For investing, small is beautiful
Investment managers are sometimes chosen on a “gut” feel or because they have fancy offices, but the biggest mistake investors make is figuring there is safety in numbers and, therefore, the bigger the better.
I’ve worked with both smaller and larger investment firms and have learned the former have many advantages, including the ability to react more quickly to a rapidly changing environment such as a volatile stock market.
Unfortunately, the larger the investment manager, the more of a disadvantage it has when trading positions. This is especially the case in the Canadian stock market, where it can take considerable time and expense to establish or exit a position even in larger blue-chip stocks.
Additionally, larger firms often require lengthy investment committee meetings before implementing a model portfolio change. A couple of missed days or weeks in this market can result in a lot of missed opportunities or capital preserved.
As a result, it isn’t surprising to see many large firms tracking close to an underlying benchmark or passive index, yet they charge fees that are multiples higher than a comparable exchange-traded fund.
On the other hand, smaller firms can react rather quickly to a market event with little difficulty getting in or out of a position, which helps improve performance.
They can also be a lot more flexible when it comes to customizing investment solutions. This is especially important to high net-worth investors, who often have varying requirements due to the nature of their citizenship or their extensive alternative holdings, such as real estate and private equity.
For example, there are many wealthy dual U.S.-Canadian citizens living in Canada who have been placed in non-compliant mutual funds by their advisers. As a result, there may be some unexpected hefty tax and/or accounting bills that will materialize upon being reported via the upcoming Foreign Account Tax Compliance Act (FATCA) requirements.
Smaller firms will often eliminate the salesperson or adviser altogether, thereby putting the investor in direct contact with the investment manager. These cost savings can be passed along directly to the investor in the form of much lower fees while promoting greater accountability.
Finally, and most importantly, even larger firms can lose investor capital, especially the ones that self-custody their client assets. Just look at multibillion dollar firms such as MF Global and Lehman Brothers.
A third-party custodian adds an important layer of protection between you and your investment adviser’s firm — both large and small. This is because the custodian is working for you and not the firm managing your money.
To determine if you have taken on this risk, see if the initial cheque to fund your account was made out to the firm managing your money.
But keep this in mind if you choose a smaller investment firm: Use the “check-first” function on the appropriate provincial securities commission website to ensure it is regulated and there is no history of infractions.