Chapter 6 – Building Your Portfolio

Chapter 6

Building Your Portfolio—A Look at Fund Options

While individual stocks may be an option for some investors who have the skill, time, and interest, they are not the best choice for most investors. Here’s why: When you invest by purchasing individual stocks, you are competing head to head with professional stock selectors. Individual stock picking demands a lot more knowledge and attention than most average investors possess.  In other words, beating the average is very difficult. Eric Tyson, author of Mutual Funds for Dummies clearly explains: the notion that most average people and non-investment professionals can, with minimum effort, beat the best, full-time, experienced money managers is, how should I say, ludicrous and absurd.

An investor needs at least 50 stocks spread into different asset classes to be diversified, and no one stock should be more than 4-5% of equity holdings or the investor will add “specific stock risk” to his portfolio. So, for most investors, and especially those who don’t want to spend a lot of time on their portfolio, using mutual funds is the rational answer.

Mutual Fund Basics

A mutual fund is a pool of stocks or bonds purchased by the fund’s manager. An investor can buy the mutual fund and thus own all the stocks or all the bonds in that fund. There are also funds that contain both stocks and bonds. I’ve mentioned that there are around 7000 stocks available for purchase, and there are even more mutual funds! You can find a fund that covers any area of the stock, bond or international markets you wish to invest in.

There are two basic kinds of mutual funds—closed-end funds and open end funds. Open ended funds are far more popular and are the ones you hear about and see advertised. All references in this guide are for open-ended funds.

Mutual funds can buy and sell stocks at the manager’s discretion; therefore, the stock selection can change. If you wish to purchase a fund you would call the fund company or brokerage that has the fund you are interested in and place an order during a market trading day, but actual purchase will not occur until the close of the market that day. The price of a fund is called the net asset value (NAV) and it always reflects the average price per share of all the stocks held in the fund.

Mutual funds can further be classified into load funds, no-load funds, actively managed funds, index funds and exchange traded funds (ETFs). Index funds and index ETFs are also known as passive funds because they are designed to track a particular asset class or segment of the market without any managerial attempt to increase returns or moderate risk.

Mutual Fund Expenses – How they earn money
All mutual funds and ETFs have management fees. These fees are expressed as a percentage of assets removed from the fund before the total return is reported. Other fees, usually advertising expenses or commissions, can be attached as well under what is known as a 12b-1 fee. 12b-1 fees and management fees are combined and expressed as a fund’s expense ratio. Expense ratios can range from a very low 0.1% for some index funds to over 2.0%. On a $10,000 investment, that’s $10 per year compared to $200 per year.

Load Funds
Load is another word for commission. Funds that carry loads are sold by commissioned agents, advisors and brokers. Loads are applied most frequently in three ways: front end (A shares), back end (B shares), ongoing (C shares). There are several other letter designations for other asset classes as well.

A shares of a fund usually have a commission of around 5.75% of the money you invest, and it is taken even before the fund is purchased. If you hand the agent or advisor $10,000, $575.00 will go into the advisor’s pocket and only $9425 will actually be invested. The  commission is sometimes not obvious because the real value of the fund—the net asset value (NAV)—is not reported to you when it appears in your account statement. Instead, you might see a buy price, market price or something similar so it will appear that all the money was invested. Commissioned advisors do not like to show you what you paid, which ought to put you on the alert about their methods. A shares do offer discounts on the commission based on the purchase amount, and the fund company is supposed to tell you when you qualify, but you might have to ask.

Mutual fund B shares designate a back-end load. This is a commission taken when you sell the fund. Back end loads usually get reduced each year you own the fund. An example would be a 5% charge the first year, 4% the second, 3% the third and so on. But it may take 6 years or more to get out from under a redemption commission. And all the while you will pay a higher expense ratio for B shares than A shares because there is normally a 12b-1 fee (commission) attached. Most B share funds convert to A shares once the redemption fee is phased out.

C shares have the commissions built into the expense ratio and they show up in a 12b-1 fee, which is part of the overall expense ratio. These are called level loads, and they are applied as long as you own the fund. This commission can raise the total expense ratio to over 2%. Additional information on share classes can be found here.
http://www.saveandinvest.org/Military/manageMoney/investorAlerts/P005975

In recent years more classes using different letter designations have been developed which further complicate the costs of funds. These loads have nothing to do with operating the fundthe money goes strictly to sales profit. The idea behind these commissions is that they are supposed to get you investment advice. But, advisors who make money this way often recommend investment choices that make them the most money. There is a lot of conflict of interest here that can bias an advisor’s recommendations.

No-Load Funds
No load funds are just that—they have no commissions at all. You buy them direct from the mutual fund company, a discount brokerage or through a fee-only advisor.

