If you’re an enthusiastic share investor, you’ve probably wondered about this one before. Should you outsource the stock selection to a portfolio manager or should you do it yourself? A few things to consider:

Do you have the skills to pick shares?

What a fantastic boost to the ego it will be if your share portfolio performance beats Allan Gray or one of the other award-winning unit trust managers. But unless you know how to analyse a company, accurately estimate its future cash flow and evaluate its business strategy, chances are slim you’d keep it up over the long term.

While I find it great fun to trade my own shares, I have no delusions. My share picking skills are not on par with award-winning investment houses with their CFA-qualified and experienced teams.

Do you have the time to manage shares?

Following company news and calculating whether the share price adjusted appropriately is a full-time job. Unit trust managers have whole teams focusing on the shares in a specific sector. They have the time to visit companies, attend shareholders meetings and ask the difficult questions.

How much are you spending on trading costs?

Because share trading costs generally form a larger percentage of the trade with small amounts, and you often pay a minimum amount (e.g. R120 with ABSA), you could end up paying away more than 1% of the trade for transactions smaller than R12 000. Unit trust fund managers, on the other hand, pool your money with other investors and negotiate much lower trading fees with their brokers. However, what you score in trading costs, you could lose in investment management fees, which are automatically deducted from your unit trust investment every year.

Does SARS view your trading profits as income?

If you are someone who won’t draw the money in your trade account within three years, but believe in frequently trading shares to benefit from short-term price fluctuations, you may find you’re paying less tax if you outsource the job to a unit trust manager who has the same short-term, opportunistic approach. That is because SARS is likely to view your trading profit as income if you sell your private account shares within 3 years of purchase. If you’re in the top tax bracket, this means you have to pay SARS 40% of the profit.

But unit trusts managers can trade the shares as often as they like – they don’t pay tax on their gains in the portfolio. You pay tax on the growth in the unit trust price from the time you invest until you eventually withdraw your investment. If you keep it for longer than three years, SARS views the growth as a capital gain and not as income – even though the fund managers had the freedom to sell shares whenever they saw opportunities. This means you could pay four times less tax than if you traded the same shares yourself.

How much risk do you want to take on?

Unit trust funds are usually well diversified and invest in portfolio of at least 20 shares. This diversification decreases your investment risk. It’s therefore unlikely that you will lose 80% of your money in one year; it’s also unlikely that you will gain 80%. With your own share portfolio you don’t have the restrictions of the Acts regulating unit trusts and can hold only one share in your portfolio, if that’s what you want.

If you’re either a speculative, high-risk investor or a semi-retired portfolio manager, a share trading account will probably appeal to you more.

So, you’ve decided you have enough time to sit through all the ups and downs of the stock market and hope that handsome returns will reward your patience. I bet you’re getting plenty of contradictory advice from other share investors, who seem to be divided into two main camps: the index-trackers versus the believers in active equity management.

What is the difference?

With index-tracking you buy all the shares in the index in the same weightings as that index. If you track the FTSE/JSE All Share Index, for example, your index-tracking fund will invest in all the shares listed on the JSE and if Anglo American makes up 20% of the JSE, your fund will allocate 20% of its capital to Anglo American. In other words, index-tracking funds just replicate an index and their managers don’t have to decide which shares offer value for money. They are therefore also called passive managers.

Active managers, on the other hand, seldom buy all shares in the index and if they think Anglo American is too expensive relative to its anticipated future earnings, they may decide to invest only 5% of the fund in this share, for example. Conversely, if they think a share is cheap, they may buy more of it than its percentage weighting in the index. They have the freedom to actively pick shares in quantities that they think suit the shares’ value-for-money ratings.

To choose active management, what do you have to believe?

1. Shares are not perfectly priced all the time

Active management only makes sense if you believe that the market does not price companies correctly over the short term, which offers opportunities to buy under-priced shares.

2. Managers who consistently out-perform the market exist

Sobering slide 5 in the latest Nedgroup Investments September 2008 Partnerships Roadshow presentation shows that over the past seven years, the average equity unit trust manager returned 22% after fees – the same as the JSE All Share Index. Active management seems less futile when you think that, if about half the managers under-performed, half of them had to out-perform the Index. In other words, out-performing managers exist, but are they consistent?

I don’t expect a fund manager to out-perform every year. In fact, studies show that for a fund manager to out-perform over the long term, he often has to take contrarian views, which could frequently make him one of the worst performers over the short term. Your typical active manager expects the value of his chosen shares to unlock after three to five years only. With ‘consistent out-performance’ I therefore mean out-performance on a rolling 5-year basis.

3. You know who the out-performers will be

You should be able to get hold of the names of the rare few managers who have consistently out-performed on a rolling 5-year basis over the past 20 years. But that is historic performance. Do you believe that they will continue to out-perform?

4. The out-performance will out-weigh the higher costs

When you compare past performance, remember to look at the return after all fees and fund expenses were deducted. Generally, active managers are more expensive than index-trackers due to the time that they spend on researching and valuing companies.

When you choose passive management, what are you settling for?

1. Average stock market performance

While there’s little risk of investing in the worst-performing equity fund, you have no opportunity to out-perform the stock market either.

2. No way to detect and avoid market hype

It is a mistake to think that index investing is less volatile than active investing. When the stock market or one specific sector (e.g. IT) moves into ‘bubble’ territory, you automatically buy those over-priced stocks as part of the index. And experience the subsequent price correction.

How do you access active management?

1. Unit trusts

There are almost as many actively managed unit trusts as there are shares listed on our JSE. You can familiarise yourself with the managers by reading about their process and philosophy and studying their fund fact sheets. Equinox provides an on-line list of most South African unit trust portfolios.

2. Your employer’s fund

Maybe your employer’s pension or provident fund offers member choice. In other words the fund trustees allow you to pick the underlying portfolio from a shortlist. I would expect at least one of the options to be an actively managed fund, but its equity exposure will probably be limited to 75%.

3. A retirement annuity

Many modern, flexible retirement annuities allow you to choose your own underlying investment portfolio and an actively managed fund should be one of the options. As far as I know, Allan Gray is currently the only company that allows you to choose a 100% equity portfolio if you invest in their retirement annuity.

4. Your own share trading account

If you have the time and skill to analyse companies yourself, you could also build your own equity portfolio with an online share trading account. Just keep in mind that the tax treatment of trading profit is not always as favourable as with a unit trust portfolio or retirement annuity.

How do you access passive management?

1. Satrix

Satrix has created exchange traded funds (EFTs) which invest in the main South African equity indices. The Satrix 40 fund has a total expense ratio of 0.37% – a good selling point. But if you invest through the Satrix investment plan, the annual administration fee is 1.0% of the market value of your investment! In addition, your brokerage fee on any purchase or sale is 0.1% per transaction. For large investment amounts, it may be cheaper to use a stock broker rather than the Satrix plan. Also, your dividends don’t automatically get re-invested when you invest in the Satrix 40, but are paid to you after costs. This means your capital grows slower than if dividends were re-invested.

2. Unit trusts

There are a few unit trust portfolios that track the JSE All Share or the ALSI 40. Currently, Gryphon’s All Share Tracker Fund seems to offer index-tracking at the lowest cost: a total expense ratio of 0.69% and no initial fees.

3. Your employer’s fund

If your employer’s retirement fund offers member choice, I’d expect them to also offer a low-cost index-tracking option as one of the options.

In the next post we’ll have a look at the new investment methodology that tries to keep over-priced stocks out of your portfolio: fundamental or risk-adjusted indexation.