Friday, February 21, 2014

Without the Glitter.

Gold as an investment

Gold is a speculative commodity.  It hedges very little.  It has not been a good long-term investment.  Mining gold can be a profitable business, however it is extremely cyclical.  Gold miners have learned to adapt to the speculation in their output.  Consequently, there are times when the stocks of the gold miners are attractive investments. 

Current supply and demand conditions in the gold market, as well as the response of the mining companies to recent market conditions, suggest that now may be an appropriate time to investigate the stocks of gold miners.  This posting discusses the issue and summarizes the Hedged Economist’s response.  However, the more important take away is that now is a good time for any investor to review his or her exposure to precious metals.

In previous postings on The Hedged Economist, both gold and gold mining stocks have been mentioned.  The April 5, 2010 posting on gold entitled “Gold: Be sure you know what you’ve hedged,” focused on debunking many myths that surround gold.  In many peoples’ minds it has taken on almost magical investment qualities.  As the posting pointed out, those magical qualities do not and never have existed. 

The May 16, 2010 posting entitled “Gold again” pointed out: “In the long run it isn't a very good investment, but as a short-run speculation, it has its moments.”  The August 20, 2010 posting, entitled “Worthrepeating and, yes, gold again,” compared the return on gold to other investments.  The comparison was made for a number of different time periods.  It showed that it is very hard, if not impossible, to find any periods where gold was other than a short-term speculation.

Gold miners are businesses.  Any investment related to gold has to be done with considerable caution.  However, gold and gold miners are two different investments.  Gold miners are businesses and regardless of the speculative component that influences the demand for their product, they produce a product that is subject to supply and demand.  They have costs.  They have financials.  They have stock prices.

The posting on May 5, 2011 entitled “Up, up and away in my beautiful balloon, or is it abubble?” discussed both gold and gold miners. The business of any miner can be evaluated using fundamental analysis just like any other business.  However, given the speculative component in the demand for their product and the lackluster performance of sector, is there any justification right now for putting in the effort to analyze individual mining stocks?

The answer is yes there are reasons to investigate the sector.  The first, and always the most important consideration, is how gold miners’ stocks fit into the investor’s portfolio.  The mining sector should be represented in a portfolio.  However, extractive industries are highly cyclical, and precious metals constitute very small portion of the sector.

As was mentioned in the posting cited above, The Hedged Economist can see no justification for holding much exposure to precious metals.  An average exposure of a couple of percent seems reasonable, but contrary to many prescriptions usually advanced when the price of gold has rising, there is no justification for a constant exposure of more than that.

If one holds a couple of percent exposure, the poor performance of gold miners, both in absolute and relative terms, will have reduced that exposure below the desired threshold.  The Hedged Economist has maintained a portfolio weight between less than 1% and up to 5% with the average being closer to 1% than five. 

There is no effort to maintain a stable exposure.  Rather, the exposure fluctuates within that range based upon the cyclical performance of the metal and the miners.  Often when the prices of the metal or the mining stocks advance, that exposure is reduced in order to take advantage of the price increase. 

The other side of the portfolio management, and the current situation, is that when the exposure falls because of a fall of the price of the metal or the price of the miners stocks, additional purchases are considered.  When prices are down, that is the time to consider additional purchases.  Thus, the portfolio suggests that it is a good time to consider investing in the sector.

Another reason involves the demand for gold.  Of course one has to guess, but it appears that a good deal of the speculative demand for the metal has abated.    It is only a guess, but there number reasons for making that guess.

First, the amount of gold being held to back the gold ETFs has decreased as their price decreased.  Gold held to back ETFs is definitely gold held on speculation.

Second, that guess or interpretation is consistent with warehouse inventories at theComex.  Thus, it appears that less gold is being held to meet the demand of speculators that trade on the Comex. 

Third, warehousing of metals is less appealing to banks in the current regulatory environment.  Banks are themselves speculators, and they hold inventory to facilitate the trading of other speculators. 

Fourth, that interpretation is consistent with the performance of gold versus certain gold mining stocks.  The Hedged Economist has held a small position (less than one percent of the portfolio) in Newmont Mining (NEM) for many years and has come to believe that certain divergences between the price-performance of gold and Newmont’s stock provides some information about the amount of speculation embodied in the price of gold. 

The bottom line is that there are reasons to believe that further downward pressure on prices from speculators reducing positions has stopped. 

By contrast, the physical demand for the metal has held up or increased.  Some of the demand is being repressed.  For example, import restrictions in India (one of the major consumers of gold jewelry) have kept the price of gold high in India.  There are estimates that the price of gold in India has been as much as $100 above the world market.  That sort of government intervention indicates that prices could increase in India without reducing the physical demand.  Elsewhere the demand for gold coins and jewelry has held up or increased as prices fell.

It is always good to remember that there is a huge physical inventory of gold in central bank vaults and warehouses.  Whether central banks add to those inventories is a wildcard in any demand projection.  It is also important as it relates to the third reason that now is an opportune time to investigate gold miners’ stocks. 

The third reason for believing that now is an opportune time to consider the stocks of gold miners concerns the supply of gold.  If central banks began to divest themselves of their gold, they could easily flood the market with far more gold than the miners produce.  There is no reason or announced plans for major gold-holdings central banks to sell their gold.

