Most financial advisors today recommend mutual funds and ETFs for their clients’ investment portfolios. Advisors tend to regard stocks as too risky for their clients, by which they mean the prices of individual stocks are too volatile. Moreover, learning to value an operating company and then navigating the short-term distinction between the company and its stock price requires a great deal of experience. When investors do not care about individual stocks vs. stock funds, advisors will invariably find that using funds is far easier.
However, we believe investors should care about this distinction.
Peloton occupies a small but important niche in the investment advisor marketplace: on the one hand, we serve primarily high net worth private clients; on the other hand, like institutional managers, we use primarily stocks, not funds, as the foundation of portfolios we manage. This article details five ways in which owning individual stocks offers distinct, tangible benefits vis-à-vis stock funds, particularly for taxable investors.
Fees on Fees
With each layer of fees, the advisor’s burden to demonstrate their value proposition becomes heavier. If an advisor collects a 1% fee and recommends funds which also charge 1%, investors must ask whether the combined 2% fee is worth it. We know of advisors who charge their clients a fee, then pay a consulting fee to a firm which selects funds, which in turn charge fees themselves – three layers of fees. Peloton clients own carefully researched, thoroughly diversified portfolios of individual stocks, and typically a few extremely low-cost ETFs. The net effect is that their all-in cost is capped at about 1% or lower. That relative saving is a true value add for our clients.
Large flows of money into and out of actively managed funds can create excess cash balances and forced sales, respectively. Some fund managers may also practice market-timing, allowing cash to build when they feel uneasy about the market ahead. This raises an important question: if a stock fund is comprised of, for example, 80% stocks and 20% cash, is it still a stock fund? By using individual stocks instead of actively managed funds, Peloton can ensure that your asset allocation stays close to your personal need-based target.
Tax Loss Selling
2021 was kind to investors who owned large cap stocks, with the S&P 500 equal-weighted index rising 27% during the calendar year. If you had invested $200,000 in an ETF tracking the index at the beginning of 2021, you would have had a $54,000 unrealized capital gain at the end of the year. Now imagine you had instead invested $10,000 in each of twenty S&P 500 component stocks instead of the ETF. Suppose also that at least one of your stocks fell into each return decile. The median 2021 return for the 10th decile (the worst performing 50 stocks) was -14%. In this example, it is likely that at least one of your stocks dropped in value from $10,000 to $8,600.
Whereas the index ETF investor would have no reason to sell and realize the 27% gain, the investor who lost $1,400 on one stock could sell that individual position and realize a capital loss. That loss could be used to offset other capital gain income or as a deduction against ordinary income, subject to a $3,000 annual limit.
The other side of the tax-loss example above is that charitably giving shares of appreciated stock instead of cash may both avoid realizing large gains and provide a tax deduction. Using the same example, now assume that at least one of your 20 stocks fell into the top return decile. In 2021, the median return of the 50 best performing stocks was 78%. Your $10,000 investment in that stock would have grown to $17,800. If you made a $10,000 charitable gift of this stock’s shares instead of selling it, you would be able to avoid realizing a capital gain of $4,400 and you would still have $7,800 of the stock left in your portfolio. To make the same gift, the ETF investor with a 27% return would avoid only $2,100 of potential realized gains and would reduce the position in the stock to $2,700. Simply disaggregating the holdings in an index can offer significantly better charitable gifting opportunities.
Investors who replenish gifted stock shares with cash avoid reducing their wealth. Best of all: unlike tax-loss selling, there is no time limit (the “wash sale rule”) to replace gifted stock. An investor could give shares of appreciated stock and buy the same company’s stock that same day without consequence.
ESG (“Environmental, Social, and Governance”) investing has become extremely popular. Many investors want to earn an attractive return on their savings but also be consistent with their personal values. Market cap weighted index funds allocate money across all stocks fitting the inclusion criteria, regardless of their ESG merits. While funds following ESG criteria are becoming more common, their exclusion policies may not match perfectly with your ethical commitments. The best way to ensure that your investments align with your values is to use individual stocks instead of funds.
In our more than two decades managing wealth for prominent families, we have learned an important lesson about volatility. Investors do find volatility disconcerting at times but unless they are coached to worry about it, they do not care about differences between stocks and stock funds. Quite the opposite is true: knowing the businesses they are invested in and being able to speak with portfolio managers directly often brings peace of mind.
Past performance is no guarantee of future results. Investing involves risk, including loss of principal. Diversification may not protect against market risk or loss of principal. The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities. Actual investor results may vary.
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