Archives for May 2011

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Roulette ETFs For Today’s Market Conditions

Mike’s note: Since I first found my way to the Bogleheads forum, one of the members I’ve most looked up to is an anonymous writer by the name of nisiprius. He’s always impressed me with his wit and insight, so when he offered a guest post in reply to last week’s “asset allocation comes first” article, I jumped at the chance to publish it. I hope you enjoy it. 😉

Investors are taking a fresh look at roulette ETFs, which invest in bets on roulette wheels at casinos. Roulette gambling has long been used by hedge funds and university endowments, but was formerly out of reach of individual investors due to the time and cost of travel, and the difficulty of diversifying among casinos. But ETFs now provide low-cost access to this asset class.

Bram Stoker, senior analyst at Transylvania Capital Management, says “roulette spins have been shown to have low correlation with stocks, making them a powerful diversifier in a portfolio.”

It is important to understand the differences between roulette ETFs, because they don’t all work in the same way, so look under the hood before deciding which of them you need to add to your portfolio today.

Mike’s note: I’m 95% confident you’ve all figured this out by now, but just in case: This article is a satire, poking fun at (among other things) the product-focused nature of the mainstream financial media.

Index roulette ETFs, such as Roquefort’s ROQ, simply bet on red and black equally. Roquefort uses random numbers generated by a proprietary atomic decay device, and cites academic research that claims this reduces the standard deviation compared to traditional selection methods.

Roquefort also offers two chromic strategy ETFs: REDS, which always bets on red, and BLAK, which always bets on black. Stoker notes that these are riskier: “Be sure you know which color you like before investing.” Roquefort has just introduced OO, which bets on the double zero. The potential for 3500% returns is attractive, but Roquefort notes that due to volatility it may not be suitable for all investors, only for better-than-average investors like you.

Nisiprius Investments Ltd. says that its global roulette fund, WHEE, places bets in Monaco, Macau, Antigua, Baden-Baden, Moscow, and Sun City, South Africa. We talked to fund manager Blaise Pascal, who said “Why are you pestering me with all these silly questions? It’s global, what more do you need to know? Global! Global! Global! Do you hear me, global!”

Strategic Cluster Asset Modeling is a new entrant, providing two actively managed ETFs, CLUS and CLUD. CLUS follows a progressive cluster roulette gambling system, backtested with 40,000 spins. Spokesperson Mary Martingale says it could offer the possibility of a conceivable potential for steady winnings regardless of what the wheel does. CLUS is only for sophisticated investors. The minimum investment is $250,000, and you must include a photograph and three letters of recommendation with your application. CLUD, the 2X leveraged version of CLUS, has a minimum investment of $500,000 and you must send two photographs and six letters of recommendation, and the existing shareholders can blackball you. With $1.35 million assets under management, CLUD is off to a fast start, and both of its shareholders think the world of it.

What is an appropriate roulette allocation? “We are currently recommending allocations of 5-10% to all our clients,” says Stoker. “We think roulette will prove to be a valuable addition to their portfolios. We follow market trends closely, and if roulette doesn’t pan out we’ll have other hot asset classes to recommend, but what with the end of QE2, the sideways trend in the VIX, and uncertainty about the possible end of the world, our analysts think roulette is the place to be today.”

I asked Stoker whether the house percentage could cause the long-term return of roulette funds to show a long-term trend in any particular direction. He replied “Investors who limit their portfolio to assets with positive long-term returns are pathetic losers who are going to miss out. An asset may do nothing but lose money, yet improve the portfolio as a whole. Some guy once won a Nobel prize for showing how bonds help stocks. The correlations for roulette are even lower! You must not consider roulette in isolation, you must consider how it works in the portfolio as a whole.”

Which of these roulette ETFs will you add to your portfolio? Only you can answer that question. But you better add at least one of them. Today!

Vanguard Wellington: Is it a Good Fund?

As a follow-up to Monday’s post about selecting funds only after choosing an asset allocation, I received this question:

I know you prefer index funds, but what about a low-cost actively managed fund with a great track record? If it fits my asset allocation, should I have it in my portfolio?

Specifically, I’m thinking of Vanguard’s Wellington fund, which appears to consistently outperform Vanguard’s Balanced Index Fund, which has a similar asset allocation.

Using Appropriate Benchmarks

While Wellington does have a similar allocation to Vanguard’s Balanced Index Fund, they’re not precisely the same. Wellington actually should have somewhat higher (before-cost) returns than Vanguard’s Balanced Index Fund because it takes on somewhat higher risks:

  • The overall portfolio has a slightly higher stock allocation (66% rather than 60%),
  • The stock portion of the portfolio is tilted toward value stocks, and
  • The bond portion of the portfolio has significantly more credit risk: Wellington has just 6% of its bonds in Treasury/U.S. agency bonds, whereas the balanced fund has 43% in Treasury/U.S. agency bonds.