Index Funds
An index is a group of stocks chosen to represent the whole market or certain parts of the market. The performance of an index represents the average returns of the market segment being followed. The Morgan Stanley Capital International (MSCI) broad market index is one of several indexes that track the total U.S. stock market. You cannot buy the actual indexes, but you can buy mutual funds that track them.

There are index funds for all nine of the asset classes shown previously plus some others as well. The most famous index fund is the Standard and Poors 500 (S&P 500). The S&P 500 is used as the standard for the total market because it tracks the whole market very closely and it was created before there was a total market index fund.

The hallmarks of true index funds are they are capitalization-weighted and track their asset class closely. Most, but not all, are very low cost because they don’t have an active manager, they don’t need to spend money on stock research, and they have very low turnover. Many are also very tax efficient.

Exchange Traded FundsIndex
ETFs are put together and sold as a single unit like a stock, which means you can buy or sell them at any time during a trading day. But like a stock, you have to purchase through a broker and you may pay a commission for the trade and there will be a bid/ask spread meaning you may pay slightly more or less than the actual NAV to buy the shares. Buy/sell commissions can run from zero dollars at a discount broker to over $100 at a full-service broker.

When ETFs first arrived on the scene, they were all copies of true index funds. But now there are many more that index something other than a pure cap-weighted asset class and there are also actively manager ETFs. Like index funds, most ETFs have very low expenses. Avoid those that don’t. ETFs can be a good choice if you refrain from frequent buying and selling.

Actively Managed Funds
As the name implies, these types of funds hire a manger to put together and maintain a fund. The objectives of active funds as a group are far more varied than index funds which just have the job of tracking an index. In general terms, fund managers are trying to beat their benchmark index, although some actually try to limit downside risk as well. The ways in which mangers try to achieve their goals is where the creative variations come in. More on actively managed funds – http://en.wikipedia.org/wiki/Active_management

Choosing Passive or Active Funds
The debate over which is better is a never-ending one. The benefits of indexing are not obvious nor intuitive, and that is one reason they are only chosen by about 1 in 6 individual investors. But they are chosen by three out of four institutional fund managers.

Individual investors choose active funds for a variety of reasons. For many investors it’s simply because that’s what they learn about. You can’t turn on the TV or read a magazine without hearing about top performing funds. So active fund investors believe by selecting the right funds they can beat the index returns. Furthermore, they falsely learn it is easy to do. Index funds do not crowd the top of the hot fund lists, but they definitely do produce higher than average returns over longer periods of time. This is a well documented fact not even disputed by knowledgeable investors who choose active funds. There are two simple reasons for index outperformance: 1) Index funds have lower costs, and over time this advantage becomes very significant. 2) Index funds are not subject to several problems that active funds can encounter which reduce returns.

Costs and average returns
Index fund long term performance happens in a slow, methodical way. There are no stellar annual returns to make headlines. They simply produce consistent average returns minus low costs, and they never run into bad streaks, whereas active funds subject to the same performance average must first outperform well enough to overcome their higher costs. Then they must continue to outperform to show superior results. But the long term record clearly show they that they cannot do it consistently.

The following data shows the percent of funds beaten by their index for all nine market segments over a ten year period ending June, 2010. Over longer periods the numbers are even higher. After 20 years, outperformance is in the 80-90% range.
LV=41%
LB=65%
LG=78%
MV=73%
MB=80%
MG=77%
SV=47%
SB=63%
SG=78%

As you look at these numbers, you will observe that large value (LV) and small value (SV) have not outperformed their benchmark over the past 10 years. Do not therefore jump to the assumption that these two asset classes are better choices for active management. Five years from now, this list will not look the same.

Numbers for other time periods can be found by looking at Standard and Poors SPIVA Report online. SPIVA = Standard and Poors Index vs Active.

This following link provides a list of index fund advantages and a series of quotes from professionals compiled by author and investor advocate, Taylor Larimore. http://www.bogleheads.org/forum/viewtopic.php?t=881

Studies on active fund performance
There are dozens of studies showing index funds outperform actively managed funds over long periods of time. Most of them conclude that active fund managers show no persistent skill, and any noticeable outperformance is due to luck. But that may not be correct. It may be more accurate to say all top fund managers have excellent skills and are therefore indistinguishable from each other. They are all top of their class and the best available. They make a lot of money because they are talented. The skill level is high, but the competition is extremely tough and it tends to cancel out any outstanding manager. The end result is the same: individual fund managers don’t appear to demonstrate outstanding skill beyond their peers before costs.

The only place you do find persistence is in the two bottom quintiles where the less talented managers, or those saddled with restrictive company requirements, remain. All others in the upper quintiles fight for high rankings. Changes in position can be due to something as simple as changing market conditions or problems the fund managers must deal with that they themselves did not create. So, yes, noticeable winning streaks from the ranks of equally talented managers must involve a little luck that is independent of their skill. The distinction between luck and skill might not be all that apparent in fund managers, but the influence of luck can be easily seen in many other competitive examples.

