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 

diversification.

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.