To see whether Wellington’s management has added value, it would be best to compare the fund’s results to those of an indexed portfolio with a closer-matching composition. Something like this, perhaps:

  • 54% Vanguard Value Index Fund,
  • 12% Vanguard Total International Stock Index Fund,
  • 28% Vanguard Intermediate-Term Investment Grade Fund,
  • 6% of your money market fund/account of choice

How Did Wellington Do?

How does Wellington hold up when compared to such a portfolio?

I don’t know. Because I didn’t check.

Frankly, I’m not all that curious. Checking an actively managed fund’s performance against a relevant benchmark tells you how well the fund did, but it doesn’t tell you much about how well the fund is going to do, which, of course, is what we care about.

The bottom line is that there’s just no way to know whether an actively managed fund’s returns are the result of skill or luck.

So is Wellington a Bad Choice?

I don’t use Wellington in my portfolio. But I wouldn’t say it’s a bad choice by any means. I know several very well-informed investors who use it in their own portfolios. (And I’ve read that John Bogle holds it in his own portfolio.)

Wellington’s expense ratio is just 0.22%, assuming you qualify for Admiral shares. For an actively managed fund, that’s extremely cheap–just ~0.10% higher than what you’d pay for most Vanguard index funds.

If you want to make a bet on active management, you’d be hard-pressed to find a lower-cost bet than Wellington.

Just be careful not to assume that Wellington’s past performance figures (whether absolute returns, or returns as compared to relevant benchmarks) tell you very much about how the fund is going to perform in the future.

Asset Allocation Comes First. Then Fund Selection

I received this question via email a couple days ago:

“What do you think of Vanguard’s Small-Cap Growth Index Fund? Looking on Vanguard’s site, it looks like it has had very good long-term performance (5 and 10 years), and Morningstar gives it 4 stars.

I know it’s an aggressive fund, but I’m a young investor, so I think that might be OK. What do you think?”

I liked this question because it’s a perfect example of a common investing mistake: Building a portfolio backwards by starting with investment selection.

A better way to build your portfolio is to first decide what asset allocation you want to use, then select which investments you’ll use to meet that allocation. After all, a fund can be a great fund, but have absolutely no place in your portfolio.

For example, I think Vanguard’s Inflation-Protected Securities Fund is excellent. It’s a low-maintenance, low-cost way to invest in TIPS. But I don’t use it because I don’t want an allocation to TIPS in my portfolio (because I’m not very exposed to inflation risk).

Choosing Your Asset Allocation

As we’ve discussed before, when choosing your asset allocation, the most important questions are:

  1. What portion of your portfolio do you want in stocks (as opposed to bonds or cash)?
  2. What portion of your stocks do you want to be invested in the U.S. (as opposed to internationally)?

After you have answers to those questions, you can move on to selecting investments to meet that allocation.

Or, if you want to, you can further customize your allocation in any of several ways–adding an allocation to REITs, tilting your stock holdings toward small-cap and/or value stocks, including an allocation to TIPS, etc. But you don’t have to.

Selecting Investments

After you’ve decided what allocation you want to use, it’s time to go ahead and pick funds to meet that allocation. My approach to investment selection involves just two rules:

  1. In each asset class (U.S. stocks, international stocks, bonds, etc.), select the lowest-cost option available.
  2. Use as few funds as possible.

When selecting investments, it’s important to remember to view your portfolio as a whole rather than viewing each account as a separate portfolio. By doing so, you can simplify your holdings dramatically (because you won’t need to hold multiple funds in each account), and you may be able to reduce your costs as well.

No Need to Complicate Things

There’s little point in researching a fund unless you’ve already decided that the asset class represented by the fund is one that you want to include in your portfolio. And once you have decided which asset classes you want in your portfolio (and how you want to allocate between them), the portfolio almost builds itself–just keep costs low and keep things simple.

Fixed Lifetime Annuities and Fees

I frequently write about reducing your investment-related expenses (fund expenses, brokerage commissions, etc.) as a great way to improve your expected returns.

I also write frequently about the usefulness of fixed lifetime annuities–they’re a (mostly) safe way to increase the amount you can spend from your portfolio per year.

So it’s no surprise that many readers ask questions about the fees involved in fixed lifetime annuities. For example:

  • When comparison shopping between annuity providers, how can I determine the amount of fees bundled into a given annuity?
  • Isn’t the insurance company just investing my money, taking a cut, and paying me what’s left? Shouldn’t I cut out the middleman and invest the money myself?

Don’t Bother Looking at Expenses

The answer to question #1 is easy: Don’t bother.

When selecting mutual funds, it’s important to look at expense ratios because they’re an excellent predictor of fund performance. (Lower-cost funds tend to outperform higher-cost funds.)

When selecting a fixed annuity, however, you have access to a much better predictor: the payout the insurance company promises.

In this regard, it’s much like buying an individual bond from a corporation. Rather than spending time analyzing the various expenses the company has or trying to figure out what the company will do with the money you loan them, you’d probably pay more attention to:

  • The bond’s interest rate, and
  • The credit rating of the company.

