The main difference between a portfolio consisting of funds and stocks is performance potential. Let’s use 2007 as an example.
- Only 10 stocks had over 100% gain in S&P 500 index in 2007.
- None of stocks in Dow Jones 30 index had over 100% gain in 2007.
- There were 4628 stocks with market cap over $100M as of 12/31/2007. 209 of them had over 100% return in 2007. A portfolio of 50 stocks selected carefully could easily contain some of 209 winners.
- For mid sized funds buying stocks with minimum $1 billion market cap limitation, there were only 2136 stocks to select from in 2007. 91 of them had over 100% return in 2007. A portfolio of 50 stocks had less chance to contain some of 91 winners.
- For large funds buying stocks with minimum $10 billion market cap limitation, there were only 572 stocks to select from in 2007. 30 of them had over 100% return in 2007. Most of the stocks in a portfolio of 50 stocks were guaranteed not to be in the 30 winners.
To make up the difference in performance potential, many trading techniques have been devised to capture the up trend of funds while avoiding the down trend of funds.
Following summarizes other differences between funds and stocks.
Pros of Funds:
- Require very low amount of capital to start with some diversification.
- Low cost way to buy and sell a basket of investment vehicles, such as a basket of home builders.
- Can purchase investment vehicles other than stocks, such as real estates, bonds, gold, silver, oil, foreign currencies, international stocks, etc.
- Able to short without unlimited loss or margin issue through inverse funds.
Cons of Funds:
- Too many to choose from. Over 20000 mutual funds and over 800 ETFs are available in US.
- Holdings of mutual funds are not transparent. Prone to end-of-quarter/year window dressing.
- Cannot customize by excluding certain stocks in the holding of funds.
- May not be aware many funds include same popular stocks, increasing risk of over concentration.
- Over-diversification – due to funds size limitation, many mutual funds either simply buy and hold stocks of mega cap or buy hundreds of stocks like an index, offering little upside potential.
- High management effort to properly time buy and sell a portfolio of different funds.
Pros of Stocks:
- Complete transparency of portfolio holding. Stop loss can be applied on any individual stocks as bad news happen.
- Offer better performance potential by picking the best individual companies regardless their size.
- Able to liquidate completely on any dramatic event when market is open.
Cons of Stocks:
- Very high management effort to establish and maintain a well diversified portfolio with 50 stocks or more. There are more than 8000 stocks in US exchanges to select from.
- Even trading commissions has come down a lot, it is still cost prohibitive to build a diversified portfolio with 50 stocks or more for account size less than $100,000.
- More items to report on schedule D for taxable accounts.
- Unable to take advantage of tax-deferred variable annuity or life insurance.
- Difficult to buy certain asset classes, such as real estates and international.