Individual investors, possible structural advantages

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
psteinx
Posts: 2909
Joined: Tue Mar 13, 2007 2:24 pm

Individual investors, possible structural advantages

Post by psteinx » Thu Jan 11, 2018 3:38 pm

TLDR - I propose a list of areas (below) where individual investors may be able to outperform a 3-fund portfolio due to certain structural issues. For those who are interested in, possibly, doing a little bit better than a standard, simple portfolio (at the likely cost of extra time and effort), I hope this post is worth reading and perhaps commenting on.

====

There are structural differences in the investment options and strategies available to different classes of investors. These structural differences may be a result of differing tax situations, government/banking regulations, agency issues, liquidity constraints, and/or costs of research time. As a result of these differences, there may be cases where relatively standard BH advice (3 fund portfolio, perhaps with a separate allocation to REITs, a small value tilt, or whatever) may be beaten with an alternate approach tailored to the individual's structural constraints.

This will not necessarily be a comprehensive analysis, nor an exhaustive list. These alternatives may not be great for all individual investors (we each face our own set of structural constraints). But they're areas where, in my opinion, there are solid reasons to think an individual might outperform a base case investment. Also, I have experience with some of these, but not necessarily all. Do your own research please. I encourage commentary and additional suggestions. Warning: for some of these, it may be difficult to get as diversified as one can easily get with large index funds. But the tradeoff may be worthwhile...

1) CDs - direct and/or brokered (possibly on the secondary market). May yield a bit more than similarly safe government bonds. Reasons: a) $250K of FDIC insurance is too little for biggest players. Big players may not want to pick up small secondary market brokered CDs. I'm not an expert in these - I don't think they EXACTLY match the risk profile of treasuries (some issues with interest, if the bank defaults I think), and (state) taxes are likely different, but they may be worthwhile nonetheless.

2) Munis - especially in state, secondary market, tough to analyze stuff. This is less applicable if you're in a state with a very good (i.e. generally Vanguard), state specific muni fund. But for those of us without, we've already got a tailwind from state tax savings. I'm in Missouri - 6% state tax. So, if I find good munis with a 4% yield, I'm saving almost 24 bp in state taxes (I probably would still get a BIT of state tax free stuff in a national muni fund), plus around 9 bp in E.R. on a cheap fund. So that's about 33 bp to offset commissions, spreads, research time, and a somewhat riskier portfolio (less diversified). But I think the real boost is that I can research individual secondary market issues, and find some that I think are particularly attractively priced. A $1B (or $5B) fund doesn't want to spend a lot of time researching the $30K slice of some old unrated issue that just came onto the secondary market. I *can* research this relatively efficiently. It's a potentially deep topic, so I'll stop there for now, but am willing to engage in further discussion.

3) Physical investment real estate - direct ownership. Obviously not as hands off as buying an index fund or a REIT. But I think there are decent possibilities here for the investor with the time and inclination to get hands on. There are also, I think, some possible structural advantages in using a bit of debt for the smaller investor, secured not only by the real estate but also by W-2 income and the like, that are not strictly comparable to what's available to a REIT.

4) Physical real estate - backing other small players. I think, once in a while, we see folks on BH claim success by hard money lending and/or going in on real estate deals with trusted partners. Should be less hands on than #3, but more hands on than a REIT or fund.

5) Closed end funds, at least sometimes. Yes, even big investors *could* invest in closed ends, but there are some reasons why they rarely do, including liquidity. I think the opportunities here are stronger at certain times than others - there's are some liquidity issues when the market (or a portion of it) panics.

6) Illiquid investments generally. In the 2008-9 market environment, in my opinion, some large players were, net sellers, and there was insufficient liquidity to soak up the selling, resulting in large, actionable price disruptions. Again, a deep topic, I won't dive too far into it now, but I think that an eyes-open investor with some ability to reallocate across asset classes will sometimes see some good opportunities that aren't fully arbitraged away by the efficient market/large investors.

