Post-Millennial Personal Finance

20TH CENTURY INVESTING

For most of the 20th Century, this is how people saved for their retirement (or other long-term goals such as a college fund). You took your money to an investment advisor/broker. The advisor would do some research (hopefully) to develop and maintain a portfolio of investments suitable to your situation (usually managed mutual finds).

In return for this research and maintenance, the advisor would receive commissions from the funds. Specifically whenever there was a sales charge (load), some of the load collected was kicked back to the advisor; and whenever quarterly or annual expenses were assessed as a percentage of assets held (the expense ratio) the fund manager also received a portion of that assessment. Furthermore, some advisors would charge a flat annual fee directly to the investor.

The portion of sales charges and annual expenses that did not go to the advisor, stayed with the fund to pay the fund’s own management costs. These costs included the research done by the fund to select and maintain its underlying stocks or bonds.

Sales fees are typically 5.75% of the purchase, and annual expenses vary widely, but naturally the funds that many advisors offer carry expenses amounting to 1% to 2% annually, which is on the high side.

401(k) plans take the commissioned advisor out of the loop, so sales charges are often waived and expenses drop below 1%. But for managed funds, the managers still want no less than 0.5%.

21ST CENTURY INVESTING

This is how an increasing number of investors are saving for their retirement (or other long-term goals such as a college fund). You take your money to a fiduciary investment advisor. The advisor would do some research (hopefully) to develop and maintain a portfolio of investments optimal (not merely suitable) to your situation. This research may involve the advisor accessing computerized algorithms to generate the optimal mix. Usually the advisor will come up with passively managed index funds, either in the form of mutual funds or Exchange Traded Funds (ETFs).

In return for this research and maintenance, the advisor would receive nothing from the funds. A fiduciary, by definition, cannot accept such kickbacks, neither from sales nor annual expenses. The advisor is paid only by the investor, who pays either a percentage of total assets, or an hourly fee, or perhaps a flat fee.

None of sales charges and annual expenses go to the advisor, and instgead stay with the fund to pay the fund’s own operating costs. Since the underlying stocks or bonds in an index fund are already defined, there is no research to sponsor, and the only costs are for trading the underlying investments to keep the fund in synchrony with its index.

The result is expenses are very low. The funds’ expenses themselves are often below 0.2%, and the only major expense is the advisor’s fee, typically runs between 0.7% and 1% annually.

Some enlist completely computer-based fiduciaries called robo-advisors to build their portfolios. The computer system is set up to run the same massively detailed analysis for each investor (varied according to how much time until retirement).

An ever increasing number of investors, leveraging the knowledge of the Internet, are choosing to be their own advisors. This way you’re guaranteed a fiduciary advisor, with no advisor fees. Still, the cost is some time, but it doesn’t have to be time slaving over research into mutual funds and stocks, but rather learning how to stack up index funds to align with your objectives. I happen to be one of the do-it-yourself investors. My new blog will discuss the ideas behind the decisions I make.

AUTHOR’S PERSPECTIVE

The “old” approach costed a lot. This approach was valid as it enabled many individual investors to retire with financial security, but at the same time the individual’s advisor would retire quite comfortably, not to mention extremely so for the mutual funds’ managers. But the new approach is closer to optimal, because it removes a lot of ancillary expenses.

Investments usually are not FDIC-insured, appreciation is not guaranteed, and your investments may lose value. I go further and say your investments will lose value at some time. If you lose all or part of your life savings following a decision you’ve made based on my suggestions or theories, it’s your own dumb fault for trusting some random blogger on the Internet!

This article is not really to educate you on the fundamentals, but it is mostly my perspective on selecting investments by type. My approaches are loosely based on history, but I don’t try to optimize historical returns. It is more forward-looking, and being prepared for change (which is the only thing that can be safely assumed) by diversifying within the stock market (which is hard to do).

Stock (Equity) Funds, Bond Funds

As you may already know, the suggested percentage of your portfolio in equity funds decreases as one approaches retirement, while the percentage in bond funds increases in kind. Different people have different recommendations, but the guideline I use while pre-retirement is:

% in stock = 25% + (years until retirement X 3 ), not to exceed 98%

This is based on nothing in particular; there is no study saying this is the formula that will theoretically maximize returns. I don’t actually think there is a magic formula at all. But it makes sense that persons aged 40 and under should invest completely in the stock market. It also makes sense that one who is just retiring may want to have some fraction of assets in the stock market; if that person and/or their spouse should live another 20 years, there is a comfortable time span over which assets can continue to grow in the market.

The remainder of this blog post, and mostly the entire blog itself, are focused on only the stock portion of the portfolio. Bonds are important, too, but I’ll drive myself crazy trying to concentrate on more than one topic at a time!

Fund Types and the Style Box

Morningstar popularized (invented?) the Style Box. This is a tic-tac-toe grid where from left to right, there are Value, Blend, and Growth; and from top to bottom there are Large Cap, Mid Cap, and Small Cap.

My thoughts are that the total balance in the Large Cap row should be about 4 times everything combined in the Mid Cap and Small Cap rows, or an 80-20 split favoring Large Caps.

There are sources that claim Value outperforms Growth in the long term. Personally I target a 50-50 or maybe 60-40 mixture favoring Value.

Market Sectors and Sector Funds

I like to get into sectors, mainly because in modern times, the technology sector and the financial sector dominate the market. The S&P 500 index is my “anchor” investment, and it contains stocks representing all 11 sectors, but not in an equal distribution. If they were perfectly equal, each would be 9.09%, but instead each sector has a different weighting; and again the Technology and Financial sectors have the heaviest weighting.

