Index Funds vs Active Management: Cost vs. Cost-Justification

Lots of talk these days about making sure you have low-cost mutual funds.  All things being equal, yes, the lower the internal costs of a fund, the better.  Assuming, that is, you are talking about funds that invest in the same way and get similar returns...

But all funds are not equal and do not all invest the same way.  Some fund managers are better at picking investments, and they get better returns.  You can do better if you choose those benchmark-beating funds.

Think of a football team...  the same playbook and strategy would be more successful most of the time if all-pro players were on the team.  That is what my Strategic portfolios aim to accomplish--the mutual fund versions of a team with "all-pro players" on the field for us.

These "all-pro" funds cost more than the low-cost index funds, but that should not matter if their net performance is better.  If one fund delivers net-of-fees performance of 7.5% per year and another 7.0%, why be concerned about how much each fund charges?

Uncertainty is the only reason--we don't know if the outperformance will continue.  But if we find funds with consistent track-records over several market cycles, we can have confidence that they really are better at investing.

But these funds are hard to find.  80% of actively-managed funds underperform their benchmarks.  How does one know which are in the 20% that outperform?  Can't figure that out for yourself?  I will do it for you for about 1.25% per year.  I know what to look for, and I have the tools--my firm's most expensive overhead cost is the research database with which I hunt for the actively-managed mutual funds that are worthy using.

And even if the cost-justification makes it merely a wash compared to using index funds, you still have me on retainer to help with personal financial strategy and advice:  how much to save, which accounts to use, buy or rent a home, lease or finance a car, what kind of insurance to buy...


There is Nobel Prize-winning research that guides most financial advisors on how to diversify portfolios.  If we're following that asset allocation guidance, then portfolios using benchmark-beating funds should do better most of the time and over the long-haul than those using index funds, even if the latter have lower costs.  The Strategic portfolio models I offer will have beaten strategically similar models comprised of index funds, and over just about every time period.


To summarize, index funds are all pretty much the same, so go for the ones with the lowest cost...  but a well-constructed portfolio of the best actively-managed funds should beat that, and even if you don't know how to do it yourself, an advisor like me can do it in a way that cost-justifies the additional advisory fee.  Value.  Cost-justification.  Good stuff!

I appreciate your time.  Thank you for reading this post.

