Pick A Winner Or A Portfolio?

We examine why it is becoming increasingly difficult for investors to benefit from "winners" and why building an investment portfolio is more suitable.

I met a very glum Italian fund manager at a Dublin bus stop the other day. A former client, he’s usually a cheerful chap and my initial fear was that after 18 years living in Ireland the excruciating “1-minute due” display at urban bus stops had finally broken him. I was wrong. Something else was broken.

Irrespective of our professional relationship, both of us over the years would have shared a passion for financial markets and the events that shape them. On this particular morning, my fund manager friend was less talkative and declared he was past caring about the specific drivers of markets as it just didn’t matter anymore. For a brief moment, I thought he had lost his job but he quickly reassured me he was still working in the equities market. He then explained that the reason for the dip in his professional enthusiasm was a sense that markets were “broken”.

After further discussion, it was clear that central banks’ ultra low-interest rates and consequent turbocharging of prices across all asset classes were not his only professional frustration. Yes, as an “active” fund manager this combination of almost free money and frothy asset inflation made it difficult for his firm to beat or even match the performance of overall market replicating index funds and exchange-traded funds (ETFs). But there was also a whiff of resignation that the higher fees charged by an “active” manager who picks individual stock winners could no longer be justified. Bluntly, the active fund manager business model was in danger of breaking too.

Not so in the world of super cheap index funds and ETFs. These funds don’t pick winners or actively trade. They just mimic at very low cost the exact constituents of major indices like the S&P 500, Nasdaq, Dax and FTSE 100. The past decade has only seen one negative performance year for global equities and passive fund costs to investors continue to go lower, in some cases to almost zero. No surprise then to see that index funds and ETFs have quadrupled in size since 2010 to just over $10 trillion according to Robin Wigglesworth at the FT.

The investor flight to cheap index portfolios is killing the traditional active manager who charges his/her clients an annual management fee based on their expertise in researching and selecting winning stocks. The ugly truth is that such “expertise” fails to reveal itself consistently and only a very few active managers produce long-run market-beating performance. Time is possibly the active manager’s greatest weapon – think Warren Buffett. However, long-run historic data would suggest there really are only a few meaningful winning bets.

We have previously referenced a famous 2017 research paper from Arizona State University’s Hendrik Bessembinder. The findings are stunning. The best-performing 4% of all listed companies account for the entire gains of the US market since 1926. As practitioners in the world of start-up investments, this has given us pause for thought as to the best investment strategy for investors on equity crowdfunding platforms like Spark CrowdFunding.  The good news for crowdfunding investors is that a critical component of performance/success in the larger public markets is low costs.

The no-fee model for investors on crowdfunding platforms is a great start. It gets even better if one takes into account a further 40% discount on your initial capital stake when the investee start-up company carries an EIIS badge.  So far so good. The next suggestion leverages the experience of active and passive managers over the years and the historical truths in Bessembinder’s research. It is incredibly difficult to pick winners, particularly at an early stage in a company’s journey. The information gaps are huge. However, by employing a portfolio/index type strategy an investor can not only build his own low cost (free) exposure to an entire asset class of start-up private equity but can also avail of a steady stream of opportunities on crowdfunding platforms over 3-4 years.

A simple monthly budget of even €100 to be invested in a company every month for 4 years would give a patient investor exposure to almost 50 companies with exciting prospects. Some companies might not survive but those that thrive can deliver very nice returns for the overall portfolio. Don’t forget you have a 40% tax cushion to start with so your approximate €5,000 budget over 4 years is really only €3,000. Then remember that 4% figure from Arizona.  My fund manager friend is beginning to realise his time would have been better spent building portfolios for specific asset classes (like private equity) rather than trying to find the very few “winners” in the broader market indices.

Crowdfunding investors can benefit from the 2020 hindsight of battered active fund managers over the coming years with a sensible portfolio strategy. We will be writing much more on this in the coming weeks as we get a sense of our monthly pipeline of campaign opportunities. Unlike Dublin Bus, we will avoid the “1-minute” hype and do our best to provide a steady flow of campaigns through 2020.


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