The problem for individual investors trying to choose the best managers is a winning manager is not noticed until the streak is already started, and no one can tell how long it will last. All to often, it ends soon after the outperformance is discovered by investors. Secondly, there is no way to tell which manager will begin a winning streak in advance. So, performance records are not very useful in selecting the best manager or fund.

A Study Supporting Active Management
One recent study on active funds titled ‘How Active Is Your Fund Manager’ does conclude that a specific style of investing shows some persistence. The study also concludes that concentrated funds, market timing funds, and closet index funds do not beat indexing. The study’s conclusion also suggests that it is not the manager’s talent that shines, but rather it’s the method used. In fairness, it’s probably likely that most managers would not even attempt the superior strategy because it’s very demanding.

Beating the Market
One critical mistake uneducated investors make is to believe they can easily select managers that beat the market. Successful investors, however, understand that trying to beat the market long-term has unfavorable odds—it’s a a real uphill battle.

The purpose of investing is to achieve financial goals with an efficient, systematic plan. It is always a balancing of risk against reward—not a contest to see who can get the highest returns. This is not surprising news to the small percentage of investors who do use active funds successfully. Those who are successful have four things in common;
1) they are very knowledge,
2) they are very disciplined and avoid behavioral mistakes, especially overconfidence,
3) they keep the overall costs of investing as low as they can.
4) they don’t chase performance

The Reality of Investor Returns
Investors do not actually capture the returns funds produce because of:
1) behavioral mistakes,
2) costs, including taxes
3) fund performance variation that forces investors to make decisions on whether to sell or hold.

The losses are significant, ranging from 10% to over 50%. So, the smart play becomes eliminating things that can reduce returns. To put it simplified terms, don’t shoot yourself in the foot. Maximum long-term gains are the result of capturing the highest percentage of market returns. Increase the odds of long term success by minimizing behavioral mistakes such as overconfidence. Eliminate unnecessary costs, and minimize the possibility of potential problems beyond your control.

Active Funds Additional Risk
As mentioned, managed funds start off with the handicap of higher costs and an array of potential problems that can suddenly sink a fund. Investors need to understand that this handicap equates to higher risk of success because it’s not possible to identify those funds which will encounter problems or begin win streaks next year.

If an investor holds 10 active mutual funds, the odds are high that two per year will experience sub-performance. Investors can’t tell if the sub-performance is transitional or permanent so they must wait and watch. Managing a portfolio of all actively managed funds requires more time evaluating performance and searching for replacement funds. Because some will fail, they are not good choices for taxable accounts where tax consequences will add to the problem.

Potential Problems
Asset bloat – Nothing kills success like success. Popular funds draw a lot of new money. And ironically, too much success is one of the biggest causes of eventual failure. As the fund’s assets grow it becomes harder and harder for the manager to find good stocks to buy. A fund company with true fiduciary responsibility to its investors will close the fund, but most will just keep taking in the money until performance sinks to the bottom of the list.
Manager changes – Managers who have put up good numbers and received lots of media attention tend to move on to other, more lucrative positions. It’s worth noting, though, that some very good active funds have multi-managers, which suggests that the company’s underlying philosophy is more important than the manager.
Fund Purchase– it’s not uncommon for successful smaller fund companies to be bought-up by big firms with mediocre records and high fees. The funds with the good records are heavily advertised, but once the higher fees and new company management interference is in place the outstanding funds from the smaller company lose their luster.
Style drift – A managed fund that you purchased to cover the small value asset class can change to small blend, mid value or something else. When this happens, your target allocation gets shifted.
Objective changes – Managed funds can decide to change what they are investing in or how they invest, which dismisses the carefully chosen reasons you bought the fund in the first place.
Internal Pressures – There is great pressure put on fund managers to not underperform their benchmark. The result in some cases is to see a manager just try to mirror their index benchmark rather than chance underperformance. The result is a higher cost index fund, which has no chance of even matching the index after costs.

Choosing Good Funds.
I’ve explained why using active funds offers more challenges, and for some with the knowledge and time it might be a decent option. In other cases holding at least some actively managed funds is mandatory. Tax-deferred plans like 401ks, 403bs and 457s may not offer index funds or even top rated managed funds. Participants in these plans must work with what is available.

