Financial Planning Blog

Posted on: 04/25/11

Would you rather be researching mutual funds or riding your mountain bike in the Boise foothills? OK, maybe slogging your way up the south side of Table Rock isn't your idea of fun, but "normal" people don't look forward to studying Morningstar mutual fund reports or figuring out how to rebalance their portfolio. Balanced, or asset allocation, funds are possibly a great solution for the person who has some money to put to work, but would rather invest their time elsewhere.

Balanced (or Asset Allocation) Funds

Balanced funds are often considered boring. Generally speaking, they are mutual funds on training wheels--designed to keep investors on-track with a sensible, diversified portfolio. They are a type of single fund investing solution, or all-in-one fund, that spreads the investors' money across various asset classes (e.g. domestic and international stocks and bonds) and within asset classes (stocks and bonds from many different issuers). In Part 2, we examined target-date retirement funds--single fund solutions that dynamically shift to more conservative asset allocations as the investment objective (retirement) draws near. Balanced funds are similar, however they provide an asset allocation that is independent of any time-based objective. In other words, it will not be shifting to more conservative allocations just because time is passing by. You can find balanced funds with conservative, moderate, or aggressive asset allocations, and these funds will presumably have the same or similar asset allocations 10 or 20 years in the future.

Some asset allocation funds have distinct portfolios of stocks and fixed income investments. Others, similar to most target-date portfolios, are funds-of-funds. This means that they consist of a number of underlying mutual funds that invest in various parts of the stock and bond markets. Sure, you could probably go purchase all the underlying funds yourself, but buying the balanced fund makes the initial and subsequent purchases easier. And, no matter how the balanced fund is constructed, it is the fund manager's job to keep the fund's portfolio in-line with its asset allocation target. This relieves the investor of the burden of rebalancing, an important investing discipline that keeps helps control the level of risk in your portfolio and offers the potential of marginally increased returns. This automatic rebalancing, along with the increased tendency for balanced fund investors to buy-and-hold the investment through market cycles, helps them realize a larger portion of potential returns.

Although balanced funds are simple investments to buy-and-hold, there are a large variety of these asset allocation funds available in the marketplace, and this can make the initial selection daunting. Here are some of the considerations to be aware of in searching for the right fund for your preferences and situation.

  • How much risk are you willing to take? Balanced funds are differentiated by their asset allocation--most importantly what proportion of the portfolio is dedicated to equity investments (for more growth potential) and what proportion is in fixed income or other defensive assets. Morningstar categorizes asset allocation funds as follows:

The sweet spot for balanced funds is in that moderate allocation category, with about a 60% stock and 40% bond allocation. However, be aware that not all balanced funds are targeting this moderate profile.

  • Is the fund's asset allocation strategic or tactical? Most asset allocation funds set a strategic allocation to various asset classes and only deviate within relatively narrow bands. In other words, the asset allocation remains relatively static. Others are tactical asset allocation funds, where managers have broad discretion on how much is invested in each asset class. The hope is that the fund managers can tactically move between various types of investments given their assessment of opportunities and risks. Although these tactical allocation funds may sound appealing, realize that they won't necessarily perform better than a static allocation. It is extremely hard to consistently time market moves--if it was easy, everyone would be doing it successfully.
  • How much is the convenience of a single fund costing you? Whenever you are investing you should be aware of the underlying costs. Similar to target-date funds, there is a wide range of costs associated with investing in balanced funds, or any mutual fund. Be aware that higher costs are a substantial headwind that makes progress toward your goals more difficult.
  • Do you want passive or active management? Some balanced funds passively follow a balanced index, while others consist of a collection of underlying index funds. These passively managed funds focus on providing investors with broad diversification and exposure to an appropriate asset allocation at a very low cost. Other funds are actively managed, with the objective on selecting a smaller number of stocks and bonds in hopes of beating a benchmark. Still others (e.g. Vanguard's Life Strategy Funds) take a hybrid approach, combining passive and active management. You can be successful either way, but it is wise to understand how the fund is managed and have the correct expectations of its performance versus various benchmarks.
  • How much international exposure is there? All asset allocation funds will be diversified across stocks and fixed income investments. One area where there can be wide variation between funds is the amount of exposure to international stocks and (to a lesser extent) bonds. For example, Vanguard's Balanced Index Fund has 60% of its portfolio in stocks--but only U.S. based companies. In contrast, another passively managed balanced fund with 60% in stocks, Schwab's MarketTrack Balanced Investor has a healthy allocation (15%) in international stocks. And, actively managed American Funds Capital Income Builder has 40% of its portfolio in international stocks, along with its 30% stake in domestic stocks. In general, most would agree that a healthy exposure to international equities (including some in emerging markets) is a key component of a diversified portfolio. (In fairness to Vanguard, they have a number of other all-in-one funds with reasonable international diversification.)

As is often the case with any type of automatic or "simple" solution, when you look under-the-hood things are a bit more complex. Hopefully, considering the factors discussed above will help you in selecting a balanced fund that meets your needs. Ultimately, choosing to go with an all-in-one fund, whether it is a target-date or balanced fund, is a decision to go with a "good enough" plan that will be executed very well. This is opposed to the perfect plan (e.g. your brother-in-law's 30 fund portfolio) that runs a substantial risk of poor execution. As stated in this recent Morningstar article on investor returns: "Balanced funds may not be entertaining, but if they keep you from doing stupid things you could learn to love them."



Posted on: 04/15/11

Sometimes you just want a simple solution to your problem so that you can get on with your life. In Part 1, we looked at situations that called for the simplest of investing options--single mutual funds that provide a diversified portfolio appropriate for a variety of circumstances. These funds come under different labels--balanced funds, asset allocation funds, all-in-one funds, life-cycle funds and target-date retirement funds are the most common. Let's explore single fund investing solutions so you can determine if they may make sense for your situation.

Single fund investing solutions, or all-in-one funds, offer broad diversification both across various asset classes (e.g. stocks and bonds of various characteristics) and within asset classes (many different stocks and bonds from many diverse issuers). The investor could choose to get that level of diversification by using many mutual funds with different investment objectives, but the all-in-one fund provides the convenience of a single fund. Although all-in-one funds each seek to provide a broad level of diversification, they can then be split into two basic categories:

1. Target-date funds: Sometimes referred to as life-cycle funds, these funds set an asset allocation that is appropriate for an objective at a future point in time. The unique characteristic of the target-date fund is that the fund's asset allocation is dynamic--shifting to a more conservative allocation as the target-date objective gets nearer. (Target-date funds will be discussed further in this post.)

2. Balanced or asset allocation funds: These funds provide an asset allocation that is independent of any time-based objective. You can find balanced funds with conservative, moderate, or aggressive asset allocations, and these funds will presumably have the same or similar asset allocations 10 or 20 years in the future. (Balanced or asset allocation funds will be examined in Part 3.)

Target-Date Funds

Target-date retirement funds actually are a series of funds with varying target-dates for your retirement. It is common to see a series of about a dozen funds with target dates ranging every 5 years, say from 2005 to 2055, plus an income fund appropriate for those who have retired prior to 2005. The first series of target-date funds was introduced by Barclay's in 1993, and they have steadily gained in popularity. Today, over 25 different mutual fund families have target-date series. Although you will find them offered in the majority of employer sponsored retirement plans, you can also buy them as an individual investor through the fund company or a fund supermarket like Charles Schwab or Fidelity. Typically, target-date funds are "funds-of-funds", meaning that the target-date fund holds several underlying mutual funds.

When selecting a target date retirement fund you should give consideration to the following points:

  • Is the fund's asset allocation aggressive or conservative? Every target-date fund has an asset allocation that the provider believes is appropriate for an investor with the assumed objective of retiring at a particular point-in-time. For example, a 2025 fund from Vanguard has an asset allocation of 74% equities and 26% bonds. To many this seems reasonable for a 50-55 year-old thinking of retiring in 14 years, but to others it may seem a bit aggressive. The investment managers at American Century advocate a more conservative approach and have only about 60% of their LIVESTRONG 2025 Portfolio invested in stocks. On the other hand, T.Rowe Price's 2025 fund is even more aggressive than Vanguard, with over 78% in stocks and only 22% in bonds. It shouldn't come as a shock that equally smart, reasonable people have different opinions of what is smart and reasonable when constructing an investment portfolio that balances expected risk and return for an individual.
  • Is the fund's asset allocation "glide path" one you are comfortable with? Not only are you concerned with whether the target-date fund's current asset allocation is acceptable to you, but you need to be aware of how this asset allocation is going to change over time. This is what is referred to as the "glide path"--in other words, how the fund transitions to a more conservative portfolio as the target-date approaches, or is passed. As already noted, funds take very divergent approaches and it is amazing how the "equity landing point" (i.e. the percentage in stocks at the target date) differs among providers. This graphic from Barclay's Global Investors illustrates the vast differences in asset allocations and glide paths between funds. Note that biggest differences between funds occurs at the equity landing point where the most aggressive funds have more than 60% in equities and the most conservative ones under 30%.

 

This great discrepancy of asset allocations as you near retirement led to much controversy concerning target date funds after recent major downturn. Apparently, many investors thought having their money in target-date funds--funds that were supposedly transitioning to more conservative portfolios as they neared retirement--would protect them better when the market cratered. Although the target-date concept is a pretty sound one, the actual performance in various markets is dependent upon the implementation. And, it is certainly not a guarantee that you will not lose money in a down market. This is why you need to pay attention and choose a fund you can live with.

  • What are the underlying funds? Beyond the top level differences in the stock/bond allocation, there can be major differences in the number and type of underlying mutual funds. Some target-date funds, like Vanguard's, consist of a small number of highly diversified, low cost index funds. Others consist of ten or twenty actively managed funds that cover many different corners of the market. There isn't necessarily a correct recipe, but you may have personal preferences regarding active versus passive management. Also, you may have opinions on the amount of international or emerging market exposure you desire, or possibly the addition of international or inflation protected bonds.
  • How much are you paying for this convenience? In the mutual fund world, costs matter. They are not the only thing that matters, but the less you pay for managing the underlying investments, the more money is left for you in retirement. (See this earlier set of posts on pesky mutual fund expenses.) There is a sizeable range of costs for target-date funds, and since these are funds-of-funds, you want to make sure you are comparing the total cost--the cost of underlying funds plus any additional expenses to manage the target-date portfolio.
  • You don't have to use the fund with your "target-date". There is no requirement or for you to use the fund recommended for your expected retirement date. It may make sense for you to use a fund with a target-date that is earlier or later than your anticipated retirement. For example, maybe you really like Vanguard or T. Rowe Price's retirement funds (both are Morningstar analyst picks), but both are on the aggressive side. You could still choose these families, but select an earlier target date in order for the allocation to be a bit more conservative.