Another positive development regarding the supply is that gold miners have become more disciplined in their response to gold prices.  Developing a mine has very long lead times.  Consequently, often mines that were started during periods of high prices would come online when prices were depressed.  The consequent oversupply would further depress prices.  However, during the recent price decline gold miners have delayed or halted development projects in response to the price decline.

Part of that new discipline regarding supply reflects better management.  But part of it reflects the demands of the financial markets.  Some mines had to be delayed or halted in order to avoid further declines in specific company stocks.  That decline could reflect a market reaction by owners of the stock or by the company’s financial need to dilute their shares in order to secure adequate financing to pursue their expansion.  The result is that it does not look like gold miners will flood the market for the metal.

The same market reaction that has restrained the development of new mines has forced management to more carefully manage their balance sheets.  Consequently, one would expect some gold miners to be in good financial shape to expand production, take market share, and avoid pressure on their margins.

One can also apply technical analysis to the price of gold miners’ stocks.  In fact, BARON’S on February 12, 2014, posted just such a technical analysis in their Getting Technical feature.  The article was reprinted in the weekend edition as “More Support for Gold: Charts Take Bullish Turn.”

Aficionados of technical analysis may want to check out that article.  The Hedged Economist purchased shares in a gold miner (Gold Corp.  – – GG) on February 3 before the article was published.  The fundamentals and portfolio considerations rather than technical analysis were the driving influence.  However, given the advance in gold and gold miners’ stocks since February 3, some readers may find the technical analysis reassuring.  The Hedged Economist, not being an aficionado of technical analysis, is more reassured by the relative performance of miners versus the metal, and both miners and the metal relative to the overall stock and credit markets.

The confirmation that the markets have provided is extremely important.  Keep in mind, any decision related to gold is subject to revision at any time.  That is especially true of a decision that increased the portfolio weighting for gold mining stocks to 2%.  Two percent is above The Hedged Economist's normal portfolio weighting.  Nevertheless, for now, some gold miners look like reasonable investments.

Monday, February 17, 2014

Funds for Asset Class Diversification

Supplementing an equity portfolio with mutual funds

One of the appropriate uses of mutual funds is to gain exposure to asset classes where the investor does not feel comfortable making decisions on individual holdings.  In some cases, the investor may simply be choosing to focus his or her attention on other asset classes.  In other cases, it may be very difficult, to the point of almost being impossible, for the investor to acquire individual assets in the class.  In other cases, there may be tax advantages to holding the assets indirectly through a mutual fund rather than directly. Rather than trying to distinguish between the potential reasons for using mutual funds, this posting starts from an assumption about what category of assets holds directly.

Areas where supplements may be needed.        
Specifically, this posting looks at mutual funds as a supplement to a portfolio of bonds and large-cap equities.  The actual mutual funds discussed in this posting are designed to provide asset class exposure outside of those two categories.   

Part 1 of the previous posting (“A Core of MutualFunds: Part 1”) discussed the logic and limitations of diversification across asset classes.  Therefore, this post is will proceed on the assumption that the pros and cons of diversification do not need to be addressed.

There are three areas where mutual funds seem like a convenient way to supplement the portfolio of stocks and bonds.  (1) Since they are supplementing a large-cap US equity portfolio, small and mid-cap stocks are a logical focus.  (2) Further, since the portfolio is US equities, international exposure seems appropriate.  (3)  Finally, international exposure to developed economies can be achieved in ways different from that of emerging markets.  Therefore, emerging markets can, and should, be addressed separately from developed markets.

Cost considerations

As with any mutual fund investment, costs are an important consideration.  Mutual funds specializing in these three asset classes tend to have higher costs:  Markets may not be as liquid which can lead to higher trading costs.  Different markets may be governed by different regulations and trading conventions which have to be researched.  Further, the information on individual companies may have to be verified.  At the extreme, this requires significant travel, especially for managed funds that focus on fundamental analysis involving meeting the management of the company.  Consequently, research costs are often higher for these fund categories.  Those higher costs are reflected in higher fees. 

There are some fees that can be ignored given the role assigned to these mutual funds as a part of a total portfolio.  Often funds in all three areas have charges associated with short-term holding periods.  There are such fees on all three of the funds used as illustrations in this posting.  However, as discussed here, one would anticipate holding the supplemental funds for the long-term, as long as one is holding the large-cap US equity portfolio.  Thus, the cost imposed on short-term trades of the mutual funds can be ignored.  The supplemental funds are not being purchased as short-term trades.

Fund selection

One has to decide between index funds versus managed funds.  As discussed in a previous posting (A Core of Mutual Funds: Part 2), index funds outperform the average managed funds after costs.  That places a particularly heavy burden on managed funds in the relevant categories because of their tendency to have particularly high costs. 

Further, the objective of the supplemental funds is to expose one to the relevant markets.  Consequently, a managed fund that specifies an objective different from the performance of the overall market is inappropriate.  In the case of the supplemental funds in these three categories, the performance of the market is the objective.

For an index fund to truly represent a market requires that the market be fairly liquid under normal conditions, and it requires a market that has enough listings so that the index is not totally dominated by a single company.  In other words, a market that can be represented by an index has to exist.  Those two requirements are clearly met by the US small and mid-cap market and by the market for stocks of companies from developed economies. 