Do I need my portfolio to be equally weighted among sectors? The idea of equal weighting has been researched and some firms conclude that it is historically more beneficial to equalize than not. Conceptually, I lean toward these conclusions because “stocks of a sector, flock together”, as they are subject to the same market forces, as well as business-to-business interactions. And as well, if a portfolio is heavily weighted in a certain sector, that sector’s market movement makes the portfolio that much more volatile.

A perfectly equal weighting of the 11 sectors is 9.0909…% per sector. In reality, it is difficult to achieve such an allocation with that kind of precision. A reasonable target for me would be for each sector to be represented in the 7% to 10% range.

It is nearly impossible to bring tech and financials down to 7%-10%, without devoting nearly the entire portfolio to sector funds, but I can dilute them to maybe 12%-15% each by investing in other sectors. Meanwhile, I don’t try to balance the Consumer Defensive, Health, or Industrial sectors since they each come close enough to 7%-10% naturally. That leaves six sectors to target: Real Estate, Utilities, Energy, Consumer Staples, Telecommunications, and Materials. Each sector gets an additive amount, such that the overall portfolio has 7%-10% in each of these sectors.

A pitfall: Sector indices, and hence sector funds, to have individual stocks that occupy more than 20% of the sector. In a rough example, if I have 10% in a given sector which has 20% in a given stock, the result is my overall portfolio has 2% in only that stock. A sector fund may have a couple of these heavily weighted stocks, so now 4% of my portfolio is expressed in 2 stocks. This is compounded further if I’ve got 2 sectors with this same issue; now 8% of the portfolio is just 4 stocks.

The solution: Use an alternative index. Normally I look to Vanguard to provide sector funds. But the Telecommunications and Energy sector indices Vanguard uses are each dominated by a few large stocks. In these two cases, I go with iShares’ respective sector funds, which have smaller portions. Note that iShares have higher expense ratios than Vanguard funds, but this is acceptable because they are used sparingly.

Actively and Passively Managed (Indexed) Funds

There is still significant debate as to whether actively managed funds are superior to passively managed funds. Call me biased, but I identify the former as a 20th century option. These funds were profitable but they were less than optimal; the 1% expense ratio did not provide the added value of outperforming. I identify the latter, passively managed funds, as part of a 21st century approach, as these are becoming increasingly common, and feature expense ratios in the 0.1% neighborhood. I use passively managed funds exclusively.

Mutual Funds and ETFs

Equity ETFs might be thought of as indexed mutual funds in a stock’s clothing (in reality, it’s the reverse – some mutual funds are actually a single ETF in a mutual fund wrapper). ETFs trade like stocks; the same mechanics apply, including Bid Prices and Ask Prices and Limit Orders, etc.. The ability to trade any time the market is open may be convenient, but is of little relevance to the long-term investor.

The disadvantages: If an investor does not know how to trade stocks, said investor must either learn how or use a broker. Only whole shares trade, sometimes at over $100 per share. Sales take two market days to settle before the money can be used. There is an inherent loss in trading on the stock market, just due to the mechanics of Bids and Asks (and your Limit); and some use the Spread as a measure of this loss. One must also seek out ETFs with adequate trading activity (liquidity), to avoid being stuck with an ETF that nobody will buy. Avoid leveraged and inverse ETFs; they are not for the long-term investor!

Worth mentioning: A portfolio with a mix of mutual funds and ETFs can take a while to rebalance. It can take up to a week if one sells the ETFs by day, sells the mutual funds by dusk, waits for complete settlement of the ETF sales (two days), buys ETFs by day and mutual funds by night. There might be some shortcuts to the process, but it becomes a puzzle.

The advantages of ETFs lie in availabilty and expenses; they provide access to more indices than mutual funds, and they (usually) provide the lowest expense ratio available without having to meet any minimums.

After all of this, it may seem like ETFs are too complicated to use. My experience is that they are simple, but I’ll plan all my moves before proceeding. I use ETFs to access Vanguard’s sector funds. Vanguard has sector mutual funds, but each has a prohibitive $100,000 minimum. The iShares collection is offered exclusively in the form of ETFs.

Research: https://www.etf.com

Portfolio X-ray (Very Useful!)

Morningstar has a great tool for analyzing portfolios. First, morningstar wants asks for registration (bummer, I know):

https://www.morningstar.com/members/register.html?referid=A3673&HID=MKT_LNK002

Once registered, don’t create a portfolio, just go directly to Instant Xray:

https://www.morningstar.com/portfolio.html?requestUrl=/RtPort/Free/InstantXRayDEntry.aspx?dt=0.7055475

Enter the symbols and values for each investment in the portfolio, and then click Show Instant X-ray. The page that’s returned is full of information. You might want to print or take a screenshot of this, because it won’t let you save your inputs (unless you pay the subscription fee).

I look at are the Style Box (discussed above), and figure out if I need any adjustments. Again, there should be a total of 80% across the top row, and roughly a balance of value and growth in all sizes (perhaps a slight lean toward value).

Then I look at the sectors. I note which sectors are far less than the 7% to 9% target, and I adjust their proportions relative to the entire portfolio to compensate. I only try to get within a full or half percentage point; it’s too hard to hit those moving targets with any more precision than this. This year, I chose 6 sectors that were the most underrepresented, and beefed up the corresponding sector ETFs.

After making changes, I’ll go back to Morningstar and edit the amounts of each holding (if the website still remembers them). This whole process might have to be repeated a couple of times. When I’m satisfied with the Style Box and Sector balances, I’ll print out the result again.