Strategic and Flex Portfolio Performance Through July 2014

US and Foreign Indexes		3 mo	1 yr	3 yr	5 yr	10 yr	2008
Stock Markets (50-40-10)		1.8%	16.1%	12.4%	13.1%	7.6%	-40.2%
S&P 500		3.0%	16.9%	16.8%	16.8%	8.0%	-37.0%
MSCI EAFE		0.6%	15.1%	8.0%	9.4%	7.1%	-43.4%
US OE Diversified Emg Mrkts		6.5%	13.0%	0.3%	7.0%	11.3%	-54.4%
Barclays Agg Bond--US		0.9%	4.0%	3.0%	4.5%	4.8%	5.2%
Barclays Agg Bond--Global		0.4%	5.1%	1.6%	4.0%	5.0%	4.8%
Aggressive		1.7%	14.6%	11.4%	12.1%	7.4%	-36.3%
90 Flex V		0.8%	9.9%	8.5%	11.3%		-19.1%
90 Strategic II		0.8%	11.2%	12.6%	15.5%	10.0%	-34.0%
Fidelity 90		1.6%	14.2%	12.2%	13.2%	7.8%	-35.2%
Moderately Aggressive		1.6%	13.5%	10.4%	11.4%	7.3%	-32.0%
80 Flex V		1.0%	9.6%	8.1%	11.0%		-16.9%
80 Strategic II		0.9%	10.5%	11.8%	14.4%	9.6%	-30.2%
Fidelity 80		1.2%	12.7%	10.3%	11.3%	7.3%	-32.0%
Moderate		1.3%	11.0%	8.4%	9.6%	6.8%	-23.1%
60 Flex V		1.3%	9.1%	8.0%	10.9%		-13.1%
60 Strategic II		1.1%	9.3%	10.1%	12.6%	8.9%	-24.2%
Vanguard 60		1.9%	9.3%	9.1%	10.3%	6.6%	-23.8%
Moderately Conservative		1.0%	8.5%	6.3%	7.7%	6.2%	-13.3%
40 Flex V		1.6%	8.7%	8.1%	10.9%		-13.1%
40 Strategic II		1.0%	7.3%	7.7%	9.9%	7.5%	-16.8%
Vanguard 40		1.5%	6.8%	6.6%	8.0%	5.9%	-15.1%
Conservative		0.8%	6.0%	4.2%	5.7%	5.5%	-2.5%
20 Flex V		1.9%	8.2%	7.6%	10.4%		-5.2%
20 Strategic II		0.9%	5.4%	5.4%	7.4%	6.3%	-9.1%
Vanguard 20		1.3%	5.2%	4.9%	6.6%	5.6%	-0.7%
Asset Allocation		USA	x-USA	Bond	Cash	Other
20 Flex V		14%	5%	48%	29%	4%
40 Flex V		28%	10%	31%	26%	5%
60 Flex V		34%	15%	21%	24%	6%
80 Flex V		44%	20%	8%	21%	7%
90 Flex V		51%	22%	1%	18%	7%
20 Strategic II		11%	6%	52%	27%	3%
40 Strategic II		22%	12%	40%	22%	3%
60 Strategic II		35%	18%	27%	17%	3%
80 Strategic II		45%	25%	14%	14%	3%
90 Strategic II		50%	29%	8%	11%	3%
NOTE 1:  Past performance is no guarantee of specific future results.  This data is presented by Potomac Wealth Strategies, LLC.  This data is from Morningstar and should be accurate, but it has not been independently verified.
NOTE 2:  "Flex" and "Strategic" portfolios are designed and managed by Potomac Wealth Strategies, LLC.  These models show track records of better returns, lower volatility, or both, compared to their benchmarks and popular competitors.
NOTE 3:  "Vanguard 80" and "Fidelity 80" are low-cost Moderately Aggressive portfolios.  They are comprised of index funds from Vanguard or Fidelity.  This is what many might recommend due to low-costs and portfolio efficiency.
NOTE 4:  Nothing on this blog post represents investment advice to any individual or organization.  If the information hereon is of interest to you, please contact us at Garo.Partoyan@PotomacWealthStrategies.com for a consultation.

January Financial Checklist:

1)  401(k)/403(b)/TSP contributions limits are $17,500 for most, higher for some.  Make sure your automatic contributions are updated if necessary.

2)  IRA contribution limits--$5500 for most, $6500 for some; talk to your tax person to be sure.  Don't forget to complete your 2013 contributions first--folks with automatic deposits need to watch this carefully.

3)  Get your tax forms together a month before you meet with your tax preparer.  Folks who wait will probably leave money on the table by not maximizing refund or minimizing payment owed.

4)  If you die or become disabled, what income will be there going forward?  Life insurance and Disability insurance are not pains in the neck or expensive "upsell" products; they are your first line of defense.  Get on this, or double-check what you have in place.  (Note:  Although I do not sell insurance, I still want clients to have--or buy--what they need to protect themselves.)

Year-End Mutual Fund Distributions--Fear Not the Price Drop!

Good morning.  Most of my clients are in some mutual funds that appear to have dropped in value suddenly, but fear not.  The share prices have been reduced in exchange for cash (or more shares in the case of the cash being reinvested).  The value of our investments did not drop from this--it's all just fine.

This is a normal activity for many mutual funds at this time of year.  The cash is a distribution of "long-term capital gains", "short-term capital gains", and/or "dividends"--not the usual monthly or quarterly kind, but special annual distributions.  Such are made per regulations that require mutual funds to make some distributions directly to clients instead of incorporating them into the Net Asset Value (share price) of the mutual fund.  Yes, it is a little tricky to explain, but I am happy to provide more detail if you want.  But it is normal, expected, and does not represent an unusual reduction in value of our investments.