This certainly isn't everything there is to know about target-date funds. Hopefully, it is a good rundown on what you need to know to get started. These funds are simple and convenient, and offer the benefits of a professionally managed asset allocation that adjusts automatically over time. By putting your investments on auto-pilot you may also be insulating yourself from many common investor errors, such as failing to maintain an age appropriate asset allocation, failing to rebalance your accounts, chasing hot funds, or bailing out of the market at inopportune times.

In Part 3, we'll explore the second category of single fund solutions, balanced (or asset allocation) funds.

 

 

 



Posted on: 03/24/11

At Table Rock Financial Planning we value simplicity, and certainly don't think you need to be lazy to appreciate an elegantly simple investment portfolio. Granted, often things can get more complex as you seek to manage your personal financial risks, maximize your investment returns and minimize your tax obligations. We can probably all agree, however, that some circumstances call for the simplest of investment solutions. How about a diversified investment portfolio consisting of just a single mutual fund?

Very reasonable single mutual fund investing solutions do exist. Before we explore what is available, let's consider some of the situations when a single fund solution would make sense.

  • The investor is unwilling or unable to deal with any additional investing complexity. This could be your elderly mother who would rather be spending time with her grandchildren than tending her portfolio, or your son or daughter serving overseas in the military.
  • The investor is a neophyte. Maybe you have just started a new job and investing for retirement for the first time. You're engaged and interested, but haven't had time to come up to speed with investing basics.
  • The investor is starting small. You may have done your research and be capable of constructing a great portfolio of mutual funds, but you are limited by the required minimum initial investment of each fund. (For example, even though we often recommend Vanguard funds, most require a $3,000 initial investment. A simple four fund portfolio would require $12,000 to start.) In addition, you may wish to make consistent monthly investments, but unable to split the contributions across multiple funds due to minimum restrictions.
  • The investor has a small account or two, orphaned from a main diversified portfolio of several mutual funds. This is a common situation--a couple has over 95% of their retirement portfolio in workplace (e.g. 401K) plans, but also have a couple of small IRAs opened many years earlier. They wish to have the smaller accounts invested with a reasonable asset allocation, but don't want to spend much time managing them.

Although you have a choice between different types of single fund solutions, each type of fund will provide you with the following advantages:

  • Diversification across several asset classes (stocks and bonds; domestic and international; large and small; etc.) along with diversification within asset classes (many bonds, many domestic stocks, many international stocks, etc.).
  • Professional management of an asset allocation strategy--i.e. exactly how much is invested in each asset class at any particular time.
  • Automatic rebalancing of your investments.
  • Simplicity and convenience.

In following articles we will explore the two major categories of single fund solutions--target date funds and balanced (or asset allocation) funds. Before we do, however, please consider an important point. Although many single fund solutions suffer from high expenses and less than optimal asset allocations, don't assume that by taking the simple road you are necessarily accepting lower returns. By automating your investments with a single fund solution, it may help you avoid many of the common errors that drag down so many investors' returns. These include well documented tendencies toward under-diversification, failure to rebalance accounts, and chasing the performance of hot funds or market sectors.

A 2010 Morningstar article on investor returns pointed out how investor (or dollar-weighted) returns trailed total (or time-weighted) returns in various equity and bond fund categories over the previous ten years. In other words, the average investor did not do as well as reported mutual fund returns would suggest. However, average investor returns in balanced funds (i.e. a single fund solution) were actually higher than the average total return of the funds.

Interestingly, balanced fund investors did manage to beat the averages. They earned a 3.36% annualized return, compared with 2.74% for the average fund. A mix of bonds and stocks leads to moderate results, and more investors stick with these funds through the down periods. In theory, it shouldn't matter if you hold a stock fund and a bond fund separately or get the same exposure through an allocation fund, but in practice it seems that boring balanced funds don't push fear or greed buttons that throw people off. As Jack Bogle says, emotion is the enemy of the investor.

The moral is simple: Simple can be smart and profitable.

 



Posted on: 12/03/10

In Part 1 we looked at historical data showing the higher average returns of value stocks relative to growth stocks. Pondering this data one could ask: Why not invest only in value stocks, especially small and mid cap value stocks? One concern is obvious--just because value has out-performed in the past doesn't mean that it will do so in the future. Also, even though the value has out-performed growth over the long run, it certainly doesn't every year. To illustrate this fact, take a look at this "periodic table of returns" from Russell Investments--the folks who built and maintain the Russell U.S. Indexes, such as the Russell 1000 large cap index and the Russell 2000 small cap index.

These periodic tables of returns are great illustrations of why you diversify your investments across different asset classes. You'll note how the leading asset classes change from year-to-year, as do the underperforming ones. If you study this table, you'll see how large cap value has out-performed large cap growth in 10 of the 16 years (from 1994-2009). Over the same time period, small cap value also out-performed small cap growth in 10 of 16 years. But even if you are convinced that a "value" strategy is a likely key to higher returns, growth stocks often out-perform value, and sometimes by a great deal.

Recognizing that investors won't always wait 20 or 30 years to see the benefit to value investing, Craig Israelsen of BYU examined the relative performance of value and growth stock indexes for shorter periods of time-one, three, five, seven and ten year periods. From 1980 through 2008, large value stocks had higher returns in 59% of the one year periods. Mid cap and small cap stocks had higher returns 62% and 66% of the years. As expected, as the periods lengthened, the frequency of the value premium also increased. For rolling five year periods, value out-performed over 70% of the time. For ten year holding periods, it was 85% of the time for large stocks and an eye-opening 95% of the time for smaller stocks.

From: The Value Premium, by Craig Israelsen, Financial Planning, June 1, 2009, pages 108-110

Another finding by Israelsen was that when value out-performed growth, it was generally by a larger margin than in the periods where growth was on top. For example, in the 76% of the rolling 5-year periods examined, small cap value out-performed growth by an average of 7.56%. In the other 24% of the periods where small cap growth out-performed value, it did so by only 2.48%. The differences were not quite as impressive for large and mid cap stocks, but still very significant.

As opposed to chasing growth stocks with a great story, or even investing solely in broad market indexes like the S&P 500 and Russell 2000, this data may prompt you to consider a more significant, over-weighted exposure to value stocks. However, it is not suggested that you eliminate growth style stocks altogether. Even though a strategic overweighting to the value style appears to be a sensible approach, an underweight, balancing exposure to growth stocks will most likely smooth your ride. A less volatile portfolio not only allows you to sleep better at night, it can also help reduce "volatility drag" on your long term returns.



Posted on: 11/24/10

Are you a value investor or a growth investor? Do you, or should you, care?

Stock market investing is often categorized into a couple of "style" camps--value or growth. Value stocks are those with a price that is lower relative to the investment fundamentals of the company--things like earnings, book value, cash flow, and dividends. In essence, you are paying less for a dollar of earnings. In contrast, growth stocks are those with better growth prospects, but you pay a higher price relative to the current fundamentals. Growth stocks have a "good story", and are sometimes referred to as "glamour stocks". Value stocks are sometimes considered boring--unless, of course, they are in danger of going under. Then they may be very exciting, but not in a good way. With growth stocks you think of companies like Netflix and Amazon. With value stocks you thing of Idaho Power (IdaCorp) and Ford. (Yawn.)

Although you would think that growth stocks would provide higher returns over time, this is not the case in the aggregate. The long term data in the US and in international markets is that value stocks have out-performed growth stocks consistently over the years.

Here is some interesting historical data for you to chew on. In Stocks for the Long Run, Wharton professor Jeremy Siegel breaks down the US stock market by company size (5 quintiles) and style (5 quintiles of value/growth) criteria. He ends up with 25 groups of stocks of varying style and size characteristics. In each of the 25 groups he has calculated the average compound annual return from 1958 through 2006, as shown in the table below.

 

On the right, you have the largest mega cap companies in the S&P 500. On the far left would be considered micro cap stocks. In the middle are small, mid cap, and large companies. From top to bottom you move from companies with considerable value characteristics down to the most extreme growth stocks. As you can see, in all the size quintiles, value has out-performed growth over this extended time period. And, even though this "value premium" is noteworthy on large stocks, it is even more pronounced in small and midsize companies.

As an investor who understands that expected return and risk and are inextricably related, it may be reasonable to assume that if value stocks produce higher returns over time, then value stocks must be riskier than growth stocks. However, using the most common measure of financial risk (standard deviation of returns, or volatility), we find that is not the case. Value stocks have been shown to have lower volatility than growth stocks. In other words, they are less risky--at least by this measure.

Economists argue about whether the market is efficient in relation to this value effect, or if there is some additional element of risk associated with value stocks that is not captured by the traditional measures, but is still priced in by investors*. William Bernstein presents an interesting discussion of the risk of value and growth and concludes "that although value and growth both have their unique risks, those of growth stocks are more regular and pervasive. During a depression, growth companies may hold up better than value companies...But, when bubbles burst, you can take to the bank that growth will get whacked more than value."

In Part 2 we'll look at some more data on the persistence of the value premium, and discuss the potential implications for your portfolio.

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*In the 1990's economists Eugene Fama and Kenneth French proposed that about 95% of the expected return of a diversified stock portfolio was determined by its exposure to three risk factors: 1) overall market or systematic risk, often referred to as "beta", 2) the percentage of small cap stocks by market weight, and 3) the percentage of value orientation by market weight. The data shown above illustrates both these small company and value effects.



Posted on: 05/13/10

Last week Vanguard joined Charles Schwab and Fidelity in offering commission free trading of selected exchange traded funds (ETFs) on their brokerage platform. It is great to see competition between these discount brokers bring down transaction costs for the individual investor.

If you aren't familiar with ETFs and how they may fit into a low cost, diversified investing strategy, please check out these previous articles explaining what ETFs are, their advantages, and some cautions. Now let's compare the ETF offerings from these three discount brokers.