Using index funds totally eliminates the disadvantage of higher costs discussed above.  Index funds that focus on small and mid-cap companies have fees that are comparable to index funds for large-cap US stocks.  The same is true of index funds focusing on the developed economies other than the US.  Thus, index funds are an appropriate way to address those two asset classes.

Similar arguments are not robust when applied to the stocks of companies operating in emerging economies.  The stock markets in emerging economies can be highly illiquid under normal conditions, and what liquidity there is can be very fragile.  Also, because the stock markets are operating in smaller economies with fewer listed firms, they can be dominated by a single company.  It is not at all unusual for the market of an emerging economy to be dominated by a single industry.  Consequently, the rationale for using index funds does not fit emerging markets.  Thus, a managed fund is used as a representative fund addressing emerging markets.

Portfolio components

The previous postings on a core portfolio used funds from Vanguard.  So, just for balance, this posting on supplemental mutual funds uses examples of funds available through Fidelity.  The selection of one fund family or the other is just a matter of convenience, and clearly, funds from other fund families could be used.  What is important is the description of the funds’ objectives and approach.  However, all the funds used as illustrations meet the requirement that they manage costs effectively.

Spartan Extended Market Index -- The first fund included in the portfolio is the Spartan Extended Market Index. It seeks to provide investment results that correspond to the total return of stocks of mid- to small-capitalization United States companies.  It normally invests in common stocks included in the Dow Jones U.S. Completion Total Stock Market Index.  That index represents the performance of stocks of mid- to small-capitalization U.S. companies. It excludes companies in the S&P 500® Index.

Spartan International Index Investor Class -- It seeks to provide investment results that correspond to the total return of foreign stock markets in developed economies. Normally it invests in common stocks included in the Morgan Stanley Capital International Europe, Australasia, Far East Index.  Spartan International Index Fund seeks to provide monthly results, before expenses, that match the returns and characteristics of the MSCI® EAFE® Index as closely as possible. It includes large- and mid-cap companies in 21 developed countries, excluding the U.S. and Canada.

Lazard Emerging Market Equity Blend Portfolio -- This fund is offered through Fidelity, but is not managed by Fidelity.  It is a managed emerging markets fund. The investment seeks long-term capital appreciation. The fund invests primarily in equity securities, including common stocks, ADRs and GDRs, of non-US companies.  Under normal circumstances, it invests in equity securities of companies whose principal business activities are located in emerging market countries. The fund may invest in companies of any size or market capitalization.

Portfolio management

Portfolio management is always a matter of taste.  For some reason, people find that easier to accept when it involves what stocks to own in what proportion.  When it comes to asset diversification across the capitalization sizes and international boundaries, they somehow lose sight of that fact.  Consequently, a substantial portion of this section is devoted to debunking many of the myths concerning allocating investments across these asset classes.  Many of the myths and recommendations are totally irrelevant and, in some cases, highly destructive.

The most silly and destructive allocation is based upon the capital market sizes.  The logic goes that the US market constitutes X percent of all market capitalization and therefore the investor should be investing no more than X percent in the US market.  People advance this argument without realizing how silly the underlying assumptions are.  It is surprising that people who make this argument are taken seriously.  To illustrate how destructive and silly the approach is, two shortcomings of the approach are highlighted below.

First, a global capital market is a nice theoretical construct. Unfortunately, the world does not work that way.  There are barriers between capital markets.  What is even more important is that the theoretical construct is totally irrelevant to individual investors.  It assumes that the investor is that proverbial “man with no country.”  Every investor, even an investment corporation, has a tax residence.  For the individual investor, the residence is much more than just where they are taxed.  Global capital markets and the global economy are not what the individual experiences.  The individual lives in his or her own personal economy.  Their investment decisions should be a response to that personal economy.  They invest to address their own personal need.

Data about “home country bias” (the tendency of investors to hold assets in their native currency and local economy) are interesting and informative.  However, the very name, home country bias, implies a misinterpretation of the phenomena.  It is not a bias in any sense.  It is a rational response of investors to their own personal financial needs.  Research that attributes it to naive nationalism or ignorance about foreign economies, displays its own arrogance and ignorance.

Second, allocating one's capital based upon market capitalization would be highly destructive.  The basic reason for allocating capital to different asset classes is that their values move somewhat independently.  When prices go up in a market, the capitalization of that market will increase.  Using capitalization as a guide one would be increasing one's investment in that market as prices increase.  Similarly, when prices go down in the market, the capitalization of that market will decrease.  Using capitalization as a guide the investor would sell holdings in a depressed market.  Buying when markets are up and selling when they are down is not a very constructive process.

The bottom line is that investors should ignore anyone who recommends allocating investments based upon the capitalization of different markets.  It is irrelevant and destructive.

Another supposed guideline for allocation is economic growth.  This rationale is often heard in connection with emerging market investments.  The argument goes that emerging market economies are growing faster.  Therefore, stocks in those markets will appreciate more than that of stocks of companies in developed economies.  While not as destructive as capitalization, it is largely irrelevant.  The ECONOMIST published a very interesting article on the issue in the February 15, 2014 edition.  The Buttonwood feature had an article entitled “The Growth Paradox.”  The conclusion is fairly well summarized by the subtitle: “Past economic growth does not predict future stock market returns.”

