Stock Picking or Model Portfolio?

Why having “a guy” who picks stocks became a harder case to make, how model portfolios and TAMPs replaced it, and the trade-offs of each.

For decades there has been a belief that stockbrokers could pick some of the best untapped, undervalued stocks in the equity markets. Before the commercialization of the internet, it was not uncommon to “have a guy” who would pitch different stocks. Fast forward to 2017, and stockbrokers are becoming less mainstream and more of a one-off ideology. Movies like The Wolf of Wall Street make stockbrokers out to be sleazy. However, investment firms have begun repackaging stockbrokers as investment adviser representatives and having them pitch Turnkey Asset Management Portfolios, otherwise viewed as Target Asset Model Portfolios (TAMPs). Essentially, TAMPs are strategies that pool mutual fund managers, exchange-traded funds and indexes together in an attempt to manage a client’s portfolio using some of the tenets taught in Modern Portfolio Theory (MPT). Unfortunately, these TAMPs have done little to further the belief that active management can outperform market indices over an extended period of time. Therefore, a fundamental question arises: which is better, a stock picking service or a model portfolio? This article will dive into each strategy to better answer this question.

Stock picking services

The art of picking stocks originated with the premise that information is the key to making money. Before the commercialization of the internet, information moved more slowly, which made it easier to trade on public information. However, over the last 20 years technology has made significant strides in bringing information to investors more efficiently. Through these technological advances, picking stocks has become more challenging, as information is abundant, almost to an excessive point. With hundreds or thousands of pieces of content written about a company, it can be difficult to wade through the material and decide when or where to invest. This is why stock picking services like Motley Fool Stock Picks or Jim Cramer’s television show Mad Money have been well received. While we do not endorse or support these services, many investors believe they offer stock picking advice based on research, trend analysis, and technical or fundamental data points. Essentially, investors have outsourced their stock research (for a fee) to these services in an attempt to save time and, more importantly, to rely on others to make bold predictions on their behalf.

However, not all professionals are created equal. Under the Investment Advisers Act of 1940, there is an exemption outlining who is required to be licensed to provide advice on investments and who is exempt from the rigorous licensing requirements. The exemption states, “publishers are excluded from the Act if advice is provided impersonally, is ‘bona fide’, and is of general and regular circulation.” In other words, the authors of these stock picking publications may be providing a point of view without the securities licensing that regulators require of a financial advisor or investment adviser representative. Make sure the person originating the content is a qualified, licensed investment professional.

The value of a model portfolio

I believe the process of investing involves two elements: art and math. A well-thought-out investment plan is the intersection of those elements. More aptly stated, an individual can conduct extensive technical and fundamental research to find appropriate investment opportunities. The research can indicate where to invest in a market, which companies to invest in and when to invest. However, if investing were only about the math, then it would stand to reason that anyone could arrive at the same calculations. This in turn could translate into everyone buying the same, or similar, investments. To stand out amid a sea of sameness, there needs to be something that differentiates one strategy from another. This is considered the “art” of investing.

As new information is produced, changes to investment strategies may need to happen quickly, making access to real-time information a priority. Therefore, anyone who is not able to stay on top of stock picks or be actively involved in the day-to-day management of a portfolio tends to turn to pooled investments like mutual funds and exchange-traded funds. Under these investment structures, an investor no longer needs to worry about daily stock picks. The investor leaves daily management to the investment manager who operates the fund. So why would an investor need a TAMP strategy when the investor can simply invest in a mutual fund or exchange-traded fund?

TAMPs were built on the same premise as a stock picking service: to provide professional investment support for a fee. However, instead of investing in individual equities, this group of investors prefers to hire a company or person to diversify their investments among many fund managers. It is the fund managers who conduct research and make the stock picks based on a myriad of factors, such as market trends. TAMPs differ from stock picking in three areas:

• TAMPs leave active individual security selection to the money managers of the individual funds, allowing multiple strategists to coexist within the same portfolio.
• TAMPs focus on finding value-added fund managers that complement each other, thereby building an asset allocation model that meets an investor’s goals and risk preferences.
• TAMPs are built on the bedrock of MPT, using asset allocation and diversification to manage the risk-return tradeoff.

Each of these points highlights the desire of some investors to delegate direct oversight of their investment strategy to professionals. However, over the last fifteen years TAMPs have come under fire for not outperforming their benchmark indices. This underperformance has further supported the claim by passive investors that index-based investing is better and less expensive. Why? It has to do with diversification and asset allocation.

Two of the tenets of Modern Portfolio Theory are asset allocation and diversification. In essence, these tenets posit that a portfolio’s overall performance is a product of the types of asset classes used and the percentage invested in those asset classes. Combining enough non-correlated asset classes should produce a reduced, weighted standard deviation that can minimize a portfolio’s volatility. An example of this concept can be seen in combining three indexes of different asset classes. Since an index represents a basket of underlying investments, combining (in equal proportions) a domestic equity index with an international index and a fixed income index should produce lower volatility than a single equity index. Unfortunately, these tenets create a problem as it relates to performance. The more “watered down” a strategy is through extensive diversification and asset allocation, the more likely the strategy’s performance will be impacted. This performance impact can be exaggerated when the TAMP’s fees are deducted from gross performance, resulting in underperformance compared with the TAMP’s benchmark.

Choosing what fits you

When deciding to invest, it is always important to make sure you understand your financial goals, investment goals and comfort with risk. If you are very risk tolerant and comfortable with single-stock risk, then the risk of stock picking may not be a concern for you. On the other hand, if you are not interested in single-security risk and would prefer to use pooled investments like mutual funds or exchange-traded funds, then you will need to conduct your own research on which fund managers are best suited to your investment strategy. However, if you do not want to perform the necessary research on various fund managers, then you may want to consider employing the services of an investment company. If you do employ an investment company to manage your funds, make sure you understand how its model portfolio(s) are constructed, what the performance history looks like and whether its strategy is aligned with your financial objectives.