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Winnipeg Free Press - PRINT EDITION

Banks pushing index products? You can do better

By: Fabrice Taylor

Posted: 04/28/2012 1:00 AM | Comments: 0

The trouble with this country is while it looks big on a map, it's really quite small.

Thirty-five million people is not a large number, and we pay for it in a variety of subtle ways, mostly by being beholden to a number of oligopolies, such as in airlines, cellphone providers and banking.

Banking is particularly pernicious, and not only because of the fees we get charged (you may have noticed, or not, that your regular banking fees have gone up lately. When banks' loan books slow down, they reliably tap us for more income through little fees that add up when you have a lot of customers).

The other trouble with having so few financial institutions is we are easily brainwashed to do what the banks and big firms want us to do.

And as investors, what they want us to do is buy index funds or ETFs that invest in the big index. This is an easy trap to fall into when you're not too financially sophisticated or you're just too busy or lazy to take the time to understand things (hey, we're all lazy sometimes). But it's costly and here's why.

The major index on any market tends to be the biggest names traded on that exchange. Bigger firms tend to be more liquid. Liquidity means average trading volume -- measured by the number of shares, the total value of the traded shares or both.

You may have noticed when a company goes public, its value typically goes up. Those who owned it privately enjoy a valuation "lift" when the stock starts to trade. Why? Because of the liquidity. The convenience of being able to buy and sell a small amount of shares brings in more buyers who couldn't buy privately, and for this convenience they will pay a premium. So, liquidity adds tremendous value -- as much as 30 per cent -- to a company.

The more liquid a company, generally, the more valuable it is -- that is, the bigger the premium its stock fetches in the market.

That means the index tends to be not only liquid, but also relatively expensive.

Now here's the rub about liquidity. If you manage a billion-dollar fund, you won't buy shares in a $10-million company no matter how promising. Why? Because even if you buy 10 per cent of that firm's stock, that's $1 million. If it doubles in value, you make a 100 per cent return, which most funds can only dream of (they're very happy with 10 per cent). But you only add $1 million to the fund, or 0.1 per cent. It's just not worth the time and effort to look for these little stocks. Similarly, a $300-million company with excellent prospects but with management owning half the stock is also likely out of the question because it will have no liquidity.

Hence, we get a bias of information that the index is the place to be because it's more liquid (and usually safer and diversified). But if you're a small investor, liquidity is highly overrated. You are not investing $1 billion. Much less. So you can invest in that $10-million company, or the one with high-management ownership. And you will do better than the index if what we described about them is accurate. On top of that, a lot of these smaller firms, which are always described as "risky' by investment professionals, are in fact not as risky as the index, which is the canary in the coal mine. When the Greeks riot in the streets or the Spaniards can't borrow money, the index gets crushed. But a portfolio of smaller firms doesn't necessarily (and I can attest to that because my own investments don't care what's happening in Europe).

Banks and financial firms, of course, want you to buy their index products, which are cheap for them to run and scalable -- meaning more profits for them. But a smaller money manager who doesn't need the liquidity of the big boys and is skilled will give you much better returns, all else equal.

Fabrice Taylor is an award-winning financial journalist and analyst and author of the President's Club Investment Letter. Email him at:

fabrice.taylor@gmail.com

Republished from the Winnipeg Free Press print edition April 28, 2012 B9

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