Recently in the Wall Street Journal there was a piece titled “Small Stocks Could Be Getting Too Cocky.” Quite frankly, it was full of the usual nonsense we’ve all come to expect from the financial press. What should I do with my portfolio now? Where is the market going? Less obviously it asks the question: “Which mutual funds should I own?”
You see, this column “features” the model portfolios of various investment advisors. In short, it’s a dressed up version of “Top ten mutual fund” lists that so frequently is spread across the pages of the web and magazines. In this specific article, the interviewed advisor lays out his “moderate” risk tolerance model portfolio for the readers. The model portfolio looks much like most advisor’s investment management strategies and many account statements that come across my desk for review. As such, it shares some of the most common faults that are common across the industry.
The model portfolio has a 40% allocation to broad US equities, but only a 15% allocation for foreign stocks. Currently the United States makes up 49% of the global stock market. Half of the world’s investment markets exist outside of the United States. To limit the exposure of one’s portfolio outside of the United States relative to the global market place is taking a fairly large macro-level bet. In doing so you are telling the markets that they are wrong about the value of both international companies and US companies. Not to mention that there is good evidence that a very small exposure to international stocks may hurt the long-term risk-adjusted return of your portfolio.
Index Or Active?
The model portfolio has both a core position in the S&P 500 SDPR ETF (SPY), and Vanguard small/mid cap index fund and multiple positions in actively managed stock mutual funds. Many advisors will call this a “core and satellite” approach but in practice it does not make much sense. Either active portfolio management works and market inefficiencies can be exploited, or investors should stick to index funds. David Swensen (of the Yale Endowment) has often told investors to be at one end of the “active” spectrum or the other. Either aggressively pursue a concentrated active management strategy or keep things simple and inexpensive. From an interview in 2009 with ProPublica, he says it much better than I can:
The investment management world is a strange place in that the right solution is not in the middle. The right solution is at one extreme or the other. One end of the spectrum is being intensively active. The other is being completely passive. If you end up in the middle, which is where almost everybody is, you pay way too much in fees and end up getting subpar returns.
The model portfolio has seven US stock funds or ETFs, including the S&P 500 SDPR ETF. Three of the funds (exclusive of the S&P 500 ETF) are US large cap stock funds. These funds have a great deal of overlap in the stocks that they all own. This means that the portfolio has the appearance of diversification but the pieces are more similar than they appear. Each of the three funds has a correlation to the S&P 500 of at least 0.90 (the highest possible correlation of two assets is 1.00). Essentially, these mutual funds are index funds in disguise with little to no chance of beating their benchmarks after expenses.
Positions for Positions Sake
Building intelligent investment portfolios starts with asset allocation: how much are you investing in bonds, US stocks, foreign stocks, etc. These allocations affect your portfolio’s behavior and long term performance. But they have to be material allocations. A 1% allocation is for show and nothing else. A 1% allocation will never have a material impact on performance. A 1% allocation serves only one purpose: to make investing look complicated, to make the investment advisor’s job appear elaborate.
Track Record Investing & Survivorship Bias
Imagine that you’re an investment advisor who gets a call from someone at the WSJ. They want to do a piece on your portfolio management strategy and want you to provide a sample portfolio. Which funds are you going to trot out? Of course you are going to put your best foot forward and make sure every fund on the list looks good. So as expected, practically every fund on the list is rated 4 or 5 stars by Morningstar. Most have excellent trailing performance, in the top decile or quarter of their peer group. Some have even recently beaten their benchmarks.
Unfortunately, what we cannot know is how long these funds have been a part of the model portfolio. The article states that the portfolio was up 11% over five years through 2013. But several of the funds in the model portfolio did not exist in 2009! So the model portfolio carries significant survivorship bias – only showing us how good things look now, without knowing which funds were actually part of the portfolio in the past. And of course, a great track record is nice for people who owned the fund in the past but means very little to those who own it today. There is absolutely no relationship between a fund’s past and future performance. These funds that were in the top quartile from 2009 – 2013 have less than a 5% chance of still being there after 5 more years. The persistence of outperformance in actively managed funds is worse than you could expect from a coin toss. You would quite literally be better throwing darts at a list of funds (or, better yet, buying the cheapest fund you can find) than relying on a nice-looking track record for future success.
I am sure that it seems like I am picking on this one portfolio from this single advisor in a single article in the Journal. The reality is that I see portfolios like this time and time again and I used to build and analyze them myself! But it should not take much research and study to understand that attempts to beat the market with this portfolio (and the thousands more like it) will ultimately end in higher taxes, higher fees and lower net returns to investors. This standard model of investment advice is great for the advisor who can charge high asset-based fees and appear to be the “investment expert” but will leave investors worse off in the end.