Index funds are one of the lowest cost, most transparent and tax efficient methods of constructing an investment portfolio. Done properly, an index portfolio can equal the risk and return characteristics of some the best constructed institutional portfolios in existence.

One often hears that to achieve a diversified portfolio an investor should use the professional skill of a mutual fund manager for stock selection. What is rarely heard is that during any 5 year period, less than 30% of stock mutual funds beat their benchmark. That statistic does not take into account effect of survival bias. The term survival bias refers to the mutual fund industry's practice of closing or merging poor performing mutual funds into better performing mutual funds. As a result of this being done, the performance of the closed or merged funds is not reflected in the percentage of mutual funds exceeding their benchmark. It is believed that this effect tends to overstate the true percentage of funds that surpass their benchmark. Either way, a less than 30% probability that a mutual fund will out performs its benchmark is not a very comforting statistic when considering the use of mutual funds in constructing an investment portfolio. As an example, the Fidelity Magellan fund has never been able to replicate the stock picking success of Peter Lynch.

Another very important aspect of the decision process is the costs of owning a mutual fund. On the whole, mutual fund expense ratios range from as low as 0.2% (usually for index funds) to as high as 2%. The average equity mutual fund charges around 1.3%-1.5%. You'll generally pay more for specialty or international funds, which require more expertise from managers.   On top of this, there are sales loads, 12b-1 fees, the undisclosed trading costs of the fund management and distributed capital gains to be considered.

Just about every study ever done has shown no correlation between high expense ratios and high returns. This is a fact. If you want more evidence, consider this quote from the Securities and Exchange Commission's website:

"Higher expense funds do not, on average, perform better than lower expense funds."

If an investor does decide to use the expertise of mutual fund managers for stock selection , they should do so knowing that they have several hurtles to overcome: a less than a 30% probability of meeting the category bench mark, high fees, risk of investment duplication, and potential tax inefficiency.   All of these concerns are negated by the use of index funds.

How should a portfolio be diversified?

Almost everywhere you look, stock investment performance is compared to the S&P 500 Index. Investors almost universally believe that if their portfolio performs as well as this index then it is properly invested. They are mistaken. The S&P 500 index is not a true proxy for the stock market. It only represents one component of the market and that component is a blend of large capitalization U.S. stocks. To use this as an investor’s benchmark is to ignore the two of the other major capitalization weighted segments; Mid Cap and Small Cap as well as ignoring international stocks which represent more than 50% of the world’s total stock market capitalization.

What risk controls should be employed?

Many investors have learned over the last decade that the variability of investment returns on a buy and hold portfolio make it very difficult to plan for the future in any meaningful way. This begs the question: Should managed risk controls be employed in an attempt to reduce the variability of the returns? If the answer is yes, then the question becomes how.

Please contact us so that we may discuss how we can make a real difference for your future.