Hot markets always end the same way …..

How to make sure it doesn’t happen to you

The last few weeks have exposed the glaring problem with momentum and more importantly when self-directed investors succumb to the fear of missing out. There are an increasing number of horror stories from the ASX after a volatile month, but it is those most loved and talked about companies of early 2018 that have been hit hardest. A few particular lowlights are as follows:

  • Technology darling, Afterpay (APT), has fallen 44% from its 2018 high;
  • Amazon competitor, (KGN), has fallen 72% from its high;
  • Sukin Skincare owned, BWX, is down 66% after rebuffing a management buyout;
  • Low-cost jewellery retailer, Lovisa, is down 40% from its 2018 high;
  • Long-short listed investment company, L1 Capital, is down over 30% after floating in

Even though almost every investment book, successful investor and in fact most financial advisers stress the importance of not chasing the hottest stocks or investments, it seems that most people are still prone to doing so. We experience this daily in our own lives as the majority of interest raised from our articles is around the smaller, speculative companies we have covered in the past.

The existence of a bubble in high growth technology companies was obvious, the market was being driven by investors whose sole purpose was to invest in shares that have already gone up. The sealer for us was when we reviewed the recent flow of investment into Australia’s best performing shares. The evidence was clear, retail investors with a fear or missing out, identified by the fact that they generally trade with Commsec or other online brokers, began outnumbering the institutions in the scale of their buying earlier this year. In fact, the majority of institutions and insiders were actually selling down their holdings of Afterpay and Kogan some time ago.

In sharemarkets, but particularly in the ASX where DIY investors dominant in a way not replicating overseas, there is dumb money and there is smart money. Unfortunately, the former tends to be in the hands of those who need it most and who rely on their

investments to fund their lifestyle. It isn’t just in chasing the hottest stocks that DIY investors are prone to lose capital, there are many ways that parts of the financial sector are actually out to get your capital. In the following sectors we look at a few ways to avoid the mistakes that occur in hot markets and provide a sure-fire strategy that will keep you on the right path.

Look out for vested interests

Even though the finance industry is one of the most heavily regulated in the world, it remains rife with vested interests, hidden commissions and strategies aimed at extracting your capital with little concern for how it performs once it invested.

One such example is the proliferation of listed investment companies of LIC’s that have been flooding the sharemarket in recent years. We speak to DIY investors and SMSF trustees regularly and they al seemingly prefer the use of an LIC over an identical managed fund. But why have they become so popular and why are so many being issued today?

Well, the structure of an LIC is a closed end fund, which means there are no redemptions or applications from the underlying assets. On the other hand a managed fund is structured as a unit trust, with units redeemed and issued on a daily basis. Why does this matter? Being a closed end fund means the investment manager will always have the same amount of capital to invest, and more importantly to charge fees on.

Take for instance L1 Capital and its highly touted but poorly performing long-short fund. The associated brokers managed to raise $1.2bn for this LIC, on which they will now receive a management fee of some 1.35%, that’s $16m per year regardless of performance. There is little wonder that the managers elected to return capital to investors in their managed funds.

An additional issue connected with the proliferation of LIC’s is the way in which they are sold to investors. In general, any stockbroker, financial adviser or planner that is recommending you invest in one of these IPO’s or LIC issues, is receiving a commission of between 1% and 2% of the capital you invest. There is little wonder that the list of brokers associated with most IPO’s these days include up to 12 ‘co-managers’ or ‘joint- lead managers’; in the early 2000’s it was only one.

Well-timed product launches

We are amazed on a weekly basis by how quickly the ETF and LIC providers are able to get a product to market when a particular sector or group of companies is popular. In the last few months we have seen ‘disruption’ funds, lithium battery funds, cyber security and before that the famous BEAR fund, that bet on markets falling.

ETF’s and LIC’s used to be highly diversified investments, offering a solid option for less involved investors to gain a general exposure to the benefits of the sharemarket. Unfortunately, they are becoming increasingly specific, more volatile and higher risk. They tend to come to market at the most opportune moment but then consistently outperform, in our view they are not specialists but opportunists, driven by sound marketing but poor investment nous.