Example:  In one account I reveiwed, the First Eagle Overseas Fund dropped NAV from 22.83 at market close on 12/12 to 21.66 at close on 12/13.  That's a 5.1% drop in share price, BUT the value of the fund's investments did not drop by 5.1%.  How?  Well, on 12/12 the account received three chunks of cash (long-term cap gains, short-term cap gains, and some dividends) totalling $747, and that was reinvested into 32.7 shares at $22.83 (closing price on 12/12).  So, prior to the special distribution, there was $14,616 in that position and after the distribution/reinvestment it was $14,576…  the $40 decline (about 0.2% of the value) is attributable to the slight market decline that particular day.

Please contact me with any questions, of course.  Thank you, and make it a great Friday!

--Gary

NOTE:  I offer a special "Thank You" to a certain client for reminding me that this should be explained to everyone!

Flex Portfolio Performance Through November 2012

With the creation of the new Flex IV portfolios, most clients will be moved out of Flex II and Flex III portfolios.  The Flex portfolios are designed to provide nimble tactical management even while my clients and I aim to keep the strategic allocation in place during various market conditions.

Strategic:  diversified portfolios consistent with Nobel Prize-winning methodology to optimize the balance between risk and reward; best to maintain the portfolio in targeted strategy, so we remain invested fully in the mutual funds comprising the Flex portfolios.

Tactical:  what, if anything, should be done within the portfolios under various market conditions; we leave this up to the managers of each fund in the Flex portfolios.

The Flex portfolios continue to demonstrate excellent risk-management while participating very well in the markets in the near-term; they show significant out-performance in the intermediate- and long-term periods.

Below are the through-November performance numbers for the key Flex portfolios and their index fund-comprised low-cost alternatives:

US and Foreign Indexes	1 mo	3 mo	YTD	1 yr	2 yr	3 yr	5 yr	10 yr
Stock Markets (50-40-10)	1.4%	3.7%	13.9%	13.9%	7.0%	6.8%	-1.7%	7.4%
S&P 500	0.6%	1.3%	15.0%	16.1%	11.9%	11.3%	1.3%	6.4%
MSCI EAFE	2.4%	6.3%	13.6%	12.5%	3.8%	2.9%	-4.8%	7.4%
Barclays Agg Bond--US	0.2%	0.5%	4.4%	5.5%	5.5%	5.7%	6.0%	5.4%
Barclays Agg Bond--Global	0.0%	1.1%	4.7%	5.4%	5.8%	4.0%	5.5%	6.4%
Moderately Aggressive	1.2%	3.1%	11.8%	12.1%	7.1%	6.2%	-0.7%	6.4%
80 Flex IV	0.9%	2.6%	9.9%	8.7%	6.6%	7.9%	6.1%	10.0%
80 Flex III	1.0%	2.0%	9.2%	7.7%	5.3%	6.6%
80 Fidelity	1.3%	3.2%	11.9%	11.5%	6.7%	6.4%	-0.7%	6.4%
Moderate	1.0%	2.5%	9.6%	10.0%	6.5%	5.6%	0.6%	6.1%
60 Flex IV	1.0%	3.1%	11.3%	10.2%	6.9%	8.2%	6.6%	10.1%
60 Flex III	1.0%	2.3%	9.7%	8.8%	5.5%	6.7%
60 Fidelity	1.0%	2.4%	9.5%	9.5%	5.8%	5.7%	0.3%	5.8%
Moderately Conservative	0.8%	1.8%	7.4%	8.0%	6.1%	5.1%	2.0%	5.9%
40 Flex IV	1.0%	3.3%	12.0%	11.6%	7.3%	8.6%	7.4%	9.7%
40 Fidelity	0.7%	1.7%	7.5%	7.8%	5.4%	5.3%	1.8%	5.3%
Asset Allocation	Cash	Stock	Bond	Other
80 Flex IV	25%	44%	21%	10%
60 Flex IV	22%	39%	30%	9%
40 Flex IV	24%	26%	43%	7%

Flex Portfolio Performance Through October 2012

With the U.S. stock market doing relatively well for most of this year, short-term performance of Flex portfolios had been lagging thanks to their significant diversification.  The stock market has declined recently, though, and the Flex portfolios have been helpful in that time, with the short-term performance gap closing considerably.