Charles Schwab fired the first shot last November when it announced commission free trades on its new line-up of exchange traded funds. Earlier in the year Schwab had announced four new low cost equity index mutual funds, signaling a new competitive push for passively managed funds. The 8 new Schwab ETFs include:

  • 5 U.S. equity ETFs tracking Dow Jones indexes
  • 3 international equity ETFs tracking FTSE indexes
  • No fixed income ETFs

For non-Schwab ETFs, on-line trades are $8.95.

Fidelity followed suit in February announcing commission free trading of 25 iShares ETFs. As you may know, iShares (formerly part of Barclays, now owned by Blackrock) is the leading ETF provider in the US, offering over 350 funds. The iShares ETFs available commission free at Fidelity include:

  • 16 US equity ETFs tracking both Russell and S&P indexes
  • 4 international equity ETF tracking MSCI indexes
  • 5 fixed income ETFs

For all other ETFs, on-line trades at are $7.95 at Fidelity.

Vanguard is offering all 46 of its ETFs commission free to Vanguard brokerage customers, eclipsing both the Schwab and Fidelity offerings. Not only that, Vanguard is offering lower commissions in trading non-Vanguard ETFs, making it arguably the most cost effective place for the individual investor to create a diversified ETF portfolio. The Vanguard ETF offerings include:

  • 27 U.S. equity ETFs, tracking mostly MSCI indexes (including 11 sector funds)
  • 7 international equity ETFs tracking both MSCI and FTSE indexes
  • 12 fixed income ETFs tracking various Barclay's indexes

For non-Vanguard ETFs, trades (on-line or over the phone) will generally cost $2 for customers with over $500K in Vanguard mutual funds and ETFs, or $7 for those with less than $500K in Vanguard assets. For those with less than $50K in Vanguard funds, the $7 trades are for only the first 25 trades per year, with subsequent trades at $20. For those with over $1M in Vanguard funds, the first 25 trades are free, and subsequent trades are only $2.

On one hand, this aggressive move by Vanguard is not surprising. They are highly regarded as low cost investing leaders, and for their passively managed index funds, in particular. However, Vanguard is not a company to encourage excessive trading, and making buying and selling ETFs so easy definitely seems out of character. (You can be sure this was not John Bogle's idea.) This had to be a difficult decision for them, and while they want to be market leaders and build their asset base, it is doubtful they are looking to attract speculators day-trading in their ETFs. To discourage excessive trading, Vanguard is reserving the right to restrict trading if an investor makes more than 25 trades in the same ETF over a 12 month period. I'm surprised they would allow that many.

Vanguard's brokerage ETF offer appears to be the strongest in the industry, especially when you combine it with the ability to buy and sell the whole gamut of Vanguard mutual funds for no transaction fees. Don't be surprised, however, if there are continued competitive responses across the industry. Whether it is worthwhile for you to change brokerages given these developments really depends on your individual situation and investment strategy. As an advocate of a buy-and-hold with rebalancing strategy, the attraction of commission free ETF trading is not to trade more often. Rather, the appeal is in paying less for the limited trades that are required to execute the strategy. One of the great advantages of the commission free trading is that it enables systematic investing in ETFs (for example, monthly dollar cost averaging) that was cost prohibitive before.



Posted on: 02/05/10

Most investors understand that in order to make a higher return on your investments you need to be willing to take higher risks. If all investments were risk free, their expected returns would all be similar to money market funds, T-bills or short term certificates of deposit--barely beating inflation, if you are lucky. The opportunity to take measured risks and earn a higher rate of return is a good thing for investors planning for long term goals such as retirement or paying for college.

Although risk provides opportunity, it also works against the investor. Volatility of returns (the typical financial measure of risk) is emotionally difficult for many. Markets going up and down like a roller coaster not only cause sleepless nights, but often incite us to buy or sell investments at the worst of times. Beyond the emotions, however, risk works against us in another way. As returns become more volatile, there is something that can be referred to as "volatility drag" eating away at the long term return of your investments. We'll look at the difference between "arithmetic" (or simple) averages and "geometric" (or compounded) averages to see how this happens.

Below are two investments (Assets A and B) and their returns for each of four years. If you do an arithmetic, or simple, average of each of their returns, Asset B is the clear winner with an average return of 8.5% versus Asset A's 8.0%. (The arithmetic average is calculated by simply summing the returns and dividing by 4 years.)

Although it would seem that the owner of Asset B earned a somewhat higher (0.5%) annual return as compensation for the volatility of the investment, is this actually the case? Of course not! As shown below, the owner of Asset A actually ends up with more money. Even though Asset B had a higher arithmetic average return, it geometric (or compounded) average return is significantly less (only 7.2% per year, versus Asset A's 8.0%).

What this simple example demonstrates is that if there is any volatility of returns, then compounded returns will be less than simple average returns. In fact, as volatility increases, the difference between arithmetic and geometric returns also increases.

Why is the difference between geometric and arithmetic averages important to understand and keep in mind? Here are three key reasons:

  • When it comes to reaching your financial goals, compound (geometric) returns are what matter, not arithmetic returns. When projecting returns over a long period, the seemingly small difference can be a big deal. For example, you may have heard how the returns from large U.S. company stocks averaged about 12.3% from 1926-2005. However, the geometric average return was just 10.4% per year due to the volatility of the stocks. If you were to use the 12.3% arithmetic average to project the performance of your $100K portfolio until your anticipated retirement, you would plan on over $1.8M after 25 years. If you were to more correctly use the 10.4% compounded return for your projection, you would plan on less than $1.2M after the 25 years. This is no small deviation--over 33% less. (There are other problems with blindly using historical returns for future projections, but we'll leave those for another day.)
  • Investors can often be confused or mislead by the incorrect use of average (arithmetic) versus compound (geometric) returns. Often it is hard to tell whether the specified returns are simple averages or compounded over time. This may be intentional obfuscation, or simple ignorance by those selling an investment product--neither would be surprising.
  • Reducing the risk of your investment portfolio has the potential added benefit of reducing this volatility drag. The difference between the arithmetic return and geometric return increases as volatility increases. The goal is to find an asset allocation that minimizes the expected volatility (or risk, usually measured by standard deviation) for a desired expected return. Not only is lower risk easier on your psyche, it can actually help increase long term compounded returns. Although you generally need to take on more risk to get higher returns, there is a penalty for taking more risk than you need to.

After a couple of years where your portfolio may have dropped 50% and then risen 50%, leaving you still down 25% (instead of even), the difference between compounded and simple averages may be fairly intuitive. In other situations the differences are often more subtle, and easy to miss. Make sure you understand these simple concepts and it will help increase the potential for hitting your financial goals. 



Posted on: 12/28/09

In Part 2 we discussed the direct, publicly disclosed costs of mutual fund investing. We discovered there are many ways that mutual fund companies are making money, even when we aren't. Unfortunately, the story doesn't end there. In this article the less understood, indirect costs of mutual funds will be explored. These costs are generally incurred as mutual funds buy and sell stocks or bonds for their portfolios. Although these costs are more difficult to quantify, and are not usually reported, they reduce the after-tax return to investors all the same.

Trading costs

The first main category of hidden mutual fund expenses is the cost of trading. Trading costs include brokerage commissions, spread costs, and market impact costs.

  • Brokerage commissions: When mutual funds buy and sell stocks or bonds they incur commission costs, similar to those individual investors pay. Although mutual funds should get more favorable terms for their large volume trading, these costs are still significant, especially if the fund trades actively. Studies estimate annual brokerage commissions average 0.30% of fund assets, which are deducted from fund returns. Researchers found a big difference between the most efficient quintile of funds (0.08% brokerage commissions) and the least efficient quintile funds (0.56% brokerage commissions).
  • Spread cost: Brokerage commissions are the most obvious cost of trading by mutual funds, but they not the largest. When stocks are purchased," market makers" take a small "bid/ask spread" between the sales price and the purchase price. In other words, the purchaser pays a slightly higher price than the seller receives--the difference providing the market maker compensation for keeping markets functioning smoothly. On average these spread costs amount to close to 0.47% of assets, according to the same researchers. Again, the range between the low and high cost quintiles funds was considerable-only 0.13% for the most efficient, and a whopping 1.23% for the least. Bid/ask spreads are relatively low for large, actively traded U.S. stocks, but can get significantly higher for small, less liquid stocks.
  • Market impact costs: When mutual fund portfolio managers try to buy or sell large blocks of a stock they impact the market for that stock. When they buy large blocks, the initial purchases tend to bid up the stock price, making the average price they pay for the shares higher. The opposite occurs as a fund tries to unload a large position, driving down their average selling price. These market impact costs are hard to quantify*, but lower investor returns nonetheless. Market impact costs are higher for funds dealing in small cap stocks, where selling sizable blocks affect the market pricing to a greater extent. Also, market impact costs tend to be a bigger concern for funds with more assets, as opposed to small funds who trade in smaller blocks.

Costs of holding cash

Another overlooked cost is the impact of holding cash in a mutual fund portfolio. Most actively managed stock funds hold between 5% and 10% of their assets in cash, presumably to handle redemptions and to be ready to take advantage of new opportunities. (Passively managed index funds hold much less. For example, the Vanguard 500 Index Fund holds only about 0.4% in cash.) Over time, this cash is a drag on the portfolio returns. For example, suppose a fund holds a 10% cash position earns a 2% return on that cash. With the remaining 90% of the portfolio, the fund earns a respectable 10% return. Unfortunately, the investor makes a weighted average return of only 9.2%. This is a sizable dent in your returns, although it may work in your favor when stocks go down. To make matters worse, you are paying the full expense ratio (possibly over 1%) on this cash--in effect making those cash holdings a very expensive money market fund.

Taxes

If you are not investing in a tax-favored account (e.g. an IRA or 401K), then you also need to be very concerned about the on-going impact of taxes on your investment returns. In your taxable accounts, you will pay income taxes on the dividends and capital gains which are distributed each year by your mutual fund. The federal, state and local income taxes you pay on these distributions act as a not-so-small leak on your invested funds. They lower the amount of money you have working for you in your investment account, and will significantly lower your long-term return. Some funds do a much better job of minimizing these distributions and thus maximizing the amount of money you have working for you. Sure, you will generally need to pay taxes eventually, but delaying the taxes as long as possible will pay off in the long term.

