How to gain exposure to a Diversified Portfolio of Companies: Collectives, Equities or Trackers?
When thinking about investing some money into Equities, or company shares, it is important to consider the best way to get your exposure and at what cost.
For a new investor, it can be difficult to judge the best approach and so here is a very concise guide to the various instruments you can use. It really depends on your priorities, whether that is diversification, cost, whether you want to invest in certain sectors or companies or indeed you want to actively exclude any. There are also considerations around liquidity. Depending on the size of the portfolio, it may be more cost effective to favour one approach over another, however all have merits and drawbacks.
There are, broadly speaking, three main routes to investing in Equities and they all have slightly different characteristics, each of which will appeal to different investors.
Investing in direct Equities
these are the individual shares in companies that you can buy directly. For instance, the FTSE 100 is an index of the 100 largest listed companies in the UK and an investor can buy into any of these companies directly. As an investor trying to build a portfolio, you will want to own a selection of Equities to give your portfolio enough diversification to ensure you’re not putting all your eggs in one basket, yet still give you good returns.
There are academic studies out there which try to put an exact number on it; generally people agree somewhere between 20 and 30 Equities is an optimal number that spreads the risk without over-diversifying. The costs are cheap – you pay a very small cost to buy the shares in the market (the “spread”), whatever Stamp Duty might be applicable (0.5% on transactions over £1000) and then your platform charge.
The benefits include being able to invest in exactly the types of companies you want and in whatever weightings you want. You are not forced into owning anything you do not want to own and you can, if you are skilled or lucky enough, beat the market performance by owning the higher growth companies and avoiding the bad ones. The larger the company, the more liquid it is because there tends to be more buyers and sellers. Investing directly, you are in complete control which can be a good or a bad thing. You also then need to invest the time to monitor your Equities on an ongoing basis.
Passive Index Trackers
these have becoming increasingly popular for investors who simply want exposure to various markets, for instance the FTSE 100 or the S&P 500 Index. The trackers – in the form of Exchange Traded Funds (ETFs) – aim to move up and down almost exactly with the underlying index they are tracking.
They are increasingly very cheap and it is a highly competitive industry and so liquidity is usually very good. They are especially good for people who do not want to outperform or underperform a market but just want the exposure, and hence it is referred to as Passive investing. You can, though, still build a portfolio made up of many different ETFs and change the allocations to various markets or geographies easily.
However, you have no control over what the underlying index has in it – investing in a FTSE 100 tracker means you will have significant exposure to Oil, Gas and Mining companies… sectors that can be very volatile. If you are an ethical investor, these sectors may not be part of your plans and so you have to be careful about which indices or ETFs you decide to buy. And whatever companies end up going into the index every quarter that it is rebalanced, you automatically get exposure to them. The costs are simply the
platform charge and whatever the ETF charges (this can be less than 0.1%, but can be much more).
Actively Managed Collectives
these are baskets of Equities that are actively picked by a fund manager and so could bear little resemblance to its benchmark. The fund manager takes your money and invests it in a large number of equities and so they are usually well diversified. The fund will usually have a stated aim, for instance investing in US Smaller companies, or UK Income companies.
There are hundreds of funds to choose from and will all have slightly different processes in how they select their underlying investments. They differ from Trackers as they will try to beat a certain index, or invest with specific criteria/restrictions, meaning their performance can be very different to their benchmarks. They tend to have higher costs than a Tracker as there is usually an ongoing annual management charge, and although these are under downward pressure they can be the best part of 1% on an annual basis.
The benefit is that you are paying for a manager who between him/her and their teams, spend a lot of time analysing the companies they are investing in and therefore claim to have a superior grasp than a simple Tracker. The sector weightings can end up looking very different to that of their underlying benchmarks and so the performance will also vary. Some of the best performing investments are Actively Managed funds, but they also have some of the worst returns where a fund manager can continually fail to beat its benchmark.
In truth, and like so many other debates that occur, there are always many things to consider when choosing what style is most appropriate for you. There are plenty of ways to skin a cat, so to speak, and a lot of the decision will come down to an investor’s particular motivations for investing, what other investments they may already have, and also whether they have any specific requirements. “Smaller portfolios”, however that may be defined, tend to benefit from the diversification and simplicity that ETFs and Trackers offer, and the more complexity you want to add the more Direct Equities you will want to include. There is no one solution for everyone, but it is worth spending the time to weigh up all your options when establishing a new portfolio.