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Why Advisors Are Recommending Index Funds

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  • The Street...and MJG=).
  • Reply to @Charles:

    Hi Charles,

    You are mostly correct in your assessment that I now favor Index-like investing.

    I say mostly because our family portfolios are only partially committed to Index positions; we do have actively managed mutual fund holdings. To a limited and diminishing extent we still seek just a little Alpha, excess returns. That might well be a wealth robbing residual from my earlier investment lifecycle when I invested in a small group of individual stocks. I learn slowly.

    When asked by younger folks with little savings, almost zero investment knowledge, and no time to devote to learning the rules and disciplines of the art, I invariably recommend a short list of Index products.

    I never have shared the divergent incentives that The Street article identified as motivating financial advisors in the past. Since I have no such incentives, my positions on the matter are much more pure in many ways.

    So I do acknowledge that I can be mostly counted among the ranks of those who advocate a passive Index investment philosophy.

    Here is an incomplete list of a few distinguished investment wizards, top tier academic researchers and acclaimed financial writers who subscribe to that passive investment style: Warren Buffett, John Bogle, Bill Bernstein, Peter Bernstein, Scott Burns, Jason Zweig, Gene Fama, Jonathon Clements, Paul Samuelson. Burton Malkiel, Charles Schwab, Jeremy Siegel, Charles Ellis, and even the Motley Fools and the AAII organizations (partial endorsements).

    That’s not bad company. A more inclusive list would be almost endless.

    What are the primary drivers that solicit such an impressive cohort? It’s low cost. It’s low turnover. It’s owning the entire market. It’s the freedom of being able to participate in the markets without a huge time commitment. It is a time proven successful strategy.

    The historical record is clear. When properly benchmarked, passive Index funds outperform their actively managed rivals roughly 67 % to 80 % of the time. Active fund managers have a difficult time recovering their cost hurdle handicap.

    Additionally, numerous studies document that individual investors mostly underperform the funds they buy. DALBAR annual reports demonstrate that investors only gain a fraction of the yearly returns that their mutual funds deliver.

    From a market timing perspective, we choose lousy exit and entry points. We chase hot funds and are typically late to the party. Behavioral research has identified a host of losing biases that damage our investment performance. I am as guilt as the next guy in that arena, perhaps even more so.

    Especially for a novice investor, I often endorse Index investing. After 50 years of my own personal investing experiences, I too am incrementally increasing my passively managed holdings fraction. But I still own low cost, low turnover actively managed mutual fund products.

    Hope springs eternal. The gambling excitement factor comes into play in my decision making process.

    Best Wishes.

  • Hello MJG.

    I've also noticed you're being a strong proponent of index funds. I was surprised to read that you held some actively managed funds. I would be interested in hearing how you use actively-managed funds in your portfolio. For myself, I want to gravitate back toward more index holdings; but I am convinced based on my brief investing career that I don't have the nerve to rebalance when market conditions warrant, and so use active managers with a record of discplined, value value investing to make those decisions/execute those trades for me (roughly 50% of portfolio is in active funds -- mostly asset allocation, but also FAIRX and a few small cap funds).

    Anyway, would be interested in hearing the roles active funds play in your portfolio.

    Cheers.

    D. S.
  • Reply to @Shostakovich:



    Hi D. S.

    Thanks for your interest.

    Please keep in mind that my current portfolio contains active components at the peripheral, perhaps 30 %. However, I expect I will always maintain a small fraction of our composite portfolios in the active category.

    It is not so much that I anticipate any excess returns generated will make a substantial contribution to our end wealth. It will likely not based on past performance. Our portfolio’s rewards will be mostly controlled by the passive component contributions.

    It is the challenge of the hunt that nurtures our family (my wife participates in any decision making) zeal to squeeze just a little above market returns from our portfolios. The risk is minimal from an end wealth and from a portfolio ruin viewpoint.

    My portfolio building career extends into the investment modeling dark ages (mid-1950s). Given my formal engineering and mathematics training, I initially attempted to master the marketplace with charting and technical analysis. An early edition of Edwards and McGee was my first technical analysis text purchased in the financial arena.

    Through the decades, as academia published meaningful research papers, my investment philosophy and style matured. I was open-minded enough to experiment.

    I went to a broad diversified portfolio guided by Markowitz’s and Sharpe’s findings. I did small and value oriented equities after Fama and French issued their 3-factor model. I ventured into momentum mutual fund buying when momentum factors were discovered that enhanced annual returns, at least with a year or two of persistence.