The article points out the weakness of any correlation between previous economic growth and stock market performance.  It looks at the issue from a number of different perspectives.  It also provides some interesting insights into why that is the case.  Ultimately, the reader is left with the inevitable conclusion that forecasting emerging market countries’ stock markets is just like forecasting any other stock market.  The fact that there emerging market countries is largely irrelevant.

A surprisingly large amount of chatter about allocation across these segments circulates in the financial media and research publications in financial economics.  Much of it is based on a firmer footing than those who naively use capitalization or previous economic growth rates.

While capitalization is irrelevant, how stock markets fluctuate (i.e., their variance and the timing and their fluctuations) is relevant.However, if one looks at the data used to support allocation schemes based upon variations in the performance of different markets, it only adds to the confusion.  The conclusions are highly dependent upon the periodicity of the data used for the analysis and the historical period covered.  They are also sensitive to the assumptions made about trading frequency.  Finally, some research explicitly makes reference to trading costs and currency risk while others completely ignore them. 

Also, the conclusions are sensitive to how the analysis treats trends in the error terms.  That is especially true of the international asset allocation.  There is a theoretical argument that the benefit of international allocation is dependent upon the degree to which the global economy is integrated.  An interesting aspect of that issue is the periodic debates about "decoupling" (e.g., whether emerging market countries have economic and stock market cycles independent of the developed economies). 

What is interesting about those debates is that they are questioning the basic assumption behind the rationale for international asset allocation.  They are questioning whether the assumption of stable asset correlations is valid.  Without explicitly stating it, one side in such debates is implicitly stating that the entire basis for Modern Portfolio Theory no longer applies.

One does not need to take a side in the theoretical arguments or become immersed in the empirical research.  The very existence of such issues makes it apparent that there is no single scheme that is optimal for the long-term investor.  Compound that with the existence of different investment objectives among investors, and it becomes apparent that the allocation is largely a matter of taste.

As if that were not enough, the assumption that identifies these three asset classes as candidates for mutual fund investment is that the investor is comfortable picking individual holdings in other asset classes.  The assumption that investments in direct holdings are restricted to large-cap equities and bonds need not be absolute.  A large-cap investor may select global firms located in another country.  Similarly, once one begins analyzing equities, holdings other than large-cap may become appealing.  An individual’s international holding or stock of a smaller company would influence how much of each mutual fund is appropriate.

As a consequence, one can make a reasonable argument for viewing investments in each of these three supplemental mutual funds as comparable to any other holding.  Usually an investor restricts individual holdings to a much smaller portion of the total portfolio than is frequently advocated for investments in these asset categories. 

Restricting the investment in any individual supplemental mutual fund to a level comparable with other individual holdings has been The Hedged Economist’s approach.  Each of these mutual funds hedges certain risks.  They are useful, but they are not the only way to address those risks.  Other assets can address some of the same risks while yielding a higher return.  Mutual funds are often viewed as a convenient way to get diversification.  Consequently, it may seem counter intuitive, but there are times when one wants to diversify away from the holdings in mutual funds.  Alternative ways to accomplish the same objective are worth searching out when the holding in any particular mutual fund becomes uncomfortably large.

Friday, February 14, 2014

A Core of Mutual Funds: Part 2.

But what three?

Portfolio design

The first decision one has to make concerning the equity portion of the portfolio is whether to put it in an index fund or a managed fund.  The relative merits of managed funds versus index funds have been debated at length.  Most people are aware that the majority of managed funds underperformed their benchmark, which is usually an index.  In other words, the majority of index funds outperform the average managed funds.  That is usually true before expenses and even more frequently true after expenses.  

The simplicity of the theoretical argument has a certain appeal.  Since the index represents the average performance of the market, it represents the result of all investors.  Within that context, to a large extent, mutual funds are betting against each other.  Therefore, it is impossible for one fund to beat the average unless another underperformed the average.  When each fund then reduces performance by expenses, the average of all managed funds has to be below the average for the total market.  There is also a powerful argument that fund managers’ need to perform every quarter causes them to incur additional expenses that will reduce their total return to a figure below the annual average for the market.

Yet, one often hears that whether a managed fund can outperform index funds is related to whether market movements are the same across most stocks.  The theory goes that if different stocks are moving in different directions or at distinctly different rates, the market should provide the manager with an opportunity to pick the stocks that will perform better.  On January 24, 2014, the WALL STREET JOURNAL ran an article entitled “The Myth of a Stock-Picker's Market.”  The subtitle pretty much summarizes its conclusion:  “Active fund managers say that they'll succeed this year because stocks aren't moving in lock step. Here's why they're wrong.”

The article does an excellent job of reviewing the math and the data relevant to the issue.  It is a particularly interesting article because it compares the performance of index versus managed funds in different environments.  It looks at environments where there is a lot of volatility versus low volatility environments.  But most importantly, it compares the relative performance when all stocks are performing similarly, versus when there is a wide dispersion in the performance of individual stocks.  Its conclusion is: “For investors, the takeaway should be that no matter the environment, active managers are no more or less prone to fail or succeed.”

