Like many UK investors who foolishly pick stocks with a proportion of their portfolio, I’m a big fan of the writings of John Lee.

(Lord) Lee has been giving regular updates on his portfolio in the Financial Times for many years. A few years ago, he revealed that by investing in small caps held within tax efficient wrappers (first PEPs, later ISAs) he’d grown a portfolio worth over £1 million.

Considering the annual contribution limits on PEPs and the follow-up ISAs, that’s an excellent achievement in anyone’s book.

Lee’s method is to buy low P/E small cap companies paying decent dividends that he considers overlooked by the market, and to reinvest the income into new shares. I think it’s as good as any method of actively picking small caps; at the least it keeps you away from blue sky punts.

John Lee moves the market

There’s a downside to being a John Lee fan, however. Because Lee is popular and because he tends to favour illiquid small cap shares, anything he writes about often experiences a sharp spike upwards in its price.

On Saturday 4th September 2010, for instance, Lee wrote about four AIM shares: Christie Group, Concurrent Technologies, Pressure Technologies, and THB.

Here’s their performance in trading on the Monday morning, as I write:

• Christie Group: Up 15%
• Concurrent Technologies: Up 14%
• Pressure Technologies: Up 6%
• THB: Up 10%

In contrast, the FTSE 100 is up 0.42%, while Aberforth Smaller Companies (an investment trust that holds Lee-style small caps) has dropped 0.75%.

It’s clear that Lee has moved the market in his four shares this morning, for a hefty average gain of 11%.

Patience is a virtue

John Lee is richer this morning as a result of his column on Saturday, but I want to stress that I don’t think he is doing anything wrong at all. From all the evidence he is a scrupulous man, writing to share his knowledge with other investors.

Also, Lee is a long-term buy-and-hold investor. The price of these shares on one Monday morning won’t be of much interest to him.

It’s also possible that his fellow investors haven’t even had the chance to push the price of these four shares up much. Rather, market makers may have read Lee’s column over the weekend, and bumped up their prices in anticipation that new buyers will emerge. Many small caps are very illiquid at present – I’ve moved prices by investing just a couple of thousand pounds – so it’s a reasonable move on their part.

Now, I have both Pressure Technologies and Concurrent Technologies on my own watchlist, and I’m very heartened to see Lee likes these companies, too.

However, I have not so far bought shares in either. It’s senseless to pay 14% more for shares today just because another investor has shown his hand.

My suggestion if you like these or any other companies that Lee writes about is to be patient. The price rise should drop away as the buzz dies down.

In the short-term the stock market is a voting machine, but in the long-term it’s a weighing machine. It’s earnings that ultimately drive share prices, not newspaper columnists.

Beware of the ramp

Incidentally, some readers recently mooted a ‘Monevator effect’ in the comments to my article on Lloyds preference shares.

The price did run up the day after I posted that article, but I think that was a coincidence; the Investor’s Chronicle also published a piece that week, and I think it has rather more sway than my blog!

If Monevator ever does move prices, then you should certainly beware of buying into short-term spikes, just like run-ups from any other source.

In particular, be very careful with discussions of illiquid shares on bulletin boards. There have been cases where posters have been found to deliberately ‘ramp’ the price of some hapless small cap, then dump the shares at the top. There’s even been rumours of the professionals getting in on the act.

Anyone who lived through the frothy Dotcom days – where a share’s price could double on being mentioned in a popular lunchtime TV program – can tell you about the risks of chasing ramped small caps.

In my experience, the best stock picks are made in relatively unknown companies that you alight on through your own research. You may be wrong that the shares are a bargain, but at least the price won’t have already been over-inflated by the opinions – correct, incorrect, honorable, or self-interested – of others.

My regular Saturday musing, followed by the links to some great articles.

Felix Dennis makes no secret in How to Get Rich about his pleasure in sending large cheques to the Inland Revenue to settle his tax bill.

An old Lefty, Dennis doesn’t mind doing his considerable bit for those who haven’t had the opportunity in life to overcome a drug and hooker addiction through poetry and tree planting.

Also, he sensibly points out that a big tax bill is a sign of success.