    There was a highly publicized quant era, a formidable concentrated, focused fund theory, and a superstar fund manager period. There were numerous combinations of these concepts. I likely participated in all of them and granted them three year exploratory trial periods.

    There is the efficient market controversy that might be exploitable. I still believe it is an unsettled issue. For a long time I believed that excess profits could be realized in certain market categories, such as small cap equities and emerging foreign markets. I committed resources to many of these controversial theories.

    Many of the resultant mutual funds delivered sub-par returns, especially when risk adjustments were made. It’s amazing just how many myths get exposed and exploded in the real marketplace. It turns out that many financial Gods have clay feet. I field tested no ideas that particularly excelled. Many of these concepts were okay in a sense that they produced market-like rewards. None delivered a king’s ransom.

    The single biggest factor in managing a successful portfolio is time. Over decades, equities and bonds deliver generally reliable, predictable returns. The year-to-year surges are averaged away. The key is to assemble a portfolio that allows you to be patient enough to stay the course. Time in the marketplace is the essential secret; it’s as easy as that.

    To stay the course you must be comfortable enough with your holdings to sleep peacefully every night. If you can’t, J.P. Morgan had a cure. He recommended that you should “sell down to the sleeping point”. I sleep well.

    I choose not to reveal my current actively managed portfolio positions. I fear they may do the MFO community more harm than good. A proper portfolio is unique to an individual. However, be assured that my actively managed mutual funds are low cost with low turnover rates, and are captained by guys with many years of fund management experience. Historical data shows that these characteristics provide the best odds for better than average performance.

    I wish you successful portfolio management control, profitable annual returns, and restful nights.

    Best Wishes.
  • Reply to @MJG:
    MJG,

    For the record, I was more interested in hearing your thought on how you actually use active funds in your portfolio, than learning your secret list of active funds.

    Thanks, regardless; and many happy returns.

    D.S.

  • edited January 2013
    Reply to @MJG:
    Time in the marketplace is the essential secret; it’s as easy as that.
    Nice post MJG. Thanks for sharing.

    Hey, what do you think of Professor Greenblatt's Magic Formula method?
  • MJG
    edited January 2013
    Reply to @Charles:

    Hi Charles,

    Thanks for the kind words and for your many informative submittals to the MFO site.

    I haven’t formed a detailed assessment of Joel Greenblatt’s several investment books and the formulas that he recommends because I have not read his works.

    Professor Greenblatt emphasizes individual stock selection criteria, and I have stripped my portfolios of all individual stock positions for over 3 years now. Individual stock selection is an immensely time consuming effort that exceeds my current interests and capabilities. I am trying to simplify my portfolio management demands. Time is my most valued commodity.

    So, I do not plan to directly read Greenblatt’s research findings. But I did become loosely familiar with his value-oriented approach through secondary source material.

    In general, I like his methodology. In a broad sense, he is a proponent of the Benjamin Graham investment philosophy: buy stocks that are priced below their intrinsic value. One secret of that philosophy is to determine a reasonable estimate of a firm’s intrinsic value. That is not an easy or obvious task. Hence, just like Graham, Greenblatt endorses application of a margin of safety policy.

    It’s interesting that both Graham and Greenblatt are from the Columbia University staff.

    Over the long haul. Value investing seems to be less risky than other alternate styles. Fama and French discovered an extra return from value dominated approaches when finalizing their 3-factor market model. The two criteria that Greenblatt formulated are perturbations of several respected value criteria. Therefore, I suppose that the Greenblatt method has the potential to deliver superior returns; the approach offers plausible advantages.

    Greenblatt has publicly acknowledged that his secret formula is not bulletproof. He recognizes that the method will underperform for substantial periods. That’s realistic. The Professor recommends that any investor who considers his system must be patient and be persistent. We have heard that wisdom many times over.

    In the end, the proof will be in the 4 mutual fund products that Joel Greenblatt now co-manages. Morningstar tracks them, but their record is too thin for a respectable performance assessment. Initially they got off to a great start, but seem to have faltered a bit in 2012, underperforming proper benchmarks. The proper benchmark is an important evaluation tool. In some of his original comparisons, Greenblatt benefited by choosing a far less than perfect comparison Index. Many financial product marketers do the same, purposely.

    I do not like the idea of a 20 to 30 stock holding portfolio. That’s too concentrated a portfolio that does not fully take advantage of diversification benefits.