In our experience, the issue with these products isn’t their approach, but the patience and process that investors take in buying them; which in most cases is none. Most people are simply attracted to the most popular options, or those supported by well-known names in the investment industry, but give little consideration as to how they form part of a broader portfolio.

Cherry picking fund managers

The most successful long-term investors have several traits in common, but one of the most important has been their willingness to partner with specialist managers around the world. Some of the highest performing funds, including the likes of Australian Super, the Future Fund and Yale Endowment, invest the majority of their capital directly with fund managers. Yet for some reason, the DIY investors of Australia show little interest in following this proven approach.

Many investors we meet are willing to copy the most popular investments that fund managers present on, but not willing to invest in their funds. Why is this? The amount of portfolios we see that contain the best 5-10 picks of the most popular fund managers is simply concerning. The underlying funds that these picks form part of usually include some 30-50 individual holdings with a success rate of 60% each year at the higher end of expectations. Attempting to cherry pick those ideas that you agree with is dangerous, particularly when markets turn. The reasons that most managers are successful is because most specialise in a specific area or sector of their market.

On a separate but related topic, we have been seeing an increasing number of well-known Australian fund managers either expanding into overseas shares or beginning to short companies in their funds. Investing globally requires extensive networks, greater research support and connections, which most domestic specialists simply do not have; it pays to stick with those who have been there for many years before.

Taking advice from journalists

The presence of high profile journalists on our TV screens, in the newspapers and at the hundreds of conferences held each year gives the perception that they know what they are talking about. Yet a quick look back on their previous predictions suggests they would be lucky to know more than most DIY investors. Investors need to be wary that these people are paid to have an opinion on a daily basis, every day they need to say something different. They aren’t paid to make you money, they are paid to sell newsletters and their own products.

One perfect example was the growth in issuance of high dividend, high yield and other similar funds focused on the ASX. This sector is seemingly one that every commentator believes they can deliver returns from, yet performance has shown they cannot, with the majority underperforming the index whilst charging substantially higher fees. Vanguard was one of the few that issued a high yield strategy many years ago, yet they have been joined by an extensive list of ETF providers and experts, like the Dividend Harvester or Australian Income Fund.

When it comes to any type of investment, we suggest investors seek to partner with the best in each sector. These people don’t run newsletters, they run their own funds and invest their own capital.

As the market continues to run hot, the number of higher risk opportunities expands along with it. At the end of this cycle it has been the likes of fractional property investing, corporate bonds and even direct loans to property developers that have gained the most attention. Each of these investments have many benefits that they can offer investors as part of a truly diversified portfolio, yet the risks are too often hidden by those recommending them. As a general rule, if you are being sold something that is being advertised based on it’s yield or performance over the last 12 months, its probably not sustainable.

Anchoring your purchases

One final issue that increasingly impacts on DIY investors ability to make decisions in volatile sharemarkets is the anchoring of the purchase price of their investments. CSL’s recent performance is a perfect example. CSL has fallen from a high of $230 to $180 today; if you owned 1,000 shares you would have lost $50,000 in capital in just a few weeks. Yet most DIY investors will not even consider this as a ‘loss of capital’, they have anchored their investment to the original purchase price of say $30, meaning they are still well ahead of where they started. This is one reason why many investors showed no willingness to sell Rio Tinto at $150 in 2007 nor remorse after it inevitably halved in value.

So, what’s the solution?

It’s actually quite simple and what we at Wattle Partners do on a daily basis. The majority of DIY investors and their portfolios have little to no framework for their investment decisions. They simply add the most popular stocks in what is best described as a hodgepodge of ideas that becomes their portfolio. There is no decision tree, nor investment policy or rules around where they should be investing and when investments should be sold.

We are strong advocates of the need for a tailored and comprehensive Investment Policy being used for the investment of any amount of capital. We are one of the few in our industry actually delivering on it. Many of the investments outlined in this article may in fact be fine, as part of a broader portfolio, however, this is not how they are generally being used. There is an increasing trends of marketing groups going direct to the DIY investor and consumer, resulting in decisions with no consideration to their role within portfolios.