How can you manage to minimize the "decompounding" effect of taxation? By using passively managed equity index funds and ETFs you can delay most, and sometimes all, of the capital gains taxation until you sell the fund. This is in contrast to actively managed funds which trade consistently, often realizing considerable long term, and worse yet, short term capital gains that must be distributed to shareholders. Recognizing the detrimental impact of taxation on investor returns, some mutual fund companies (e.g. Vanguard) have created special tax-managed funds. These are worth are certainly worth investigating if you are in a high tax bracket and investing significant amounts in taxable accounts.

Compare turnover rates

All these costs are depressing--financially and emotionally. It is all so complicated, how is the individual investor supposed to avoid incurring unnecessarily high levels of expenses? One clear indicator is comparing a mutual fund's turnover ratio with funds that have similar investment objectives. The turnover ratio is a measure of how much trading a fund has done in a given year. Although not a perfect predictor of trading costs within a fund, turnover ratios have been shown to be highly correlated with trading expenses. For more on turnover ratios, see this Morningstar article.

We'll let Burton Malkiel (A Random Walk Down Wall Street) summarize the lesson once again.

"I have performed many studies of mutual fund returns over the years in an attempt to explain why some funds perform better than others. As indicated earlier, past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance are expense ratios and turnover. High expenses and high turnover depress returns-especially after-tax returns if the funds are held in taxable accounts."

 

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*Back in 1996, Plexas Group estimated the market impact costs of large cap funds at about 0.40%/year, and about 1.5%/year for small cap stocks. This research is cited in Execution Costs of Institutional Equity Orders, by Jones and Lipson

 



Posted on: 12/16/09

Since mutual fund expenses are such an important element in determining our long term returns, it pays investors to understand and control them as much as possible. Many, if not most, investors are at least somewhat familiar with mutual fund expense ratios. The expense ratio is a standard measure of the on-going costs to manage a mutual fund. It is the summation of various operating expenses of the fund divided by the assets managed by the fund. These costs are deducted by the fund, thus lowering the return earned by investors.

The costs included in mutual fund expense ratios are:

  • Management or investment advisory fees: These are the fees paid to the team who oversees the portfolio of investments owned by the fund. It will cover their compensation, research costs, and administrative expenses. As the Motley Fool says, these costs are "necessary to make sure that the manager of the fund can be very well-dressed at all times and is able to go on good vacations."
  • Marketing and distribution or 12b-1 fees: These fees go toward marketing, advertising, and rewarding intermediaries for selling a mutual fund's shares. For example, these may fund commissions to the broker who recommends and sells you the fund. Interestingly, these fees were once justified as helping investors-since if a mutual grows its assets, existing investors would benefit by future lower management and administrative expenses due to efficiencies of scale. I don't think anyone buys this argument today.
  • Other operating expenses: These are administrative fees not captured in the above categories, and include legal, accounting, and transfer agent expenses, along with other services provided to shareholders. Again, according to the Motley Fool, thrifty funds can keep these costs low, but watch out for "the ones who use engraved paper, colorful graphics, and phone answers with highfalutin' accents."

(For more on mutual fund expenses and a handy table showing median expense ratios, see this Morningstar article.)

But, wait! Don't forget the other direct fees that may be deducted from your returns:

  • Redemption fees: Some funds will charge a fee (up to 2%) for investors to redeem their shares. These are often only imposed on short term investors-those selling their shares after only a few months or up to a year. For long term investors, this is generally not an issue, and discouraging short term trading in a fund may lower overall costs to fund investors. Although similar, these fees are different than deferred sales loads (see below), in that redemption fees offset fund expenses, while deferred sales loads are used to pay broker commissions.
  • Account service fees: Funds can impose a separate fee to maintain their accounts, although this is usually only done when accounts are below a certain value. However, for a small account these small fees can be a large percentage drag.
  • Purchase fee: An additional fee to purchase fee shares in an account. This is different from a front-end sales load (see below), in that it is paid directly to the fund to offset costs, not to brokers for sales commissions.
  • Exchange and/or reinvestment fees: Some fund families charge for exchanging shares between funds or for the reinvestment of dividends and distributions. Fortunately, these are not extremely common.

The expenses outlined above pertain to all mutual funds, including "no-load" funds that are the staple of cost-conscious investors. However, this list would be incomplete without mentioning the sales fees that can and should be avoided by the smart investor:

  • Front end sales loads: This is a fee, calculated on the amount invested, that is immediately deducted and used to pay a sales commission to the broker who sold the fund. It is typically between 5 and 6%, although it may be lower or higher (up to 8.5%). Share classes with front end sales loads are referred to as A shares.
  • Deferred sales loads: These are fees that investors pay on the "back end", or when they redeem shares in the fund. Typically, but not always, the fee is calculated based on the lesser of the value of the investor's initial investment or the value at redemption. Also, if it is a "contingent deferred sales load", these fees may decrease over a specified schedule, eventually to zero. That may sound like a good deal, but it usually isn't. This is because these "B shares" will charge a high 12b-1 marketing fee each year to compensate the selling broker. Two things are certain--your broker is going to be paid, and after you pay, you are going to be broker.

(For more on mutual fund sales charges and different fund classes see this Morningstar article.)

In Part 3, we will discuss the many hidden costs of investing in mutual funds. These costs are harder to quantify, but lower your returns just the same. In the meantime, keep in mind this bit of advice from Burton Malkiel of Princeton University, and author of a Random Walk Down Wall Street: "With mutual funds, you get what you don't pay for. The surest way to get top quartile performance from your actively managed mutual funds is to buy those funds with bottom-quartile expenses."

 



Posted on: 12/11/09

Benjamin Franklin once observed that, "A small leak can sink a great ship." The same is true for your retirement portfolio--those seemingly small mutual fund expenses can wreak havoc on your long run returns. Even though there are many things you can't control when you are investing in volatile markets, the smart investor can keep costs, and their drag on returns, to a minimum.

In investing, small numbers make a great difference over the long run. For example, $10,000 invested today earning 7% compounded annually will grow to over $76,000 in 30 years. Not bad--but bump this up to only 7.5%, and the total in 30 years is almost $88,000. In other words, that 0.5% incremental return resulted in 15% more funds accumulated. Increase the return up to 8%, and you have almost $101,000--the additional 1% return provided over 32% more at the end. Such is the power of compound interest. (For an interactive, graphical illustration of the impact over time, see Vanguard's "The Truth About Costs".)

Unfortunately, when it comes to mutual fund expenses this power works against us. The costs associated with mutual fund investing act as a drag on our returns. Each dollar spent on investment management, administration, advertising, commissions, or whatever is a one dollar less in our account. Worse yet, it is another dollar that is not out earning and compounding.

Costs are obviously not the only consideration when investing in mutual funds. Investors are really concerned with performance, risk, and exposure to particular asset classes. The lowest cost funds are not always the best performing, nor are high cost funds always lower performing. However, research from Morningstar has shown that costs and performance are linked. For example, funds in the least expensive quintile (20%) are 2.5 times more likely to outperform than those in the most expensive quintile. This should be no real surprise--the more expensive funds need to earn that much more to offset their expenses, so outperforming market averages is even more difficult. (This Vanguard article shows more data regarding the relationship between expense ratios and returns.) Other academic research also backs up this inverse relationship between costs and performance.

When considering the costs of owning mutual funds, the expenses can be broken down into two buckets. First, there are the direct costs that are disclosed and easily quantifiable. These will be discussed in Part 2. In Part 3, the undisclosed, less transparent costs incurred by investors of mutual funds will be examined. These costs are harder to get your arms around but reduce your returns nonetheless.



Posted on: 10/01/09

As discussed in Part 1 and Part 2, Treasury Inflation Protected Securities (TIPS) are an excellent hedge against unexpected inflation and one of the safer investments available. Although these bonds are not without risk (e.g. if real interest rates rise) and you should not expect high real (after adjustment for inflation) rates of return, they have a potential supporting role in many portfolios. Besides the obvious inflation protection, TIPS provide desired diversification--over time they are expected to be negatively correlated with equity returns, and relatively uncorrelated with the returns on conventional bonds.

If you decide to include TIPS in your investment portfolio, what is the best way to do it? You have two major routes to invest--each with alternatives to consider.

Direct investment in TIPS--individual bonds

Although not the simplest method, buying individual TIPS has some advantages. Like other U.S. government bonds, you can buy them directly through with no fee through TreasuryDirect.gov in increments of $100. This is a pretty easy process once you have an account set up, and over time you can create a very nice bond ladder. There are a couple of key drawbacks to this approach, however. First, you cannot set up an IRA in at TreasuryDirect, so you have to deal with the inefficiencies of TIPS in a taxable account as mentioned in Part 2. And, if you don't hold the note to maturity, selling through TreasuryDirect is not as simple, and is not free.

An alternative to using TreasuryDirect is to use your broker, bank or dealer to purchase the individual bonds. This will allow you to buy and sell them within an IRA, but there will likely be transaction fees that eat into your returns somewhat.

TIPS funds--actively and passively managed mutual funds and ETFs

If you like the simplicity and convenience of using mutual funds and ETFs for investing, here are some choices for investing in TIPS. Since expense ratios will cut into your return, you need be especially careful you to pay attention to cost. After all, TIPS are not expected to have high returns in the long run-and even the least expensive funds eat up a good share of the expected returns in this low interest rate environment.

The largest TIPS mutual fund is Vanguard's Inflation Protected Securities Fund (VIPSX, 0.25% expense ratio), which surprisingly is not an index fund. Vanguard's fixed income team believes the TIPS market is one where they can add value through some active management, while still keeping costs low. (Lower cost Admiral shares (over $100K) and institutional shares are also available.) Although Vanguard has some investment flexibility in the fund, they generally stay focused on TIPS and seek to take advantage of opportunities in that market.

Two other actively managed mutual funds that are well respected are PIMCO Real Return Institutional Fund (PRRIX, 0.45% expense ratio) and Harbor Real Return Fund (HARRX, 0.60% expense ratio)--both managed by the PIMCO team. PRRIX is available in many 401K plans, but requires a $100K minimum for individual investors. Both PRRIX and HARRX take a more active management approach, often holding up to 20% of the fund outside of TIPS, and may be considered more volatile than the Vanguard fund.

