charging. Further, this additional layer of expenses will not be reflected on an investment account’s monthly statement. As a result, a client should ask if they are paying internal expenses, commissions, hidden spreads or markups on transactions in their accounts on top of what is being referred to as the management fee. Generally, I charge only a management fee based on assets that are currently in the account. When considering if having mutual funds, ETFs or other investments in a portfolio with an additional layer of expense is a good idea, considering if the added investment is helpful with diversification, a potentially new asset class, or does having another manager in the mix add value, reduce risks or volatility. There could be times when they may, but as a rule my preference is to keep it simple and invest in the individual investments themselves, either through stocks, preferred stocks, individual corporate or municipal bonds.
Taxes
Individual stocks are only taxed on gains realized and dividends paid during the period an investor owns the shares. This is unlike other investments where investors can be taxed for gains which were made during periods the investor may not have benefited from or potentially have a loss. Further, losses taken in a portfolio may be used to offset other taxable gains. This can be very helpful when trying to minimize overall taxes. In addition, the longer the bull market continues, the greater the potential risk of this tax trap being a problem. I also try to minimize taxes when possible by selecting specific tax lots when selling or trimming positions to select shares held for over a year, which changes the taxable gain from a short-term gain to a long-term gain. This may add a significant amount in after-tax returns for investors in high tax brackets. Individual stocks can also be used to generate income through “qualified dividends,” which are generally taxed at lower tax rates than other types of income investments. This may be helpful when implemented as part of a diversified income strategy.
Using individual securities allows me to reflect a clear view of my market expectations and preferred investment themes to address my clients’ needs and goals.
When owning a basket of some investments, a client may actually own thousands of actual positions and at some point, the client can actually end up owning a portfolio which closely mirrors a broad index like the S&P 500. A manager could be doing this coincidently or on purpose, which is called closet indexing. Since clients are paying for my advice in the form of a management fee, I feel it is my obligation to invest only in the areas and themes which I have the highest degree of confidence in and which I feel have the greatest chance of being successful at making money or preserving capital. Moreover, utilizing a fee-based management structure rather than a transaction-based commission structure allows me to be proactive without causing additional expenses each time I make a transaction for a client.
Individual securities give the manager the ability to provide client customization.
Some clients have strong feelings and want their investments to reflect their convictions. A client may like everything about one of my models but one position, or one industry which is inconsistent with their beliefs. For example, a client may feel very strongly about the environment and not want to own carbon-based companies but have no problem with alcohol or tobacco companies. Another example, they may wish to overweight companies with good female representation but don’t want to exclude companies in the model that don’t meet this objective. With today’s sophisticated trading software, I have the ability to manage my model portfolios and still accommodate a client’s special interest or particular concerns. Sure, I could use another manager who specializes in socially responsible investments or a specialized ETF rather than my models; however, if a client likes my models but just wants to tweak the investments, or to have a little customization, I can accommodate their wishes without adding another manager’s entire portfolio.
Individual securities can be increased or decreased in a portfolio during different market conditions and complemented with other investments to potentially add downside protection, reduce volatility, increase income or choose when is the best time to take taxable gains.
I believe it’s much easier to implement downside protection with individual securities than other investments. When investing in individual securities, I can add stop losses or create hedging strategies to help protect against losses. I strive to spread gains over longer periods, possibly over more than one tax year and still protect profits. As the manager, I can help to protect against losses impacting the entire market or customize protection against a single large position.
I enjoy researching companies and have a passion for the markets. I also find my clients get pleasure and may feel a sense of pride in owning companies which may make the products and sell the services they use every day.
Todd Hoffman is a Founding Partner, Executive Managing Director and Wealth Manager at Steward Partners Global Advisory.