One index fund is included in the three fund portfolio.  It is the VanguardTotal Stock Market Index Fund.  An S&P 500 Index Mutual Fund would be an alternative.  The advantage of either one is their low cost.  The Total Stock Market Index Fund was selected because it includes small and midsize companies, as well as the largest 500 that are included in the S&P 500. 

The difference between a total stock market index fund and an S&P 500 index fund is minor.  Most (about three quarters) of the capital in a total market index will be invested in the largest 500 companies.  Nevertheless, the Total Stock Market Index Fund provides some diversification across the capitalization levels.  When capitalization levels are viewed as defining different asset categories, small and mid-cap companies tend to outperform over a long run but with greater volatility.  So, although the diversification is not extensive, it does help to define a well-balanced portfolio.

The math and the data make it pretty clear that a portion of the mutual fund portfolio should be in an index fund in order to ensure that it at least performs as well as the market.  After all, exposure to the equity market is exactly what the investor is seeking. 

Many advisers and the WALL STREET JOURNAL article cited above reach an erroneous conclusion about index funds.  It is foolish to recommend that all investment should be in an index fund.  The WALL STREET JOURNAL articles concluding statement: “Passive funds will outperform after costs,” illustrate the error.  It uses the word outperform as if it were defined.  But, there can be significant differences in how various investors define performance.  Those who only recommend an index fund are making the ridiculous assumption that everyone's sole objective, and thus their definition of performance, is to replicate the performance of the total market.  The total market performance is an important benchmark, but there is a big difference between a benchmark and an objective.  It is only for the mutual fund manager that the benchmark becomes the objective.

At this point it is impossible to avoid introducing some considerations that at first appear subjective.  It comes in the form of an assumption about objectives.  To some extent, it is a reflection of observations about the performance of investors, and it is consistent with the findings of behavioral economics.  It is also supported by empirical research about investment performance.  Consequently, despite the initial appearance of subjectivity, it is far from totally subjective.  It can be summarized by the statement: “Gains made during a bull market are only useful if they are not lost during the next bear market.”

Thus, the second fund to be included in the portfolio has a low beta and low volatility.    (Technically, low beta means it does not fluctuate with the market, while low volatility refers to the actual amount of fluctuation).  One way to consider the decision for the second mutual fund is in terms of the value stocks versus growth stocks distinction.  (The value stocks versus growth stocks distinction works because value stocks tend to have lower betas and volatility).  Each type of stock has periods (often multi-year periods) where it outperforms the alternative.  However, across those cycles, portfolios of value stocks slightly outperform the alternative.  Further, there is considerable evidence that it is possible to select a low beta portfolio of value stocks that can nevertheless perform exceedingly well. 

The fund to be included in the portfolio is the Vanguard Windsor II Fund.  An obvious alternative would be the Windsor Fund.  (The Windsor Fund was closed for a while, and that is the only reason for citing Windsor II rather than the Windsor Fund).  The important characteristics that make the Windsor funds appropriate are that they are managed to produce a lower beta, and they seek to achieve that objective by focusing on large-cap value stocks.  They also include some non-US exposure.  Non-US stocks are often viewed as another asset class.  Thus, one can view the Windsor II Fund as providing additional asset class 

Thus far the portfolio has been constructed to focus on equities.  As mentioned in the introductory material on financial and behavioral economics, bonds constitute an important diversifier.  They are exposed to a different set of risks from equities and perform quite differently.  Thus, the third fund should include bonds. 

Bond mutual funds contain risks that are different from those of actual bonds.  The important difference between a bond fund and a bond is that a bond fund does not provide the commitment to the return of principal on a specific date.  If one wants the diversification bonds provide, then buy bonds.  A bond fund does not provide that diversification.  At the same time, there is no doubt that a bond fund is different from an equity fund and provides some bond-like diversification. 

As has been mentioned, over a long-term investment horizon one can expect better returns from equities than bonds.  Thus, one has the choice of either accepting a bond index fund that will lower overall portfolio returns or relying on a bond manager who seeks to improve on that generic performance by trading bonds. 

Since the principal purpose of the bond portion of the portfolio is diversification, it is going to be there over the long term.  It seems reasonable to assume that one can purchase that diversification by paying to have the portfolio managed in a way that seeks to overcome the tendency for bonds to underperform equities.  That effort to overcome the inherent limitations of bonds can take the form of managing the bond holdings while supplementing them with equities that, to some extent, are bond substitutes.  Consequently, the bond exposure is going to be in a managed fund that holds both bonds and equities.  In other words, it is going to be in what is called a balanced fund.

The third fund for inclusion in the portfolio is the Vanguard Wellington Fund.  A key reason for selecting the Wellington Fund is that, like the Windsor II Fund, it leans toward a value investing approach.  One would hope that the lower beta on the equities in these two managed funds would reduce the amount of bonds one would need in order to be comfortable with the portfolio's performance.  So, while bonds are represented in this portfolio, portfolio design is intended to allow a substantial exposure to equities as well.

Components Of the Portfolio

The descriptions of the funds that follow are taken from the Vanguard website and the fund prospectuses.