7) Microcaps/nano caps. Low liquidity, lots of analysis required to understand. Probably not attractive on average, but within the broad space, I suspect appealing opportunities can be found, sometimes. Structural issue keeping big plays out are liquidity, information, research costs, market cap/depth.

8) Angel investing. Another area where I suspect the average return is not so hot, but a really savvy investor could outperform.

9) Individual stocks, emulating a passive index. Rather than buying TSM or an S&P 500 index fund, an investor could roll their own portfolio with a variety of individual stocks (hopefully diversified). Advantage? Better ability to tax harvest losers, and hold on to, or perhaps donate, big winners. i.e. Potentially better tax-wise...
Last edited by psteinx on Thu Jan 11, 2018 4:18 pm, edited 1 time in total.

asif408
Posts: 1493
Joined: Sun Mar 02, 2014 8:34 am
Location: Florida

Re: Individual investors, possible structural advantages

Post by asif408 » Thu Jan 11, 2018 4:12 pm

Another structural advantage is no boss or management looking over your shoulder who will fire you if you underperform over a year or two, like many institutions might. So if you have a long-term strategy than may take 5 or 10 years to pay off you are more likely to be able to implement successfully as an individual.

OkieIndexer
Posts: 400
Joined: Sun Aug 23, 2009 1:10 pm

Re: Individual investors, possible structural advantages

Post by OkieIndexer » Thu Jan 11, 2018 4:31 pm

psteinx wrote:
Thu Jan 11, 2018 3:38 pm
1) CDs - direct and/or brokered (possibly on the secondary market). May yield a bit more than similarly safe government bonds. Reasons: a) $250K of FDIC insurance is too little for biggest players. Big players may not want to pick up small secondary market brokered CDs. I'm not an expert in these - I don't think they EXACTLY match the risk profile of treasuries (some issues with interest, if the bank defaults I think), and (state) taxes are likely different, but they may be worthwhile nonetheless.

3) Physical investment real estate - direct ownership. Obviously not as hands off as buying an index fund or a REIT. But I think there are decent possibilities here for the investor with the time and inclination to get hands on. There are also, I think, some possible structural advantages in using a bit of debt for the smaller investor, secured not only by the real estate but also by W-2 income and the like, that are not strictly comparable to what's available to a REIT.
Yes, physical real estate or land that you own, especially if it has a pretty reliable income stream like rental property, is a true alternative investment. Rental property can even have higher returns than the stock market in some scenarios.

My Depression-era grandmother (born in 1914) bought a bunch of double-digit % long-term (probably 5 year) CDs in the early 80s, and that combined with her rental property was all she needed to fund retirement (plus Social Security/Medicare). She did great, and she would have done great even if the high inflation/bad stock market 70s had continued into the 80s and 90s.
"In bull markets, people say 'The more risk I take, the greater my return.' But when people aren't afraid of risk, they'll accept risk without being compensated." -Howard Marks, Oaktree Capital

User avatar
Ethelred
Posts: 338
Joined: Sun Oct 30, 2016 9:38 am

Re: Individual investors, possible structural advantages

Post by Ethelred » Thu Jan 11, 2018 4:54 pm

psteinx wrote:
Thu Jan 11, 2018 3:38 pm
TLDR - I propose a list of areas (below) where individual investors may be able to outperform a 3-fund portfolio due to certain structural issues. For those who are interested in, possibly, doing a little bit better than a standard, simple portfolio (at the likely cost of extra time and effort), I hope this post is worth reading and perhaps commenting on.
I think it's an interesting list, and I agree that CDs represent an investing advantage for individual investors. I'm afraid I struggle to see how any of your other items can represent an advantage to an individual investor, though.

An individual investor and an amateur (with a day job) will generally be at a disadvantage when it comes to knowledge or time availability, in comparison to the economies of scale and the possibility to develop deep expertise available to institutions. That would seem to exclude your items 2, 3, 4, 7 and 8. Some individuals should be able to find opportunities, by virtue of their occupation or social network, but for many of them there will still be a big risk that they don't know as much as they think they do.