Most of us will do all we can to avoid paying excessive taxes and to reduce our capital gains tax bill, but at the end of the day, owing a wodge to HMRC means you’re doing something right.

However it’s one thing to pay your taxes with a clear conscience and a smile, and quite another to find you’re going to be clobbered for more taxes for a year you thought was done and dusted.

Yet that’s exactly what 1.4 million UK citizens have woken up to today. Perhaps you’re one of them, who will be hit by an unexpected bill for a cool £1,500 in extra tax payments, according to the BBC:

Nearly six million people in the UK have paid the wrong amount of tax.

About £2bn was underpaid via the Pay as You Earn (PAYE) system in the past two years, with about 1.4 million people owing an average of £1,500 each.

But £1.8bn has also been overpaid and some 4.3 million people will get a rebate because they have paid too much.

A new computer system has allowed more discrepancies to be identified, but HM Revenue and Customs said the “vast majority” of tax bills were correct.

The number of people affected by over or underpayments is also higher than usual because HMRC is currently reconciling two years of PAYE contributions at the same time, rather than just one.

Watch your postbox carefully. You could be in line for a £300 windfall, or discover you’re £1,500 poorer than you thought.

For anyone without an emergency fund that’s a lot of money to find, though I suspect you’ll be able to pay it back through an adjustment to your PAYE code for 2010/11.

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I have often written about my skepticism over hedge funds, absolute return funds, and other sexy investment vehicles.

Some of the problems with these exotic funds include:

• They’re expensive – typically taking 2% annual charges and a 20% cut of returns.

• They can be illiquid, locking away your money for years.

• Many fail to deliver the absolute returns they promise.

• You may not understand what you’re investing in, or the risks. (Think Madoff!)

Now we can add a new drawback – poor performance versus ETFs.

It turns out most hedge funds are currently doing worse than the simplest tracker-and-bond portfolio!

Hedge funds hammered

Despite devoting acres of coverage to hedge funds over the years, The Financial Times has finally noticed that the Emperor may have no clothes:

Hedge funds, the most expensive item on the investment menu, have been producing returns almost identical to portfolios from the cheap burger joints of the advisory business, made up of 60 per cent equities and 40 per cent bonds.

No wonder hedge funds are worried. Bankers report increasing concern among these latter-day masters of the universe over how they will pay the fat bonuses their traders demand.

As the FT’s graph shows (right), the index of hedge fund returns versus the simple portfolio has done especially badly in the past couple of years.

Up until then it was merely tracking the performance of a cheap 0.5% a year ETF portfolio!

Do you feel lucky, punk?

Whenever I write about exotic funds, somebody will come along and tell me I haven’t considered this or that pet strategy of theirs.

Indeed, a hedge fund fan would argue that the FT piece is flawed since it is comparing a simple portfolio with a basket of hedge funds.

This basket will contain absolute return funds, directional funds, macro funds, corporate activists, and all kinds of other strategies. Each would be expected to do better at different times in the economic cycle.

To which I’d say fair enough, but I’d add that the average investor – including me – is extremely unlikely to be able to judge what strategy is best at any given moment, or to move their money around in time.

As a result, he or she will either:

• Hold the wrong hedge funds some of the time (getting average performance at high cost over the full cycle).

• Or else will have to diversify into several funds (and so again get average performance at high cost over the full cycle).

Keep it simple, silly

If you’re an Ivy League endowment manager like David Swensen with massive resources at your disposal and funds beating down your door to get a chunk of your millions, you may just be able to pick the winners.

Some people will be lucky, too. Sod’s Law says you’ll likely meet one of them in a pub, who’ll tell you he’s made his fortune backing the one in a hundred fund that delivered 10,000% returns.

But you can’t invest based on luck, and I think the average investor will lose money in their doomed search for Perfect 10 investments.

A simple ETF portfolio – or even just a mix of trackers and cash – is easier to understand, far cheaper to run, and will likely deliver similar long-term returns to these pricier vehicles.

If you must have some excitement, trade a few shares in a side portfolio with a small proportion of your wealth, and be your own hedge fund manager.

You probably won’t beat the market, but at least you won’t be helping someone to buy a Ferrari with your hard-earned cash, either!