If you are looking to invest in TIPS via index-following ETFs, look to iShares Barclays TIPS Fund (TIP, 0.20% expense ratio) or State Street's SPDR Barclays TIPS ETF (IPE, 0.18% expense ratio). TIP is by far the larger of the two, but both of these funds seek to track the Barclays Capital U.S. TIPS Index in a cost efficient manner. PIMCO has also recently introduced a series of three new TIPS ETFs which track Merrill Lynch indexes. Most interesting is the PIMCO 1-5 Year U.S. TIPS Index Fund (STPZ, 0.20% expense ratio) which is designed to be more of a "pure-play inflation-protection investment". By concentrating on TIPS with shorter maturities this fund should expose investors to less risk of rising real interest rates. There is also the PIMCO 15+ Year U.S. TIPS Index Fund (LTPZ, 0.27% expense ratio) and the PIMCO Broad U.S. TIPS Index Fund (TIPZ, 0.30% expense ratio), which should be somewhat comparable to the iShares TIP and State Street IPE funds.

Conclusion

A recent Wall Street Journal article discussed how fear of inflation fueled by high government spending has sparked a significant increase of investor funds going into TIPS funds during 2009. Indeed, TIPS have posted healthy total returns so far in 2009, after losses in 2008. The fact that TIPS are hot right now is not a good reason to invest. Invest in TIPS if you think it makes sense as part of a long term asset allocation strategy. If you don't have such a strategy, consider consulting with Table Rock Financial Planning, or another fee-only planner from the Garrett Planning Network.

 



Posted on: 09/25/09

In Part 1 Treasury Inflation Protected Securities (TIPS) were introduced with a short explanation of how they work. Before discussing how a person may want to invest in TIPS (Part 3), we'll look a number of things to consider before deciding if an allocation to TIPS is right for you

  • TIPS are a U.S. Treasury debt instrument and are backed by the full faith and credit of the U.S. government-so they are considered essentially default risk-free. (And, we hope it continues that way.)
  • Although TIPS have essentially no credit (i.e. default) risk, they certainly not risk free. As with all fixed income investments you are subjected to interest rate (or market) risk. If you hold TIPS to maturity, you are assured to receive their real interest rate, adjusted for inflation. However, if not held to maturity, TIPS can see significant price fluctuation. When real (i.e. without an inflation component) interest rates go up, the value of TIPS goes down. When real interest rates fall, you would expect TIPS prices to rise. And, if real interest rates stay relatively stable, TIPS prices should remain close to their inflation-adjusted face value. Real interest rates should be more stable than nominal (regular, with an inflation component) interest rates, thus you would expect TIPS to be less volatile than conventional Treasuries.
  • All in all, TIPS are arguably one of the safest investments available. However safe TIPS are viewed, the investor should be aware of potential volatility. For example, at the end 2008 TIPS took a significant dive in value, even as nominal Treasuries were rising in price due to the "flight to safety". This was pretty surprising--why would the real yield on TIPS rise, while the nominal yield on traditional Treasuries were falling? A recent study (Cambell, Schiller, Viceria) suggests that Lehman Brothers became a forced seller of TIPS, depressing there prices (a basic short term supply and demand phenomena).
  • Evidence (both in the U.S. and in foreign markets) points to negative correlation with of TIPS to stock market returns. This is what makes TIPS an excellent diversifier for a portfolio. Of course, there is no guarantee of this diversification benefit, and it should be noted that in 2008, both stocks and TIPS experienced losses. (See the table below to compare recent returns for TIPS, nominal Treasuries, and The S&P 500.)

  • Since you are not assuming inflation risk, you should expect lower returns with TIPS than with conventional Treasury debt of similar characteristics. TIPS are not a way to get rich--their value is in their inflation protection and as a low risk diversifier in your portfolio.
  • Even in a deflationary environment, which is a concern these days, there is protection with TIPS. Investors are guaranteed the lesser of the inflation-adjusted principal or par value--i.e. the value of the bond will not be adjusted below par, even with significant drops in the CPI. (However, if you buy at a premium, you can lose some principal.)
  • TIPS' taxation makes them a bit complicated. First of all, the fact that the inflation adjustment is taxed makes them makes them a less-than-perfect inflation hedge. You are taxed on both the coupon payment (as interest income) and on the inflation adjustment to the principal (as original issue discount), and you will receive generally receive Form 1099s for each type of income. This also creates the potential for "phantom tax" problems--if the inflation adjustment is large enough, it is possible that the bond will not generate enough income to pay the taxes in a particular year. Most advisors suggest holding TIPS in tax advantage accounts to avoid these complexities. (Using TIPS mutual funds or ETFs also makes this easier.) On the positive side, like all U.S. Treasury debt, the interest payments are exempt from state and local taxes.
  • TIPS have a cousin in I-Bonds. I-Bonds are savings bonds that are similar to TIPS in that they provide a fixed rate of interest plus and inflation adjustment. However, there is no coupon payment with I-Bonds--they work like a zero coupon bond. Income is deferred for tax purposes until funds are withdrawn, making them better for taxable accounts. There are also potential benefits to I-Bonds when saving for college.

Still interested in TIPS for a portion of your fixed income investments? In Part 3 we'll look at some of your options in investing in TIPS.

 

 

 

 



Posted on: 09/19/09

Economists are a worrisome sort. Currently, many are concerned about the dangers of deflation. Others are scared that massive government spending and increases in the money supply will bring on higher inflation that we haven't seen for over 25 years. Most economists hedge their bets and worry about both.

The fact is inflation is always a risk, and certainly something to be concerned about when you are saving and investing to prepare for future expenditures (think college and retirement). One investment that can protect you from unexpected inflation while helping to diversify your portfolio is Treasury Inflation-Protected Securities, or TIPS.

In this article we'll look at what TIPS are and how they differ from other bonds. Part 2 will follow and discuss a number of key attributes of TIPS for your consideration before making them a part of your investment portfolio. In Part 3 we'll look at your options in how to invest in TIPS.

TIPS are a special type of U.S. Treasury bond that automatically adjust for changes in the Consumer Price Index (CPI), protecting the investor from the negative impact of unexpected future inflation. Although an investor should not anticipate exciting returns, TIPS are arguably the safest and purest inflation hedge available to Americans. Although inflation protected securities have been issued in more than twenty other countries, starting with Finland in 1945, the U.S. did not make TIPS available until 1997. TIPS are currently issued in 5, 10, and 20 year maturities. Available initially, 30 year maturities were discontinued in 2002.

To understand how TIPS work, it is best to compare them to conventional Treasury notes and bonds. With conventional (nominal, or non-inflation protected) Treasuries, the investor earns the stated coupon (or interest) rate on the face value of $1000. In a simplified example, a ten-year note with a 6% coupon would pay $60 ($30 semi annually) on the $1000 investment. At maturity in ten years, the investor would receive the $1000 face value back from the U.S. government. The interest rate on these conventional notes can be thought of as a combination of an inflation expectation plus a real (inflation adjusted) interest rate. In this example, the 6% interest rate may represent a market expectation of 3% inflation, along with a 3% real interest rate. Thus, the conventional note provides a return that compensates investors for expected inflation and the real interest rate (i.e. the market cost of the capital provided). However, if inflation ends up to be higher than the market anticipates, investors will earn a lower or even negative real (i.e. inflation adjusted) return.

A ten-year TIPS issued at the same time may have a coupon rate of only 2.75%, compared to the 6% coupon on the conventional Treasury note in the example above. The 2.75% rate is even slightly lower than the 3% real interest rate expected to be earned on the conventional note, reflecting the fact that the TIPS investor is not subjected to the risk of unexpected inflation. (Remember, higher returns are compensation for higher risk, and lower levels of risk are accompanied by lower returns.) TIPS investors accept this lower stated interest rate because their return will be augmented by an inflation adjustment tied to the change in the CPI.

Although you may think that the TIPS' coupon rate would be adjusted for inflation, the adjustment is actually made to the principal, or face value, of the note. If after the first year the CPI rises 4.5%, the $1000 face value of the note will have been adjusted to $1045. The coupon rate stays constant, but will be applied to this higher principal, resulting in a higher semi-annual payment. The initial coupon payment of $13.75 (1/2 x 2.75% x $1000) will rise to $14.37 (1/2 x 2.75% x $1045). If the CPI continues to go up at a rate of 4.5%/year, the face value of the note will have increased from $1000 to over $1,550, and the investor will receive that amount back from the U.S. Treasury.

In the simplified (e.g. no tax impact, no premium or discount on the notes which are held to maturity) example above, the TIPS investor has earned a total return of approximately 7.25% per year on his investment over the ten years. This return is a combination of the 4.5% inflation adjustment and the 2.75% real return. The conventional treasury investor would not have fared so well--earning a nominal return of 6% and real return or only about 1.5%. The TIPS investor was effectively protected from the impact of the higher than expected inflation.

In real life, the TIPS investor will not always fare better than with conventional Treasuries. When inflation ends up to be less than or equal to expectations, the investor will earn a higher real return in nominal Treasuries of comparable maturity. Over the long run, you would expect slightly lower returns with TIPS than similar conventional Treasuries--after all, you are exposed to less risk. This isn't necessarily a bad thing, however, since the smart investor doesn't look to just maximize his return, but is also carefully managing his risk.

Learn more about TIPS in Parts 2 and 3.

 



Posted on: 08/29/09

Like going to the dentist every six or twelve months, people are encouraged to rebalance their investment portfolios or 401K accounts. (It seems like most people would rather go to the dentist.) In Part 1, we looked at what rebalancing means, and why it is important. Below, the impact of rebalancing is demonstrated a simple example. After that, a couple practical questions are dealt with.

To illustrate, let's expand upon the simple example started in Part 1. The investor begins with a $100,000 portfolio allocated 50% to bonds and 50% to stock. Over a five year period, stocks average an 8% annual return, but the returns range from -15% to +20%. Over the same period bonds average 5%, with returns ranging from 0% to +10%.