Items 5 and 6. While I personally think illiquid investments are under-used by individual investors, since most won't take money from their retirement accounts for decades, pension funds and some other institutional investors have even longer investment time-frames.

Item 9. This is obviously an advantage for institutions. The ERs of index mutual funds exist because they allow individual investors to take advantage of "economies of scale". Institutions either don't need to do this because they already have economies of scale and can conveniently hold lots of individual stocks, or they can use institutional mutual funds that have lower ERs.

Now, I think some limited advantages for individual investors do exist, either through the advantages only being available for smaller amounts, or through the different legal position of individual and institutional investors. An example of the former would be CD insurance through FDIC. An example of latter would be the capital gains home sales exclusion.

psteinx
Posts: 2909
Joined: Tue Mar 13, 2007 2:24 pm

Re: Individual investors, possible structural advantages

Post by psteinx » Thu Jan 11, 2018 5:08 pm

Not to dive too deep, but to expand a little on #2 (munis) and #9 (individual stocks).

Munis: There's already a tailwind for an individual, in certain states, because they avoid even the cheap (but non-zero) ER of a Vanguard national muni fund, and they can buy issues for their specific state (saving state taxes to a degree generally not possible with a national muni fund). I think there can be a further advantage in that an individual may value their research time at $50/hour or $20/hour or even $0 (if they kinda like this sort of thing), whereas a national fund would generally be valuing analyst time at a MUCH higher rate, and thus avoiding certain bonds (especially secondary issues), where research costs would swamp likely excess returns. (i.e. You might have to research 4 bonds to find 1 that's worth buying.)

Individual stocks: The ER savings here is likely smaller (and perhaps offset by other efficiencies of a fund, plus securities lending), but there's a (potential) structural advantage in having winners and losers more dispersed than they would be in a fund. Imagine a simplified investing universe of 2 stocks, A and B, and one fund F, that invests in those 2 stocks (equal weight). If, some time later, A is up 20% and B is down 20%, then the fund (F) should be flat. The investor who holds F cannot realize a capital loss, nor can he take advantage of the opportunity to appreciate donated shares. But the investor who holds A and B could sell B (realizing a capital loss), and/or donate some A to charity (donating appreciated shares can be more attractive, for tax reasons, than donating cash).

This is a structural thing. You generally have more tax flexibility in disposing of component individual stocks than you would in disposing of shares of a fund that otherwise held those stocks in the same proportions.
Last edited by psteinx on Thu Jan 11, 2018 5:14 pm, edited 1 time in total.

User avatar
willthrill81
Posts: 6425
Joined: Thu Jan 26, 2017 3:17 pm
Location: USA

Re: Individual investors, possible structural advantages

Post by willthrill81 » Thu Jan 11, 2018 5:14 pm

asif408 wrote:
Thu Jan 11, 2018 4:12 pm
Another structural advantage is no boss or management looking over your shoulder who will fire you if you underperform over a year or two, like many institutions might. So if you have a long-term strategy than may take 5 or 10 years to pay off you are more likely to be able to implement successfully as an individual.
+1

Honestly, I think that's part of the reason that we don't see active management beat passive more often than we do. Any strategy, including tilts toward anything, will underperform the broad market at some point, and it could go on for years. Investors have repeatedly shown themselves to be impatient with any strategy that lags behind the market for more than a year or two. That's why closet indexing is so rampant among active managers; they are assured that their performance won't be too different from the market's in any given year.
The overwhelming majority of top mutual fund managers — those who had the best record over a decade — spent at least three years lagging well behind others during that time, according to Joel Greenblatt, a hedge fund manager and author of the "The Little Book That Still Beats the Market." More than three-fourths of these star managers spent three years at the very bottom of the performance ladder, something short-term-minded investors tend to flee. But too bad for them. These managers all outperformed over the longer run — the decade-long period through the end of 2009.
https://www.cnbc.com/2016/12/13/berkshi ... oid-mobile

Warren Buffet has had periods where he underperformed the S&P 500 for long periods, yet he is still far ahead overall.

