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.