 

First thing to note is how the stock/bond allocation oscillates over time. In year three, the portfolio has become significantly more risky (57% stock, instead of the target 50%), and as a result the portfolio that is not rebalanced suffers a much larger negative return in that year than the rebalanced portfolio. Conversely, in year five, the untended portfolio has become slightly more conservative than planned, and there is a corresponding drag on performance in that year.

With no rebalancing of the portfolio, the investor averages 6.5% over the five years, ending up with a bit over $137,100. However, when the portfolio is rebalanced at the beginning of every year the investor averages 6.8%, and ends up with about $139,100. The investor earns about 5% more over the five years. This may not seem like a huge difference, but over time it will add up. And, when you are rebalancing across more asset classes than just stocks and bonds (e.g. international vs U.S. stocks, small cap vs large cap stocks, TIPs vs traditional bonds), you have more opportunities to benefit from rebalancing.

How often should you rebalance your portfolio?

Like so many things in finance, there is no one right answer to this question. You need to weigh the value of your time and the transaction costs (e.g. commissions and taxes) with the potential benefit derived from rebalancing. Generally, once or twice a year is deemed sufficient, but it really depends on how much the market is moving. A time based approach, once or twice a year at a preset time, is simple and relatively easy to follow. A more complex approach is to monitor your investments more frequently (e.g. monthly) and gauge whether investments have deviated from predetermined limits. Many investment managers advocate this approach to boost potential returns.

Other tips

Most 401K plans seem to have pretty good tools to make rebalancing easy. Once you figure the tools out, it is simple. There are no tax impacts and no generally no other transaction costs to concern the investor.

If you are working within an IRA or other tax advantage account, you don't need to worry about the tax impact of trading, but the task is usually more time consuming than in your 401K plan. And, you do need to worry about the transaction costs of buying and selling your funds. Using no transaction fee mutual funds may eliminate the commissions and fees, but may cost you more in the long run, if this forces you to use funds with higher expense ratios. If you are working with a discount broker, using low cost, passively managed exchange traded funds (ETFs) may be a cost effective solution to minimizing your overall portfolio expenses.

In taxable accounts, rebalancing can be somewhat expensive. Not only do you need to be mindful of commissions, but selling positions that have gone up may cause you to realize taxable capital gains. One way to avoid this is to rebalance your investments across multiple accounts. Look at your taxable and tax-favored investments as one unified portfolio and ideally use a tax-favored account for rebalancing. None of your accounts will match your target allocation exactly, but when added together they are in balance.

Conceptually, none of this is extremely difficult. However, unless you are working with a 401K or another account with tools that makes rebalancing easy, it does take some work-and the effort increases as you make your portfolio more complex. Spreadsheet skills will certainly come in handy for the DIY investor.

Obviously, this is not how everyone likes to spend their evening, which is why many investment portfolios go untended. Given the importance of your investment portfolio in meeting your future objectives, it often pays to seek out the help of a competent financial planner who can help you develop an asset allocation plan. And then let that planner assist you in keeping your portfolio in balance and on track over the years.

 



Posted on: 08/24/09

If you manage your personal 401K account, IRA, or other investment portfolio, you've probably heard that you should rebalance your investments regularly. However, you may not really understand what rebalancing is, or why it is important. And, if you don't understand these basics, it's unlikely you are going to follow through on this important bit of investment portfolio maintenance.

What do we mean by rebalancing a portfolio?

Rebalancing is the systematic process of selling some assets and buying others in order to restore your investment portfolio to your target asset allocation. Of course, this assumes you have gone through some process to decide on a strategic asset allocation that makes sense for your personal financial situation. There are numerous books and web resources to help you with the task of developing an asset allocation plan. However, if the DIY route doesn't sound right for you, this is an area to employ a competent financial advisor who will walk you through the process. If you work with a fee-only financial planner, you can be assured that their advice is not skewed by sales commissions and other incentives to push particular financial products that may not be in your best interest.

Over time, an investment portfolio will naturally move away from its original, target allocation. This is because each of the different investments will go up and down at different rates. Every so often you need to go in sell some investments that have grown to be a larger percentage of the total you're your plan calls for. You use the proceeds of these sales to buy more of the investment assets that have fallen below their target percentage.

Why is rebalancing your portfolio important?

The number one reason to rebalance is to control the level of risk that your portfolio is exposed to. For example, you and your advisor decide that a 50% stock and 50% bond allocation will likely deliver adequate returns to meet your objectives, with an expected level of volatility or risk that you are comfortable with. Imagine that over the next two years, stocks rise at 20%/year and bonds rise at 5%/year. Now your portfolio consists of 57% stock and only 43% bonds. You care about this because your portfolio has become riskier than you decided was appropriate two years earlier. The same thing can happen in reverse, when bonds do well and stocks decline in value, a portfolio can become too conservative. A portfolio that is too conservative is less likely to produce adequate returns to meet an investor's objectives. Rebalancing is about maintaining the risk/return balance that is appropriate for your situation.

A second reason to rebalance your portfolio is that the process is likely (although not guaranteed) to marginally increase your long-term investment returns. It does this by causing the investor to sell assets that have been increasing in value in order to buy assets that have been decreasing (or not increasing as fast) in value. You know you should "buy low, sell high", but it's not as easy as it sounds. It goes against our nature to sell some of the mutual funds that have been doing so well, and turn around and invest more in those currently dragging down our portfolio. This discipline, imposed by the reallocation process, can pay off with marginally higher returns over the long run. Jason Zweig of the Wall Street Journal discussed this topic earlier this year in his "The Intelligent Investor" column.

In Part 2, we'll look at a quick illustration of how rebalancing not only maintains your target risk level, but adds to your returns. In the meantime, this article from Charles Schwab has some good illustrations from their research of the value of rebalancing.

 



Posted on: 07/29/09

With the miserably low interest rates offered on savings, money market accounts, and CDs these days, it seems it just doesn't pay to be a diligent saver. Of course, it does pay great dividends--in peace of mind and the security of knowing you're doing your best to prepare for whatever the future holds. Even though you may be tempted to take more risk for higher returns (many of us apparently have short memories), there is great value in the safety and stability of FDIC insured accounts for money you may need over the next few years. However, what are your options in maximizing the interest on your emergency and other short term savings?

Internet banks

Over the past several years a plethora of banks have been offering on-line savings accounts, CDs, and even checking accounts at much more favorable rates than traditional banks and credit unions. Although you give up the option of walking into the bank and talking to someone in person, you generally get much higher rates of interest--not to mention the convenience of banking in your boxers. The general model is that our traditional checking account is electronically linked to your on-line savings account, and you can move money in either direction at anytime, or automatically at set times during the month. It is easy, safe, and I can't believe I lived without it for so many years. And, although rates are still low today, you can still find rates that are significantly higher than your local bank or CU.

A decent overview of internet banks and what to look for can be found here. If you are looking for where the best rates are and reviews on banks, check out bankdeals.blogspot.com, which is a great resource--if you can find your way around the site. You can also check bankrate.com.

There are so many banks to choose from, it can be a little intimidating. I use ING Direct, and although they are no longer the leader in terms of interest rates, I have always been impressed by their straight forward terms, ease-of-use, and service. Other big names include HSBC Direct, and Emigrant Direct, and now Ally Bank, which has morphed out of GMAC Bank. GMAC Bank essentially rebranded itself as Ally Bank and is in the midst of a big marketing blitz. They came out of the gates offering interest rates much higher than anyone else, causing the American Bankers Association to complain to the FDIC about unfair competition. Whether this lobbying was the cause is uncertain, but Ally's rates have come down significantly over the last several weeks--although they are very competitive.

High yield checking accounts

A relatively new option when searching out higher interest rates are high yield checking accounts. These accounts are generally offered by smaller local banks and credit unions, although a number are offered nationwide. Generally the accounts have above market yields (3% to 5% in mid July), but there a number of hoops you need to jump through to qualify. First, you usually have to have at least one monthly direct deposit or other ACH (automatic check handling) transfer. You also need to make a certain number of debit card transactions per month--normally around ten. And, although you generally don't have a minimum balance requirement, there is a maximum balance (usually $25,000) that the bank will pay the higher rate on. You may also need to accept electronic statement instead of paper. If these requirements fit into how you use your checking account, it is definitely worth looking into. Check out offerings in your local area, along with banks offering these accounts nationwide. At Kasasa.com you can find institutions which offer these high yield accounts in your area, with a few twists, such as very competitive saving accounts to go along with the checking accounts. 

It may seem like a lot of work to shop around and move your savings from its current home. Even though you may more than triple the interest you are earning--1.5%, 2%, or even 5% may not seem worth it. However, as interest rates rise (and they eventually will) the reward for placing your money in a more competitive bank will likely be even greater. Over the long haul, being smart about these small things will pay off. As Benjamin Franklin said, "A small leak can sink a great ship." Don't let the small leak of uncompetitive savings rates sink your ship.



Posted on: 07/21/09
In Part 1, we looked at what a stable value fund is and how they have performed over the years. Like any investment, however, there are some things to consider before putting your money in a stable value fund. Even with the backing of "insurance wrappers", these funds are not without risk, and there are no absolute guarantees that investors will not see a loss of principal. Obviously, the financial stability of the insurance providers (there are usually multiple ones) is key to the overall safety of the fund. To illustrate this risk, consider that AIG was backing a significant percentage of the wrap contracts in stable value funds when it had to be rescued in the fall of 2008. Unfortunately, stable value funds assets and these insurance contracts are not exactly transparent, making it difficult to assess just how solid the fund is. Although the stability of principal may still be maintained by the fund in the wake of losses and credit issues, it may come at the cost of lower future yield to the investor.

As mentioned in Part 1, there are often restrictions on when or how often an investor can move money out of a stable value fund. This allows the fund to invest for higher yield without the concern of providing ready access to cash, the way a money market fund is required to. These liquidity restrictions generally should not be a major consideration to a long term investor in a 401K or 403B plan. However, these limitations tend to prevent investors from switching between the stable value fund and other fixed income funds that may be currently offering higher yields. 

Like most fixed income investments, there is also the risk that earnings from stable value funds will not keep up with inflation. Also, due to the construction of these investment vehicles, they tend to lag interest rate trends--so they tend to out perform while interest rates are declining, but can lag while interest rates are increasing. Finally, as is critical with all fixed income investments, watch the costs of the fund. If the fund has fees >.5%, think twice before investing. (One local benchmark--the stable value fund in the HP 401K plan has fees estimated at only .07%.)