1.  Vanguard Total Stock Market Index Fund--Vanguard Total Stock Market Index Fund is designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks. The fund’s key attributes are its low costs, broad diversification, and the potential for tax efficiency. Investors looking for a low-cost way to gain broad exposure to the U.S. stock market who are willing to accept the volatility that comes with stock market investing may wish to consider this fund as either a core equity holding or your only domestic stock fund.

2.  Vanguard Windsor II Fund--Like many individuals making a big purchase, Windsor™ II Fund’s investment managers are mindful of price. While this large-cap value stock fund carries the same risk associated with the stock market, this “value” conscious approach may provide a less bumpy ride. That said, the fund may not keep up in a strong bull market. If you have a long-term investment goal and want less market volatility than might be present in a more aggressive investment, the fund could be a good fit for you.

3.  Vanguard Wellington Fund--The fund offers exposure to stocks (about two-thirds of the portfolio) and bonds (one-third). The fund tends to invest in large cap or mid-cap firms for its equity allocation.  The bonds that it holds are generally highly rated.  Thus, it is a very conservatively managed fund.  Another key attribute is broad diversification—the fund invests in about 100 stocks and 500 bonds across all economic sectors.  This is important because one or two holdings should not have a sizeable impact on the fund. Investors with a long-term time horizon who want growth and are willing to accept stock market volatility may wish to consider this as a core holding in their portfolio.

Fund Weightings and Portfolio Management.

Not surprisingly, how one weights the different funds depends upon how much volatility one is willing to accept.  They are listed in an order that corresponds to how much volatility one would expect.  However, one can get lost in trying to tailor the volatility too much.  Other considerations may be overriding.  For example, each fund has a minimum requirement of an investment of $3,000.  So, if one is only investing $9,000, an equal weighting to each fund would make sense.  In general, an equal weighting is good starting point.  One can then adjust the weights after having gained some experience with the funds.

It is also worth noting that the $3,000 minimum is less than the contribution limit for an IRA in any given year.  Thus, one could begin an IRA by acquiring one fund the first year.  In the second year, it would be possible to build the full three fund portfolio.  Using that approach, the Wellington Fund would be a logical first fund for a conservative investor, but an aggressive investor who is confident in the market may want to begin with the Total Market Index Fund.  The logic of starting with the Wellington Fund is that there is a lower chance of experiencing a significant immediate downturn that would interfere with establishing the three fund portfolio in the second year.

In general, the portfolio is designed to be close to a set-it-and-forget-it portfolio.  If one starts with an equal weighting for the three funds, rebalancing should not be needed for many years.  Just in terms of investment return within the portfolio, one could fix a percentage variation from equal weights as a guide for rebalancing.  However, that is largely unnecessary.

Many discussions of portfolio management proceed as if the portfolio is the only consideration when deciding how to allocate assets.  In reality it is far more likely that events that occur totally independently of the portfolio will provide more compelling reasons to adjust the balance. 

To illustrate, a young investor who holds the portfolio in equal weights is assigning about a 10% weight to bonds (the Wellington fund is 1/3 of the portfolio and about 1/3 of the Wellington fund is in bonds, 1/3 of 1/3 = 1/9).  That is a very reasonable starting allocation for a young investor.  As the portfolio grows over time, one would expect the equity investments to grow more than the bond investments.  Consequently, one would expect the bond weighting to fall.  The theory of life cycle investing would argue that the bond weighting should be increased.  However, the investor’s reality is often quite different and justifies a different approach. 

At the same time that the bond weighting is falling, the total wealth of the individual investor will be increasing as the portfolio rises.  It is also quite likely that the investor’s income is rising, both from higher wage or salary income, and from the returns on the investments.  Further, the investor may acquire other bond-like assets such as a home or vesting in a pension.  That should enable them to accept a bit more volatility in the mutual fund portfolio.  Since they are able to accept more volatility, they can let the bond portion of the portfolio fall.

Probably the most important consideration is one that financial economics often totally overlooks.  More than one posting on this blog has advocated using the total dollar value of an individual investment as criteria for deciding whether to rebalance.  That approach seems particularly appropriate for the three fund portfolio.
Basically, make the investments in thirds and then just let the relative weights of the different investments vary over time.  Postpone any rebalancing until one of the mutual funds has a dollar value that the investor finds uncomfortable in terms of their income.  For example, when the mutual fund becomes equivalent to the dollar value of the investor’s income or some multiple of the investor’s income, subsequent investments could be targeted toward one of the other mutual funds or into a totally new category of investment.

The three fund portfolio is fine as a standalone investment approach if one does not want to branch into more adventuresome investments.  But even if one has branched out, it can still be a useful core holding.  If one pursues the three fund portfolio and makes regular additions as well as letting the gains compound, setting a dollar limit will almost guarantee that at some point the investor will have to branch out. 

If one understands the logic of fund selection (i.e., remembers why one bought the thing in the first place), the three fund portfolio can be adjusted quite readily.  For example, a young retiree whose pension and Social Security more than covers their living expenses could drop the need for the balanced fund (i.e., the Wellington Fund).  If the retiree was going to be totally dependent upon the portfolio for income in retirement, he or she could increase the holdings in the low beta large-cap value fund (i.e., Windsor II) and balanced fund (i.e., Wellington Fund) in order to reduce the chance that he or she would have to take any withdrawal when the fund portfolio was down.