    At one time I was a member of AAII. I found their analysis fair, insightful, and informative. Here is a Link to a review that was generated by an AAII contributor:

    https://www.aaii.com/computerizedinvesting/article/using-the-magic-formula-for-investing.pdf

    The concluding remarks in the work by Cara Scatizzi is excellent and solidly reflects my judgment on the matter, so I close with it:

    “Like any stock screening strategy, blindly buying and selling stocks is never a good idea. Developing and implementing disciplined buy, sell and hold strategies is a better option. Greenblatt’s Magic Formula is not revolutionary, but does provide a new twist on the old value investing ideas. While his past record is impressive, it will be interesting to see how the screen holds up during this period of market turmoil and its aftermath.”

    Time will reveal the ultimate judgment on the Magic Formula.

    Best Wishes.
  • Reply to @MJG:
    I choose not to reveal my current actively managed portfolio positions. I fear they may do the MFO community more harm than good. A proper portfolio is unique to an individual
    MJG,

    I appreciate and respect your thoughts. However, in your post Re: Equity Side of Portfolio Now in Rebalance Mode ... Reducing Equity you stated:
    Since you are well aware of my proclivity for low cost, conservatively managed financial products, it will not surprise you that I selected Vanguard’s short-term investment grade corporate bond fund (VFSUX) to fill that requirement.
    I submit the two comments are incongruent.

    Mona
  • MJG
    edited January 2013
    Reply to @Mona:

    Hi Mona,

    Sorry if you feel I violated one of my own firm MFO rules of engagement.

    I really do believe that portfolios are both a private and personal matter. They are unique to each of us. What works for me might well be a devastating disaster for you given differences in goals, wealth, knowledge, experience, risk profile and timeframe.

    Discussing a single mutual fund is not the same as revealing an entire portfolio or the weighting of its component parts. Even so, I hesitated before mentioning the Vanguard product in my reply to Investor, an old Fund Alarm and MFO compadre.

    In this instance I concluded it was acceptable given that I am using this short-term corporate bond product as a Cash Equivalent. That interpretation is a little category stretch so I thought it might be more meaningful with a specific real world illustration.

    So I did it, and I am glad that I did.

    I hope this minor rule exception does not destroy your trust in my postings. I say what I mean as carefully as possible and always mean what I say. I’m not always on target, but I practice what I preach, always.

    So, from my perspective, my general reluctance policy with respect to specific equity and bond endorsements remains intact.

    Best Wishes.
  • Reply to @MJG:

    Thank you for breaking your rule by expressing your use of VFSUX. Even if you had not supplied the purpose for its use in your portfolio (as a cash equivalent), I would have found the information of personal value.

    I certainly agree that revealing your portfolio component weightings are both a private and personal matter. Accordingly, I would never request such information.

    In the continued spirit of education, if you would again break your rule by letting me know (names only) the few actively managed funds that you invest with, that would be great. Of course, I would not request the names of the index funds, because as you have said, they comprise the majority of your portfolio, and thus, would be more than a minor rule exception.

    Mona
  • MJG
    edited January 2013
    Reply to @Mona:

    Hi Mona,

    Again I hesitate, so I’ll proceed with a bit of circumspection and self-control.

    One major factor in my cautious decision process is an anticipated time-consuming controversy that my innocuous, neutral revelations would promote from some MFO members. I say innocuous and neutral since I do not especially recommend my particular selections for anyone else’s portfolio. That’s forever a personal decision.

    As evidence of a likely disruptive explosion, just consider the harsh and unnecessary buzz that Skeeter’s portfolio announcement made. It necessitated numerous defensive replies from Skeeter that are wasteful time-draining sinks. I choose not to enter that ruinous minefield.

    A few habitual MFO contributors tend to emphasize the negative; they are whiners and nit-pickers. They’d arguably find fault with 1 % of a posting that is designed to be informative and educational. As Julius Caesar wisely remarked “ Don’t be concerned with small matters!”. Some MFO participants seem to be consumed by small matters.

    But do not despair, all is not lost.

    I’ll partially address your question with my generic plan of how to construct a portfolio that is mostly Index-based, but has a small fraction that is committed to nudge annual returns in the direction of excess rewards.

    First, the assumption is that the portfolio is dominated by Index products that could or could not include bond holdings. It does not matter. The mix is basically designed to achieve a specific market return goal. That baseline mix depends on the financial needs and time horizon of the portfolio holder. That baseline portion of the entire portfolio should be well diversified to control volatility risk.

    Since the actively managed component is a minor fraction of the portfolio, it must be aggressively constructed to potentially yield a meaningful bump to the nominal returns. Otherwise, why accept the incremental performance uncertainty?