As reported in the Wall Street Journal earlier this year, the recent market turmoil also brought to light an additional risk element particular to stable value funds. When employers declare bankruptcy and ex-employees move their assets from company retirement plans, the resulting exodus can put substantial strain on stable value funds. As it turns out, most of the insurance contracts protecting assets in stable value funds do not cover employer initiated events such as bankruptcy. The Lehman Brothers' stable value suffered a small mark-down in late 2008. When the retailer Mervyns terminated its 401K plan after going bankrupt, their stable value fund did not lose value, however employees could not get access to funds for months due to withdrawal restrictions.

In spite of these risks, a modest allocation to a good stable value fund still makes sense for many investors. It should prove to be a good diversifier and provide a reasonable return for low risk. However, as we have learned over the last several months, low risk does not mean no risk.



Posted on: 07/15/09

If you participate in an employer sponsored retirement plan such as a 401K or 403B plan, one of your investment choices may be something called a stable value fund. (Other possible names are interest income, principal preservation, or guaranteed interest funds.) In periods of healthy stock market returns you may have ignored these funds--after all, most of us are looking for high returns and values that grow, not stay stable. However, with the significant declines of the last year and a half, many investors have taken a fresh look at the fixed income side of their retirement plan investment options in an effort to better manage the risk of their portfolios. So, what is a stable value fund, and should it be part of your retirement plan portfolio?

Stable value funds are a hybrid fixed income investment that are designed to offer stability of principal similar to a money market fund, but have the higher expected returns of short or intermediate term bond funds. This combination of safety and expected return, along with a lack of correlation with stock prices (i.e. they are not expected to go down when stocks go down), make them a prime candidate for inclusion in a well-diversified portfolio. They, along with other fixed income investments like bond funds, provide the necessary ballast to manage the risk in your retirement portfolio. Stable value funds are available options in more than half of the 401K plans, and according to the Stable Value Investment Association (yes, they have their own association), and around 12% of the assets in those 401K plans are allocated to these funds. (This percentage presumably has risen as equity fund values have plummeted.)

Although stable value funds have attributes similar to both money market and bond funds, they are an asset class unto themselves. Initially, these funds were structured as guaranteed investment contracts (GICs), which are contracts issued by insurance companies to the retirement plan guaranteeing investors a fixed rate of return. While this may still be the case, most stable value funds are now structured as synthetic GICs. These synthetic GICs are diversified portfolios of primarily high quality bonds of short to intermediate duration combined with various "insurance wrappers". These insurance wrappers are contracts where a highly rated insurer guarantees to make up the difference if the portfolio value drops below a given level, providing the stability of net asset value (NAV) similar to money market funds. Also contributing to the stability of NAV are book value accounting (similar to money market funds), and some restrictions on exchanges into and out of the fund.

Have stable value funds performed as designed? According to data from Vanguard, the Hueler Analytics Stable Value Pooled Fund Index (an index representing about 75% of stable value fund assets) averaged an annual return of 6.9% from 1984 through 2008. Over the same time period money market funds averaged only 4.71%. Short term bonds funds and intermediate term bond funds returned only 5.1% and 6.22%, respectively. Surprisingly, while outperforming all three of those fixed income asset classes, the stable value funds experienced considerably less volatility (i.e. risk) than even the money market funds. While this is no guarantee of future performance, it does make them worthy of consideration as part of your fixed income allocation.

Next, we will look at some of the risks of stable value funds.



Posted on: 06/30/09

In Part 2 we looked at some of the advantages of ETFs, and how they might be useful in creating a diversified, low cost portfolio. However, not everyone is keen on ETFs for the individual investor. John Bogle, who I highly respect, is one of the primary critics of ETFs. Although, as this interview by Morningstar points out, he is not opposed to utilizing ETFs for long-term, index fund investing--just as you would use index mutual funds. So, what are the problems with ETF's, and what should you look out for?

The dark side of ETFs 

The double edged sword of ETFs is that they are easy to trade. Most of the trading volume of ETFs is from active traders and institutions. While this keeps the market efficient and insures that the most popular ETFs are trading very close to their NAV, active trading of ETFs (or stocks or mutual funds) is a recipe for high costs and lower returns for most individual investors. For those of us who generally buy, hold and trade only to occasionally rebalance our portfolio, ETFs are a good product. Just because you can trade them all day long, doesn't mean you should! 

Another problem with ETFs is the extreme number of different indexes and market sectors that you can invest in. It is a ripe playground for market-timers and active investors to jump in and out of hot sectors on every whim. Just because you can invest in a small cap Brazil index, or the biotech sector, doesn't mean it's a good idea. Remember, you should have these sectors covered with broader US and international index funds. Don't kid yourself about your ability to identify the hot sector in time to profit from it. And, not only is utilizing too many sector and country indexes a complicated and doubtful strategy, but these funds are often more thinly traded. This exposes you to higher transaction costs from larger bid/ask spreads and potential discounts and premiums relative to the NAV of the fund.

Finally, there are many dangerous ETFs to be avoided. These include leveraged, inverse, and leveraged inverse ETFs. With leveraged ETFs, your gains and losses are multiplied by leverage within the fund. With inverse ETFs, you gain when the index goes down, and vice versa. If this sounds complicated and risky, it's because it is. We mere mortals should stay far away.

In conclusion, ETFs are useful for the disciplined individual investor who wants to follow a low cost, passive investing strategy. If you want to learn more about to build a diversified portfolio to help you reach your goals, contact Table Rock Financial Planning today.



Posted on: 06/24/09

In Part 1, we discussed the basic construction of exchange traded funds (ETFs) and how they differ from conventional mutual funds. Now let's explore some of the benefits of ETFs, and why it may make sense for you to include them in your investment portfolio. We'll also briefly touch upon the dark side of ETFs, where most individual investors should fear to tread.

For the mainstream individual investor, the potential advantages of using ETFs versus conventional mutual funds fall into four main categories:

  1. Asset allocation
  2. Lower fees
  3. Availability
  4. Tax management

Asset allocation: The biggest factor in determining of the risk and return of a portfolio is how investment dollars are allocated across different asset classes. ETFs are available to track a myriad of US and international stock and bond indexes, allowing the investor to effectively include asset classes they might otherwise ignore (e.g. international small cap stocks, micro cap stocks, emerging markets, REITs, or style indexes). It's not that exposure to these asset classes is not available through mutual funds, but the choice of low cost, passively managed mutual funds is limited once you stray from the most popular indexes (e.g. S&P 500 and MSCI EAFE international developed market index). With ETFs, the choices are abundant--maybe too much so! The goal of adding these additional asset classes it to provide you with a marginally higher expected return for a given level of risk. Or conversely, reduce the volatility (risk) of your portfolio for a given level or expected investment return.

Lower fees: At Table Rock Financial Planning we are proponents of keeping your overall cost of investing low in anticipation of keeping a larger share of market returns. This generally leads to recommending passively managed index funds from the low cost providers (most notably Vanguard, but also Fidelity, Schwab, iShares, and State Street). ETFs, because of the way they are constructed, enjoy certain efficiencies over mutual funds, and have the opportunity to pass these along in lower fees. For example, the expense ratio for Vanguard's Total Stock Market Index Fund (VTSMX-investor shares) has a low expense ratio of just 0.18%, but the comparable ETF (VTI) expense ratio is only 0.09%.

Lower fees don't just end with lower expense ratios, however. Take the case of Vanguard's new international small cap index fund which has both ETF shares (VSS) and mutual fund shares (VFSVX-investor shares). Not only is the expense ratio of the mutual fund considerably higher than the ETF, but the there is a 0.75% purchase fee and another 0.75% redemption fee for the mutual fund. (These are not sales loads, but are paid directly to the fund--presumably to compensate the existing shareholders for the expenses incurred by additions and redemptions to and from the fund.) Avoiding these purchase and redemption fees more than offsets the brokerage commissions incurred when trading the ETF. (There are other considerations here--specifically whether the ETF is traded at a discount or premium versus the fund's NAV--but, we'll leave that discussion for another day.)

Availability: Depending on where you hold you investment portfolio, you only have access to certain mutual funds--and only a subset of these funds are available with no transaction fee (NTF). Unless you are using Vanguard as your custodian, you will undoubtedly only have a small selection of low cost index funds available for no transaction fee. Since the transaction costs of trading mutual funds is generally higher than for buying and selling stocks (and ETFs), it will generally be less expensive to purchase ETFs than to buy a comparable index mutual fund and pay the associated transaction fee. For example, at Fidelity you will generally pay somewhere between $8 and $20 to purchase, say 100 shares, of an ETF on-line. However, to acquire the same dollar amount of a comparable mutual fund will cost you $75, assuming it is not an NTF fund.

Lack of NTF index funds is only part of the problem the smaller investor faces. Many of the best low cost index funds have minimum investment levels that are beyond some small investors. Fidelity has some great low cost index funds, but you need $10K to get into each fund. Vanguard generally has a $3K minimum, which is less of an issue. However, it may preclude a younger investor from allocating a small portion of her portfolio across a number of sub-asset classes that may be otherwise desirable.

Tax management: Index fund investing, whether you use mutual funds or ETFs, is more tax efficient than investing through actively managed mutual funds. Maybe you had the uniquely frustrating experience of having your actively managed mutual fund distribute taxable capital gains to you during 2008, despite the fact the fund may have declined >30% in value. In taxable accounts, index funds will distribute far fewer taxable capital gains to its shareholders since they do very little selling and realization of gains. You get to delay paying capital gains until you sell your own shares at a time you choose. ETFs, again due to their construction, are even marginally more tax efficient than regular index mutual funds. (Vanguard even has some patented methods that allow their index mutual funds to realize tax benefits from the existence of their ETFs as an alternate share class.)

ETFs can also help the investor manage and minimize their taxes by facilitating efficient tax loss harvesting. Say you have significant capital losses on index mutual funds or ETFs held in a taxable account. You would like to sell the funds and realize the losses for tax purposes, however you want to remain invested and maintain your strategic asset allocation. Due to the "wash rule" you cannot sell your funds to realize your loss and then buy the same fund back to maintain your position. You could, however, sell your current index positions and then immediately buy back into the market using marginally different ETFs. For example, you sell your S&P 500 fund and then buy an ETF tracking the MSCI 750 or Russell 1000--both large (and mid) cap indexes. You then substitute ETF tracking the MSCI 1750 or Russell 2000 for your S&P Completion Index (small cap) fund. There are many opportunities to effectively cover the market while tax loss harvesting, without running afoul of the IRS.