This portfolio is highly versatile.  It can be THE core holding or a core holding.  It can be a very large portion of one's total investments, or it can be used as a place to park money while waiting for other investment opportunities.  More than likely, over one's investment career, it will fulfill different roles.  

The Hedged Economist, as stated in various postings, favors selecting individual holdings.  Nevertheless, this portfolio has been a core holding for a very long time.  For the last few years, as discussed in the posting of January 31, 2014, “An Alternative to TradingBonds,” alternatives to holding bonds have seemed more appealing.  There is no doubt, that the alternative involves a little bit more risk, hopefully more return, and certainly a lot more time than just holding the Wellington Fund.  For a long-term investor who prefers the simplicity of mutual funds, a three fund portfolio such as the one discussed in this posting should be THE core holding.

Thursday, February 13, 2014

A Core of Mutual Funds: Part 1.

Three is really enough.

Why is the portfolio limited to three funds?   There are reasons grounded in financial economics, strong behavioral economic foundations as well as important practical considerations.  Each will be addressed.  Part 2 of this posting will describe the considerations relevant to the selection of the funds.  Then there will be a description of the three funds, which will be followed by a discussion of how much to invest in each fund and how to adjust the weights over time.

Financial economics.

Most mutual fund families and most 401(k)s will offer at least three good mutual funds.  In fact, most offer a lot more.  For the long-term investor, the broader variety is based upon the assumption that diversification across asset types allows one to achieve a better risk-adjusted rate of return.  It is always possible, in hindsight, to show that that could be true.  The general problem with the approach is that extensive diversity of asset classes will work well under normal circumstances.  It draws heavily on applying Modern Portfolio Theory (MPT) to the mix of assets.  It assumes that the investor is applying a trading algorithm to try to maintain the risk-return level continuously.  That algorithm may be as simple as rebalancing once a year, or it may be as complicated as the most sophisticated computerized trading system.

Asset allocation can be made to sound as complicated as possible.  However, it is actually a lot simpler than advocates of Modern Portfolio Theory make it sound.  The problem with the more complicated applications of Modern Portfolio Theory is that it is based upon faulty assumptions.  To be successful, it depends upon asset correlations (i.e., technically, the covariance matrix between all asset classes).  It assumes those covariances are stable.  Nothing demonstrated the fact that the covariances are not stable better than the recent financial crisis.  So, the theory works well under normal circumstances, and it results in a theoretical improvement in returns for any given level of risk.  When put into practice, any improvement in return is very, very slight, and, as the saying goes, “It works as long as it works and then it doesn't work.”

One does not have to understand the role of asset correlations in order to see the limitations and prudent use of the idea behind Modern Portfolio Theory.  Another way to envision the role of asset allocation is by looking at the performance of different asset classes over various periods.  A common way to show that data is a quilt chart.  If one analyzes a quilt chart, it becomes apparent that the biggest difference in performance is between bonds (or cash) and all other assets.  When there is a major market dislocation (a market collapse) or a major economic decline, all assets except bonds (or bonds and cash) have negative returns.  That exception is important.  The threshold between positive returns and negative returns is extremely significant mathematically and psychologically.

Behavioral economics.

Modern portfolio theory has been around since the 50s.  It is a very good theory if you assume that individuals’ risk tolerances are consistent over time.  However, there is considerable evidence that individuals do not have stable risk tolerances.  Further, people are not good at accurately judging their own risk tolerance, much less forecasting it. In addition, behavioral economists have shown that an abundance of options does not necessarily lead to better decisions, and the number of options influences one's perception of risk.

So, the three fund restriction may theoretically involve taking a little more risk.  In actual practice, most non-professional investors do perfectly well with the more restricted diversification of asset classes.  It may be that selecting fewer options requires them to acknowledge the risk involved in any investment.  Thus, they may be less likely to misdiagnose their own risk tolerance.  It may also be that fewer options actually anchor the risk tolerance at a higher level of both risk and return.  

It also would seem logical to assume that the more mutual funds selected the more likely it is that the investor will pick at least one mutual fund that is poorly run.  Having that blooper in one’s portfolio undoubtedly has some effect on one's risk tolerance.  Behavioral economists have pretty much been able to confirm that witnessing poor performance lowers one's risk tolerance.

Practical considerations.

First, the idea that one needs to hold a large number of mutual funds in order to be diversified into multiple asset classes is nonsense.  There are individual funds that invest across multiple asset classes.  Some try to assess an individual's risk tolerance and then adjust the asset mix to maintain that risk profile.  They may do it by periodically adjusting the mix across asset classes, or they may do it continually.

An example of the first type that periodically adjusts the asset mix would be one of the many target date funds.  Their assessment of the risk tolerance is based upon the individual’s age as reflected in the target date the individual selects.  The notion that all individuals of a given age should be exposed to the same risk, regardless of health, wealth, or disposition, does not make sense.  Despite the fact that it is absolutely absurd to assume that one's age is the only determinant of the appropriate risk, target date funds are very popular.