This is why I think that market timing is not more popular. Objective, rules-based systems have been demonstrated to reduce volatility without sacrificing a corresponding amount of return over the long-term, yet they usually underperform buy-and-hold during bull markets. Investors love to have downside protection from markets like 2008, yet most are not patient enough to lag behind from 2009 until the present. The fear of missing out is very real.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings

User avatar
Ethelred
Posts: 338
Joined: Sun Oct 30, 2016 9:38 am

Re: Individual investors, possible structural advantages

Post by Ethelred » Thu Jan 11, 2018 5:16 pm

psteinx wrote:
Thu Jan 11, 2018 5:08 pm
Not to dive too deep, but to expand a little on #2 (munis) and #9 (individual stocks).

Munis: There's already a tailwind for an individual, in certain states, because they avoid even the cheap (but non-zero) ER of a Vanguard national muni fund, and they can buy issues for their specific state (saving state taxes to a degree generally not possible with a national muni fund). I think there can be a further advantage in that an individual may value their research time at $50/hour or $20/hour or even $0 (if they kinda like this sort of thing), whereas a national fund would generally be valuing analyst time at a MUCH higher rate, and thus avoiding certain bonds (especially secondary issues), where research costs would swamp likely excess returns. (i.e. You might have to research 4 bonds to find 1 that's worth buying).

Individual stocks: The ER savings here is smaller, but there's a (potential) structural advantage in having winners and losers more dispersed than they would be in a fund. Imagine a simplified investing universe of 2 stocks, A and B, and one fund F, that invests in those 2 stocks (equal weight). If, some time later, A is up 20% and B is down 20%, then the fund (F) should be flat. The investor who holds F cannot realize a capital loss, nor can he take advantage of the opportunity to appreciate donated shares. But the investor who holds A and B could sell B (realizing a capital loss), and/or donate some A to charity (donating appreciated shares can be more attractive, for tax reasons, than donating cash).

This is a structural thing. You generally have more tax flexibility, in disposing of component individual stocks than you would in disposing of shares of a fund that otherwise held those stocks in the same proportions.
Sorry, neither of those make any sense to me.

For munis, you're saying that institutions can't compete with those individuals who like to value munis as a hobby? Choosing to value your time at zero doesn't represent a structural advantage. And I'm not even convinced it's true.

And you've explained the advantage of holding individual stocks compared to a combined fund well. But how does that represent an advantage for individuals compared to institutions?

User avatar
Meg77
Posts: 2414
Joined: Fri May 22, 2009 1:09 pm
Location: Dallas, TX
Contact:

Re: Individual investors, possible structural advantages

Post by Meg77 » Thu Jan 11, 2018 5:21 pm

psteinx wrote:
Thu Jan 11, 2018 3:38 pm

2) Munis - especially in state, secondary market, tough to analyze stuff. This is less applicable if you're in a state with a very good (i.e. generally Vanguard), state specific muni fund. But for those of us without, we've already got a tailwind from state tax savings. I'm in Missouri - 6% state tax. So, if I find good munis with a 4% yield, I'm saving almost 24 bp in state taxes (I probably would still get a BIT of state tax free stuff in a national muni fund), plus around 9 bp in E.R. on a cheap fund. So that's about 33 bp to offset commissions, spreads, research time, and a somewhat riskier portfolio (less diversified). But I think the real boost is that I can research individual secondary market issues, and find some that I think are particularly attractively priced. A $1B (or $5B) fund doesn't want to spend a lot of time researching the $30K slice of some old unrated issue that just came onto the secondary market. I *can* research this relatively efficiently. It's a potentially deep topic, so I'll stop there for now, but am willing to engage in further discussion.
I've been thinking about this a lot lately. My mom just inherited a large portfolio of muni bonds that are actively managed, and I'm having trouble recommending that she sell them all and buy the VG total bond market index instead (she's got plenty in equities in her own portfolio; keeping this bond portfolio will put her at about 50/50 AA). There does seem to be some added value in this space for active management despite the higher fees (which we are still waiting to have confirmed).

