When building a retirement portfolio consisting of funds, investors have two basic choices: give your money to a mutual fund, pay high fees and hope they “beat the market” (called “active” investing) or buy low cost index funds or exchange traded funds (ETFs) that simply own all of the stocks or bonds in a given group (called “passive” investing).
Active investing can be 6-8 times more expensive than passive investing because pros are trying to select a few stocks within the index that will “beat” it. But when you invest in an index fund or an ETF, you basically get the exact returns of the index. Since computers (not humans) manage the stocks in an ETF, the fees are very low.
We believe active investing is a loser’s game based upon decades of statistics. But if you insist on owning actively-managed funds, how do you know that your fund managers are earning their keep? How do you know that your entire portfolio is earning it’s fair share of the market returns?
In the US, we have an obsession with the Standard & Poor’s 500 stock index or “the Dow” as a gauge. But sophisticated investors have well-diversified retirement portfolios, with small-, mid-, and large-cap U.S. stocks, international stocks, real estate, bonds, and even commodities. The S&P is only one of several indices in a well-constructed portfolio. Those who judge their portfolio’s returns just by the S&P are making a big mistake, akin to grading a salad just by the lettuce. A salad is made up of many ingredients-and so is a portfolio. You have to measure how all of the components blend together to find out if your portfolio achieved “market” returns.
Let’s look at how you should have done in 2011 which was a mediocre year in the stock market. You made or lost money depending upon what asset classes you owned. For example, your US stocks like the S&P 500, you should have been up 2%. But your foreign developed country funds including Europe and Japan should have been down about -12%. Overall bond funds should have been up about 8%, and if you were smart enough to own TIPS (Treasury Inflation Protected) bonds, you were up about 13%. Did your portfolio make enough money to compensate for the risks you took and the fees that you paid? The only way to know is to create a valid benchmark for your entire portfolio.
ETFs are great tools for building a custom benchmark for your portfolio. Use Vanguard’s VWO as a benchmark for your emerging markets funds. VWO is a basket of over 900 companies in 28 countries like China, Brazil, and India. Instead of highly trained and well-paid MBAs picking stocks and betting your money that, for example, China will do better than Brazil, Vanguard has a computer that just buys every stock in every emerging market country. There’s no guessing which country or company will do better – the fund “indexes” all countries and companies. And you’ll pay only .27% for the computer, and probably closer to 2% for the human. Last year, VWO was down (18.7%), but most emerging market mutual funds were down far more.
How did your European stocks or funds do? Vanguard’s VGK owns 450 companies representing all Europe countries (including Greece and Italy). It was down (11.46%) last year. If your international fund manager was getting stressed during the meltdown in Europe last year, chances are, he was furiously trading. Most funds were down way more than VGK, and charged you 1.5% for the privilege.
To measure your portfolio’s results with a true apples-to-apples comparison, you have to compare it with a portfolio that includes all of the indices in your portfolio. To do this, use a few basic Vanguard index ETFs:
|BND||US Treasury and Corporate bonds||7.9%|
|VNQ||US Real Estate Trusts (the largest 112 REITs)||8.6%|
|VEA||Foreign Developed (Europe, Japan, Asia)||-12.3%|
For example, if you had half of your money in US stock mutual funds and the other half in bond funds, you would average the 2011 returns of VTI and BND (about 4.5%). If your returns were better than 4.5%, then you did well. If you had 33% of your portfolio each in international, bond funds, and US funds, then add the returns above of VTI, BND and VEA and divide by 3. Voila! You should have been down (1.1%).
We’re sure that if you use this benchmarking long enough, you’ll sell all of your expensive actively managed funds and buy a portfolio for ETFs. But “seeing is believing.” Take a few minutes using our simple approach to make sure you are getting your money’s worth from the funds that you own.