Their popularity seems to originate from the fact that they are simple.  Further, the periodicity with which they rebalance assets to their target mix is largely arbitrary.  It may be that their benefit is that they relieve the individual of having to make any asset mix decisions.  However, there is absolutely no reason to think that they make the right asset mix decision for any particular individual.

At the other extreme are the funds that continually adjust to a target asset mix.  As explained above in this posting, they suffer from the assumption that any individual can measure a different individual’s risk tolerance. Further, any improvement in performance from such an approach is so slight that many funds that pursue this approach have to take on leverage in order to realize a large enough yield benefit to justify their management fees.  The best examples of such an approach are some of the hedge funds (e.g., Long-Term Capital Management) that have blown up spectacularly.

Even though funds that over-diversify and try to determine the appropriate amount of risk have shortcomings, that does not mean that funds cannot provide some benefit of asset diversification.  Rather, these funds illustrate that multiple funds are not required in order to get asset diversification.

Every mutual fund has a minimum amount that has to be invested.  Further, some have charges that are steeper in percentage terms on smaller holdings.  If the amount of capital to be invested can only justify holding one mutual fund, a target date fund will provide asset diversification.  That diversification will result in less volatility.  However, in many cases,  where the amount to invest only justifies one mutual fund, strong arguments can be made for the need for the investor to expose themselves to greater volatility in the form of equity holdings beyond what would be characteristic of a target date fund.

In general, when considering mutual funds, the trick is for the investor to select funds that provide the appropriate amount of asset diversification for that unique individual.  It is also important to ensure that, once that desired level of diversification is achieved, it remain stable unless the investor chooses to intentionally change it.  Further, as discussed above in this posting, the most important aspect of diversification is exposure to both equities (stocks) and debt (bonds).  However, bonds only represented a diversifier and a source for funds when equity markets turned down.  Over the long-run, equities are going to outperform bonds.

Tuesday, February 11, 2014

The Three Fund Portfolios.

Less control, but more simplicity.

This will be the first of three postings on the use of mutual funds.  The next posting will address a core portfolio of mutual funds.  It will be followed by a posting on how to use mutual funds to supplement domestic (US in this case) stocks.  However, this posting has to first address the decision whether to buy stocks and bonds directly or use mutual funds.

So far this year, previous postings addressed managing a portfolio that holds actual stocks.  Many people believe it is easier to pick a mutual fund than a few stocks.  It is hard to understand why people think it is easier to pick a manager for a mutual fund than to recognize a few good businesses.  Nevertheless, that is the case for many people.

When one first starts, the total amount of the portfolio may not seem large enough to justify the purchase of a number of stocks.  A mutual fund may provide diversification that would not otherwise be available. In some cases, mutual funds are the only accessible option for the individual.  For example, many people have 401(k)s that restrict them to mutual funds.  Perhaps they are forced to become comfortable with mutual funds. 

Regardless of why people prefer to build portfolios of mutual funds, they do. Consequently, a portfolio of mutual funds is worth discussing .  An April 20, 2011 posting entitled “Investing PART 13: Mutual funds” discussed issues related to mutual funds, as well as some legitimate uses of mutual funds, but it never addressed constructing a portfolio of mutual funds. 

Nothing that follows should be taken as an endorsement of mutual funds.  As stated in the posting cited above, “They are an extremely inefficient, hard to analyze, and risky way to invest in certain asset classes that should be the major focus of individual investors.”  Despite their limitations, if used carefully and used with an understanding of their limitations, mutual funds can play an important role in an investor's portfolio. 

They can be used to achieve diversification with less capital.  They also can be used to achieve diversification into areas where the investor does not feel comfortable making individual investment decisions.  Further, they can be used to acquire assets that would otherwise be unappealing (e.g., due to their tax treatment) or difficult for the investor to acquire.

Finally, as discussed in the January 24, 2014 posting entitled “What is to be learned about stock acquisition?” managing a portfolio like the widows’ and orphans’ portfolio can involve anywhere from 2 to 6 trades in a year as decisions have to be made about what to do with dividends.  Obviously, it also requires selecting the stocks to put in the portfolio in the first place.  That can involve selecting 10 to 15 stocks.  That may be more than many people want to do.  A mutual fund portfolio can involve fewer decisions about where to invest and fewer decisions about when to trade.  For many people, that alone would justify the mutual fund portfolio.  The ability to achieve diversification with only one decision has tremendous appeal to many people.
The mutual funds available to each investor depend upon whether the investments are in or outside of a 401(k).  If it is within a 401(k), offerings will be restricted to only selected funds offered within that 401(k).  If they are outside the 401(k), technically, the investor could pick any mutual fund but often feels constrained to those offered by a particular broker or mutual fund company.  So, in the next two postings references to individual mutual funds should be taken as illustrative examples of the appropriate type of mutual fund.  (In order to facilitate the use of the named funds as an illustration, the posting includes descriptions of the funds).

Important consideration in any mutual fund is the expenses that the mutual fund charges the investor.  The examples referenced in the next posting are all Vanguard funds.  Vanguard places a lot of emphasis on low management costs.  Consequently, Vanguard was a convenient source for examples of how to construct a simple mutual fund portfolio.  That should not be taken to imply that the same could not be done with bonds from other fund management companies.  Therefore, funds offered by Fidelity will be used in the third posting in this series.