As you can see, ETFs can be a great tool to help you construct a well diversified, cost efficient portfolio. However, like any tool, in the wrong hands and used incorrectly there can be great harm done. For the same reasons my wife won't let me have a chainsaw, you need to be aware of some of the drawbacks and dangers of ETFs, which will be covered in Part 3.



Posted on: 06/20/09

You finally feel like you understand mutual funds, but what are exchange-traded funds, or ETFs? It's not like they are new--you've probably been hearing about them for several years--but, you aren't quite sure how they are different from mutual funds, or whether you should be suspect. (And, with the financial services industry, you generally should be suspect.) You may have even seen some negative press regarding ETFs, leading you to believe they are not appropriate for conservative, "buy-and-hold", long-term investors.

What are ETFs?

Very similar to mutual funds, ETFs are registered investment companies that offer investors a proportionate share of a portfolio of stocks or bonds. Most ETFs track market indexes (e.g. the S&P 500 or Russell 2000) like an index mutual fund, and have the same qualities (low cost, diversification, tax efficiency, etc) that make them attractive to many investors. However, ETFs differ from traditional mutual funds in the way they are constructed, and more importantly to the individual investor, how they are bought, sold, and priced. ETFs are traded like individual stocks at any time during market hours through a brokerage account. Like individual stocks, ETF prices are constantly changing, and investors buy and sell at the market price at the time of the trade. Contrast this to traditional mutual funds where orders to buy and sell are taken during the day, but the transaction is completed after the close of the market, and the price is the net asset value (NAV) of fund. (Net asset value is calculated by dividing the total value of all the securities owned by the fund and dividing by the total number of mutual fund shares outstanding.) 

When investors buy and sell traditional "open-ended" mutual funds, they are actually making the transaction directly with the mutual fund company. The company sells new shares to investors, or redeems shares for cash from investors who wish to sell. If necessary, the fund may have to sell stocks or bonds within its portfolio in order to redeem shares upon request. This can have negative consequences if it forces an untimely sale of securities, creates excessive transaction costs, or causes the realization of capital gains that are then distributed to shareholders who are taxed on those gains.

The underlying construction of ETFs differs from mutual funds, and investors do not make transactions directly with the fund company. ETF shares, in big batches called creation units, are created by large institutions providing an exact, pre-defined basket of securities to the fund company. These large brokerages or investment banks then break these creation units down into smaller quantities and sell the new ETF shares via the stock exchange. When an individual wants to buy some ETF shares, he needs to buy some of these previously created shares. When an individual wants to sell some ETF shares he cannot redeem them from the fund company as he would a mutual fund, but he must find another willing buyer via the stock exchange. Redemptions from the fund company are only done in large batches--the creation unit process in reverse.

So far this is all pretty boring stuff, and it may be difficult to see how an ETF would benefit the individual investor. In Part 2 we'll look at a number of tangible benefits of ETFs and how you might use them in place of traditional mutual funds. We'll also look at some of the negative aspects to ETFs, and why some respected people are generally down on them.



Posted on: 05/15/09

William Bernstein, author of The Four Pillars of Investing, The Intelligent Asset Allocator, and a couple of other financial books, is highly respected among knowledgeable, passive investors. He is the co-founder of Efficient Frontier Advisors, has a PhD in Chemistry from U.C. Berkeley, and until recently was a practicing neurologist in North Bend, Oregon. (OK, but what has he done lately?)

In a CNN/Money article entitled "Are Stocks a Loser's Bet?" Bernstein points out some startling stock market statistics that are worth considering carefully. Apparently, the top performing 25% of stocks are responsible for all of the gains in the broad U.S. market from 1980-2008, while the other 75% of stocks were actually generating loses. According to the research from Dimensional Fund Advisors, the bottom 75% of the stock market sustained annual losses of -2.1%, but the stellar performance of the top 25% pulled the overall market return up to 10.4% per year. Talk about carrying the team--these top stocks had to seriously outperform.

To many the obvious conclusion from all of this is to just select from the top 25% of stocks and leave the losers to the less enlightened. Unfortunately, this is a great strategy that you will most likely fail to execute successfully. In fact, you take the very real risk of missing out on many of the winning stocks, and underperforming the market. If you happened to have the misfortune of missing the top performing 10% of stocks during this period, your portfolio returns dropped from the 10.4% to just 6.6% annually. That turns out to be some serious money when compounded over 29 years.

Larry Swedroe, in What Wall Street Doesn't Want You to Know, talks about this same phenomenon in the context of small cap stocks. He references a 1997 study by Peter Knez and Mark Ready that investigated the higher returns of small cap stocks over large cap stocks. It turns out that the excess returns of small cap companies comes from a very small number of stocks. Apparently, if you remove the top performing 1% of small stocks on a monthly basis, the excess return from small stocks more than disappears. They referred to this as the "turtle egg" effect--where many turtle eggs are laid, but only a few will survive and make it to the ocean. Swedroe's conclusion was not to waste money trying to identify the few winning turtle eggs from the thousands of small cap stocks and buy the entire market through a low cost index fund.

Bernstein's suggestion is to cast a wide net so you don't take a chance on missing those top performing stocks. Sure you get the mediocre ones and the dogs, but don't underestimate how difficult it is to indentify which is which beforehand. By buying the whole market you are assured to get the overall market returns. He reminds us, "Remember that the point of investing isn't to aim for the highest possible returns. It's to make sure you don't die poor." I'm sure there are some who don't agree with that statement, but the rest of us should remember what our real goals are and invest accordingly.



Posted on: 05/12/09

Last week Schwab made their line-up of passively managed stock index funds considerably more competitive by announcing lower management fees and combining share classes. Similar to Fidelity, Schwab offers only a limited selection of index funds, but the two companies can boast of the lowest management fees on these core stock holdings. Of course, lower expense ratios are critical for investors to maximize their share of market returns, but cost is not the only thing to consider. Effective tracking of the relevant index, tax efficiency, and transaction costs (which are largely influenced by where you hold your account) are also important considerations.

Some of you may not be familiar with the alternatives in broad based stock index funds available to the individual investor. Below is a comparison of some of the top choices of index mutual funds and exchange traded funds (ETFs) in three major market categories--U.S. large companies, U.S. small companies, and foreign companies. If you are looking to create a diversified stock portfolio that will enable you to achieve market returns in a simple, low cost fashion, these funds should be on your short list. (The Schwab funds with their new, low expense ratios are highlighted.)

Using passively managed index funds is obviously not the only strategy for investing. Indexing has many advantages, however, and has been enthusiastically adopted by many institutional and individual investors. These advantages will be discussed in future articles. In the meantime, listen to Charles Schwab when he says, "Buy index funds. It might not seem like much action, but it is the smartest thing to do."

 

 

 



Posted on: 05/06/09

Good news for passive investors! Charles Schwab has significantly improved its line-up of passively managed stock index funds by lowering their management fees (net expense ratios) and simplifying their share classes. These are big reductions and come at a time when many fund companies (even Vanguard) have been raising their expense ratios. These moves make the Schwab index funds a very sensible choice for your core stock holdings, if your account is at Schwab and you can buy these funds with no transaction fee.

The table below summarizes the expense ratio reduction on the Schwab funds. The company will also be combining their investor and select share classes into single share class with a minimum investment of only $100. This means investors will not have to have the $50,000 minimum investment previously required for select shares in order to receive the lower expense ratios. Schwab has taken a big step forward in making it easy for smaller investors to benefit from low cost, passive investing.

Schwab Index Fund Fees

In the past I was frustrated with Schwab’s high cost index funds and chose to use ETFs from iShares and Vanguard in my Schwab account instead. That shouldn’t be necessary anymore. In later postings I will compare these Schwab index funds with those from other leading fund companies.



Posted on: 04/27/09

The recent stock market declines are disappointing, to say the least. How long will it take for us to regain what we have lost and to start growing our retirement portfolios again? Of course, no one knows the answer to that question—and beware if they say they do.

You may have heard some discouraging statistics from the bear market that started with the crash of 1929. It is often sited that the U.S. stock market took 25 years to return to its 1929 highs, which only fuels the today’s pervading pessimism. If you are approaching retirement, 25 years seems like a lifetime--and actuarily speaking, it is. If it helps, a closer look at the data says that although it was bad, it was not nearly that bad.

In a recent New York Times article, Mark Hulbert does readers a great service by shedding a bit of light on these dark market statistics. He points out a few things about stock market indexes that obscure what investors really experience. First, the two most popular indices, the Dow Jones Industrial Average (the index cited in the article) and the S&P 500 ignore dividends in calculating the index. Not including dividend understates investor returns significantly. In the 25 years following the 1929 crash, dividends on the S&P 500 averaged between 5% and 6% per year. In fact, during the 1932 market lows they approached 14% for few months. (Although recent dividend rates have been much lower, today the dividend yield on the S&P 500 is over 3%.)

The second major factor to consider is inflation, or in the case of the 1930’s, deflation. Because price levels fell so severely in the early 1930’s, in real purchasing power the stock market decline was not as severe as it looks on the surface. From 1929 to 1936, the prevailing price level dropped over 18%.

The last item to consider is the fact that the Dow or S&P 500, while possibly good representations, are not the entire market. Using broader stock returns data from highly respected Ibbotson Associates, again presents a more positive picture. According to Ibbotson, it took only about 4.5 years for investors to come back from the 1932 market lows and regain the 1929 market peak in real terms (i.e. after inflation and deflation are factored in). In all, it appears it took about 7 years from the 1929 peak for portfolios to return in real terms.

While 7 years, or even 4.5 years, may seem like a long, long time, it sure beats 25 years. And, hopefully your portfolio losses were tempered by a reasonable allocation of safer fixed income assets, so you don’t you don’t have as far to return to peak levels. Whatever your personal situation is, don’t let people depress you even further by citing historical market statistics in a less-than-accurate manner.




Next page: Disclosures


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