The bonds are managed by a firm out of Boston (Breckenridge if anyone has any info on them...). There are about 50 of them maturing over the next 12 years. Most have coupons of 4-5%, though the weighted average market yield is 1.96%. I'm really torn. The fee is going to be a big chunk of her return - but then again even the vanguard muni index charges 20 bps with a lot less personalized benefit.
"An investment in knowledge pays the best interest." - Benjamin Franklin

psteinx
Posts: 2909
Joined: Tue Mar 13, 2007 2:24 pm

Re: Individual investors, possible structural advantages

Post by psteinx » Thu Jan 11, 2018 5:24 pm

Ethelred wrote:
Thu Jan 11, 2018 5:16 pm
For munis, you're saying that institutions can't compete with those individuals who like to value munis as a hobby? Choosing to value your time at zero doesn't represent a structural advantage. And I'm not even convinced it's true.

And you've explained the advantage of holding individual stocks compared to a combined fund well. But how does that represent an advantage for individuals compared to institutions?
Munis: Let's say there's a block of $30K of a secondary issue muni. It's unrated, and to see if it's priced attractively, you'll need to do some reading and research. Let's say that muni has about 10 years to maturity or likely call date, and, based on previous experience, if it's attractive, it'll be about 1% better yielding than something comparable that institutionally sized, S&P rated, liquid, etc. That extra 1% per year, times 10 years, times the bond amount, is about $3K in "extra value", if it's any good. You should perhaps discount that a bit for liquidity, etc. Call it a $1500 "win" if it turns out good. But you also know, based on experience, that you'll have to look at/research several like this for every one winner.

Will Vanguard High Yield T-E be researching this bond? Unlikely. Will Van Eck or some other big fund? Maybe. But I'm guessing most of them will give it the most cursory look, at best, screening it out based on size. But can an individual operate in this space effectively, even if they value their time at some non-zero value? I think so.

As for individuals, it's not an advantage of John Doe versus Vanguard per se, but an advantage of John Doe buying individual stocks versus him buying a Vanguard fund. It's not that Vanguard is doing something wrong, or they're stupid or whatever. It's just a fact (per my understanding anyways for US investors and funds), that a typical fund cannot pass capital losses through to the investors in that fund. But investors holding the same stocks CAN realize losses by selling individual losers.
Last edited by psteinx on Fri Jan 12, 2018 2:17 pm, edited 2 times in total.

ThrustVectoring
Posts: 573
Joined: Wed Jul 12, 2017 2:51 pm

Re: Individual investors, possible structural advantages

Post by ThrustVectoring » Fri Jan 12, 2018 2:13 pm

Individual investors also get financing terms that generally aren't available for institutional investors - home mortgages. The prepayment and refinancing options are excellent and very competitively priced.
Current portfolio: 60% VTI / 40% VXUS

User avatar
packer16
Posts: 1067
Joined: Sat Jan 04, 2014 2:28 pm

Re: Individual investors, possible structural advantages

Post by packer16 » Mon Jan 15, 2018 9:06 am

The structural advantage of individual investors is the long time horizon they have for some of their money. This can provide an advantage in a panic as they can provide liquidity to selling shareholders. This can also be an advantage in small niches of the market where an individual has specialized knowledge as a result of their job or interests that can be combined with the long time horizon to purchase undervalued securities. While institutions have an informational advantage, they do not have a monopoly on how the information is processed & whether they can take advantage of the mispricing if it is in smaller securities where it will not make a difference to their bottom line. While most want a diversified portfolio, this targeted purchase of individual stocks either in a panic or based upon situation specific circumstances can be a value-add for a portion of your portfolio. The key in the targeted approach is knowing what you know and what you do not know & this can take some time to develop. IMO the targeted approach can add much more value for the effort than tilting or other "macro" techniques. I have added about 19% per year vs. the S&P 500 and 13% per year vs. small cap value since 2000 doing this. SCV tilting added about 6% per year over the same period.

Packer
Buy cheap and something good might happen

Post Reply