For long-term investors, I believe the Flex portfolios remain the best way to both implement long-term strategy and maintain short-term flexibility.  Put another way, the ability provided by the Flex portfolios to have a strategic asset allocation that can make tactical adjustments is beneficial to investors.

NOTE:  Flex portfolio data shown on this blog is for the models, not for any specific client accounts, and such data is in no way a prediction or promise of any specific future performance or trends.

Here is the data through October 31, 2012:

US and Foreign Stocks	1 mo	3 mo	YTD	1 yr	2 yr	3 yr	5 yr	10 yr
Stock Markets (50-40-10)	-0.7%	4.6%	12.6%	9.6%	5.4%	8.1%	-2.4%	8.1%
S&P 500	-1.9%	3.0%	14.3%	15.2%	11.6%	13.2%	0.4%	6.9%
MSCI EAFE	0.8%	6.6%	11.0%	4.6%	0.2%	2.8%	-5.8%	7.7%
Barclays Agg Bond--US	0.2%	0.4%	4.2%	5.3%	5.1%	6.1%	6.4%	5.4%
Barclays Agg Bond--Global	-0.1%	2.0%	4.7%	3.5%	3.8%	4.8%	5.9%	6.5%
Moderately Aggressive	-0.4%	4.0%	10.9%	8.8%	5.7%	7.7%	-0.6%	7.3%
80 Flex II	-0.6%	3.7%	9.3%	6.4%	6.1%	8.8%	5.9%	11.0%
80 Flex IV	-0.6%	3.6%	9.2%	6.8%	6.3%	9.1%	6.3%	10.7%
80 Flex III	-0.9%	2.8%	8.4%	6.2%	5.1%	8.1%
80 Fidelity	-0.3%	4.2%	11.0%	9.2%	5.6%	7.9%	-0.7%	7.3%
Moderate	-0.4%	3.1%	9.1%	7.6%	5.5%	7.2%	1.2%	7.1%
60 Flex II	-0.3%	3.4%	9.7%	7.1%	5.9%	8.5%	6.6%	10.4%
60 Flex IV	-0.3%	3.9%	10.5%	8.2%	6.7%	9.4%	6.9%	10.9%
60 Flex III	-0.5%	2.7%	9.0%	6.9%	5.2%	8.0%	5.5%	9.5%
60 Fidelity	-0.2%	3.2%	9.1%	7.9%	5.3%	7.3%	0.9%	6.8%
Moderately Conservative	-0.3%	2.3%	7.2%	6.3%	5.2%	6.7%	3.0%	6.7%
40 Flex II	0.0%	3.2%	10.0%	7.8%	5.8%	8.2%	7.3%	9.9%
40 Flex IV	0.0%	3.8%	11.2%	9.4%	6.9%	9.5%	7.7%
40 Flex III	-0.1%	2.7%	9.5%	7.7%	5.3%	7.9%
40 Fidelity	-0.1%	2.2%	7.4%	6.8%	5.2%	6.8%	2.6%	6.3%
Asset Allocation	Cash	Stock	Bond	Other
80 Flex II	22%	52%	15%	11%
80 Flex IV	26%	45%	20%	9%
60 Flex II	26%	39%	27%	8%
60 Flex IV	23%	39%	30%	8%
40 Flex II	30%	26%	38%	6%
40 Flex IV	25%	26%	43%	6%