Fund Selection Process
1. The most important thing to look for when choosing an actively managed fund—and the hardest to recognize—is a fund’s commitment to shareholder fiduciary responsibility. Investors need to evaluate the company’s philosophy and how they interact with shareholders.
2. Select funds with lower expense ratios and never buy load funds. Many company plans that  carry load funds waive the loads. High expense ratios and 12b-1 fees are a drain on higher returns. The best funds also seem to hold advertising costs to a minimum.
3. Look for funds that have low turnover. Hidden transaction costs and capital gains taxes add to fund costs. Also, the best funds seem to be those that buy carefully and then hold their chosen stocks.
4. Look at five and 10 years past performance records. There is no way you can make a judgment based solely on past performance, but the farther back you can trace performance the better. Be very leery of funds with spectacular gains. Look for consistency and discipline.
5. Pay special attention to how much money the fund is managing (asset size). When a good fund is recognized by the crowd, it can receive a lot of new money that can cause problems. The best funds will close rather than continue to accept money that will harm the investors. This is a sign of fiduciary responsibility.
6. Pay particular attention to balanced funds. They seem to be the most consistently reliable over time, perhaps because they aren’t competing against, and not trying to beat, some stock fund benchmark. Unfortunately, these types of funds are not very good choices for taxable accounts.

Additional considerations – http://www.mymoneyblog.com/archives/2007/09/flip-side-finding-the-best-active-mutual-fundmanagers, html

Moderating Downside Risk
One other reason an investor might consider actively managed funds is to reduce downside risk. Some actively managed large value funds and equity income funds have lower downside risk as defined by standard deviation and beta. Note that while past performance of returns is not an indicator of future performance, historical risk characteristics are somewhat useful in getting some sense of what to expect from a mutual fund as long as the objective has not changed.

It may be a good idea to offset your large blend fund or large growth fund with a large value fund or an equity index fund having a lower risk profile if you wish to moderate risk. This is common practice for investors in or near retirement. These types of funds usually throw off dividends too. And since the total market and the S&P 500 are naturally weighted toward growth, a large value fund is a good compliment.

Three measures of risk to look at are a fund’s volatility (standard deviation), its bear market ranking, and it’s beta number. Beta is a number that indicates a fund’s swings in returns relative to movements of an index. For stock funds, the index used is usually the S&P 500, which as a beta of 1.00. A fund with a beta of 0.85 means the fund might go up or down only 85% as much as the index. In up markets it will underperform by about 15%, but in down markets it will lose roughly 15% less than the index. Part of the reason for some of the lower risk is probably due to these funds holding some cash. Index funds do not hold cash. And be aware that there is no guarantee that the calculated performance will match the actual performance. While this type of diversification and risk management works under most market conditions, be aware that in a panic sell off, all funds may go down together.

Building Your Portfolio – An Example
“The greatest enemy of a good plan is the dream of a perfect plan.”
A favorite quote of John Bogle originally attributed to Prussian general Karl von Clausewitz. There is no perfect investment plan. No one fund, no one allocation, or one strategy will be correct for every investor in all market conditions. This goes for professional fund managers who select stocks and bonds and it goes for the average investor who selects funds. And as you will discover, the investment options available to you will not always be exactly what you want.

When first starting out, things are usually quite simple. Your first investment venture might be an IRA or Roth IRA. Using these types of accounts allows you invest in almost any fund you want, but you will not have enough accumulated money to add to every asset class. One of the best ways to begin then is to use an asset allocation fund. These can be simple balanced funds or they can be fund-of-funds such as life cycle funds, or target retirement funds. These types of funds create an instant diversified portfolio for you. Be careful where you buy these funds though. Some companies (not Vanguard) tack on a management fee on top of the expense ratios of the underlying funds, which makes them too expensive.

Balanced funds and asset allocation funds hold both stocks and bonds and you can find them in different allocations to match your needs. These are the simplest worry-free funds you can get. You can buy them and forget them because even the rebalancing is done automatically within the fund. You can get fund-of-funds and balanced funds in both managed and index varieties.

At work you hopefully will have access to 401k, 403b, Thrift Savings Plan (TSP) or other retirement accounts. These can be great investment vehicles because of their tax deferral, but it’s the rare plan that doesn’t come with some compromises or problems, including high costs and limited choices.

If you have a 401k or other tax-deferred account, the best approach to building a good portfolio is to begin by choosing the best funds available in the company plan, then use other accounts to complete the portfolio.

To keep track, break things down like this example:
Overall Asset Allocation = 60% stock, 40% bonds and cash (define your own chosen allocation here)

Equities (equaling 60%)
401k
large value fund – 18%
international fund – 15%
Roth IRA
large blend – 9%
sm cap fund – 6%
REIT – 6%
Taxable
Total stock market – 6% (tax efficient)

Bonds (equaling 40%)
401k
intermediate bond – 28%
Roth IRA
TIPs- 12%
Total = 100%

It’s not unusual to only find one low cost index fund such as the S&P 500 and one low cost bond fund in your company plan, and if that is the case, then that is what you should use. Tax deferred investing is a big advantage, so use what you can. Invest in the company plan up to the match. Then be sure to max your IRAs or Roths, and then add any extra saving to the company plan. If the company plan is a good one, max out contributions if possible.

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