    How to assemble such a riskier portfolio sleeve? Hire an active fund manager with a superior long-term performance record over numerous market cycles, with a well funded research staff, with a low cost structure, and with a low turnover history. A fund that holds many positions is probably going to reproduce market rewards. Therefore, a highly concentrated, highly focused fund is needed to improve the odds of extra returns.

    That’s a tough set of selection criteria that typically can not be satisfied by a single fund. So hire several funds that each exhibit a few of the target characteristics.

    Here are a few candidates that I have used in my earlier portfolio management history. I still own a few of them, but not all. So I launch a few decoys to draw direct fire away and to protect my rules of engagement. In military terms, clutter is sometimes deployed to penetrate a staunch defensive position.

    Dodge and Cox equity fund (DODGX) has established an experienced long-term management structure, low costs, and low portfolio turnover record. Academic research concludes that these features offer the prospects of a good excess returns likelihood. Never any guarantees under any circumstances.

    Along the star manager and focused fund dimensions I have owned Marsico Growth (MFOCX) fund and several Masters’ Select Funds products (MSEFX, MSILX, MSSFX). These funds had modest portfolio turnover numbers and above average expense ratios, but offered access to star-caliber management and highly concentrated portfolios. The Masters group has the added advantage of constant star manager review and replacement if needed.

    I also have used a variety of Fidelity and Vanguard funds for various reasons. The Fidelity research team is top tier. Vanguard preaches and practices cost control to the extreme. Examples include Fidelity Contra (FCNTX), Fidelity Low Price Stock (FLPSX), Vanguard Health Care (VGHCX), and both Vanguard Wellesley (VWINX) and Wellington (VWELX) in the balanced fund category. Each featured seasoned managers, cost containment, and disappearing low to high (bothersome) portfolio trading. In particular, the Vanguard Health Care sector play was purchased because of an aging US population. You can’t always get what you want.

    As I mentioned, at one time or another, I held these funds in my portfolio; I still own a few of them. I make no claims that my current mix is anywhere near optimum, whatever that means in terms of the Markowitz Efficient Frontier. Most of my present positions are value-oriented. In this timeframe, I do very little new candidate fund screening. The best research hints that such an effort is close to futile after the very poorest prospects are easily eliminated. Superior and persistent fund performance is illusive; there is the strong pull to regression-to-mean.

    I am sure that many members of the MFO community have far more insights than I do in the fund selection field. My work is somewhat dated. I propose that you seek their well informed and well intentioned advice .

    As a final caution, keep in mind that every specific fund must fit into the total portfolio framework, and must work within the context of the overall portfolio objectives.

    Also, please recognize that this is not the only way to assemble a fundamentally Indexed portfolio with a small supplemental actively managed component; it is merely my simple way.

    I hope this helps just a little and that you persevered through the ranting.

    Best Wishes.
  • edited January 2013
    Simply because, for probably 98-99% of the investing public, that is what will work best. As MJG rightfully noted, for many "... folks with little savings, almost zero investment knowledge, and no time to devote to learning the rules and disciplines of the art...", handing them anyone's current list of top 10 mutual funds to be invested in now will end in disaster, or at the very least, a field of broken dreams.
  • Reply to @Mark:

    Mark, I too agree.

    I meet 2 of the 3 you reference. Almost zero investment knowledge and no time (probably more so interest) to learning the rules and disciplines of the art. My experience with the likes of BJBIX is evidence.

    Consequently, about 80% of my investments are with Vanguard and in Index Funds (VTSAX, VTIAX, VBTLX,VSIAX, VGSLX, VIMAX, VVIAX). However, since I have been financially fortunate in life, and being the 20% will not change my life style, and annually get 100 free trades with Vanguard Brokerage, I will admit that I like to play around on the fringes with actively managed funds. This is especially the case with multisector bond funds and managed diversified Pacific/Asia funds, spaces in which Vanguard does not participate.

    Interestingly, while I did get upset when I let BJBIX shrink in half and there have been others (yes "end in disaster"), that is ONLY on me, regardless if obtained the recommendation from someone on a forum.

    Yes, I am very fortunate that I have not encountered a field of broken dreams.

    Mona
  • Mona, it's OK to play around the edges. Most of my portfolio is fairly static these days but I maintain a bucket of play money. House winnings I call it.

    Thought you might like to take a look at the attached article:
    http://blogs.stockcharts.com/journal/2013/01/money-management-why-market-wizards-claim-its-the-secret-sauce.html

    Of the 3 take-aways i feel 'C' sums it up best "The roadmap to success requires that you know yourself and know enough to stick to your rules."
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