Ditto for fixed annuities. Rather than trying to reverse-engineer an annuity to determine the level of expenses baked in, I’d suggest comparison shopping on the basis of:

  • The payout each annuity provider promises, and
  • The credit rating of each annuity provider.

Important note: The above discussion does not apply to variable annuities. Variable annuities are much more like mutual funds in that it’s important to pay attention to the expenses of the underlying investments.

Should I Cut Out the Middleman?

The second question–whether an insurance company is just a middleman that can be removed in order to improve returns–is somewhat trickier.

The answer is that, yes, the annuity provider is a middleman–they’re investing annuitants’ money, taking a cut, and paying the remainder back to the annuitants.

But there’s more to it than that. The insurance company isn’t just paying each person a fraction of his/her own returns. The insurance company actually redistributes money between annuitants. Specifically, annuitants who live longer than average end up getting to spend the money of annuitants who lived shorter than average.

This redistribution is what makes annuities such a useful tool for minimizing the risk of outliving your money. And, by definition, it’s a feature that you cannot replicate on your own.

So while the insurance company most certainly is taking a cut, that doesn’t necessarily mean it’s beneficial for you to “cut out the middleman” in this case. In general, the decision comes down to the size of your portfolio relative to your expected expenses in retirement.

  • If your portfolio is large enough that you’re not at risk of running out of money in retirement, then you don’t have much need for an annuity.
  • However, if your portfolio is of a size that running out of money is a serious concern, it’s probably a good idea to consider annuitizing a portion of your portfolio.

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Index Investors Can Be Aggressive Too

From time to time, I hear people suggest that if you’re an aggressive investor you may want to use actively managed funds rather than index funds–the reason being that actively managed funds have the potential to outperform their benchmarks, whereas index funds do not.

That line of thinking is nonsense.

To back up a step: The goal of aggressive investing is not just to increase risk, but to do so in order to increase the expected return of your portfolio.

And as we’ve discussed before, if you switch from low-cost index funds to higher-cost actively managed funds, you actually reduce the expected return of your portfolio–unless, that is, you have a method for reliably picking above-average funds. (I have yet to see such a method, but I’m willing to hypothesize that somebody out there has one.)

But let’s go ahead and point out the obvious: If you have such a method, wouldn’t it make sense to use it regardless of whether or not you’re an aggressive investor?

To recap:

  • If you have a reliable method for picking top-performing active funds, you should use it.
  • If you’re like the rest of us mere mortals (and you don’t have such a method), you should stick with index funds or similarly low-cost ETFs.

It’s got nothing to do with risk tolerance.

Changes that Would Increase Your Expected Return

There are, however, some steps that aggressive investors can take that actually would increase their expected returns.

[Please understand that I’m not encouraging you to increase the level of risk in your portfolio. I’m just saying that if you were interested in doing so, there are better ways to go about it than investing in high-cost actively managed mutual funds.]

If you want to increase your portfolio’s risk and expected return, just change your asset allocation accordingly: Increase your allocation to stocks or shift your stock allocation toward particularly high-risk categories of stocks (i.e., small-cap stocks, value stocks, or emerging market stocks).

For example, the following simple portfolio would be extremely aggressive, while still having an average expense ratio of just 0.25%:

  • 50% Vanguard Small-Cap Value ETF,
  • 25% Vanguard FTSE All-World ex-US Small-Cap ETF, and
  • 25% Vanguard MSCI Emerging Markets ETF.

In short: The fact that an investor a) wants high returns and b) is willing to take on a lot of risk in the hope of achieving those returns does not suddenly make it necessary or wise to pay exorbitant costs to fund companies and/or brokerage firms.

Index Funds Work in Bull and Bear Markets

In reply to our recent discussion of index funds and management risk, I received an email that began with the following assertion:

“The problem with indexing is that it only works in bull markets. Active management will outperform when the market moves down.”

The email went on from there to make other questionable arguments, but I wanted to tackle this one because a) I hear it relatively often and b) it’s demonstrably false. (More precisely, the second part of the assertion is demonstrably false. The first part naturally depends on what exactly the writer means by “works.”)

As Nobel Prize winning economist William Sharpe pointed out twenty years ago in “The Arithmetic of Active Management,” after accounting for costs, the average passively managed dollar in a market will by definition outperform the average actively managed dollar in that market.

It Works Like This…

By definition, passive investors hold the market portfolio. That is, they hold each stock in proportion to its market value. So if, for example, Apple currently makes up 2% of the total value of the U.S. stock market, a passive investor will allocate 2% of his/her U.S. stock portfolio to Apple.

Therefore, active investors must as a group hold the market portfolio as well. That is, if one active investor has chosen to underweight Apple relative to its market valuation, that’s only possible because another active investor has chosen to overweight Apple.

Conclusion Part 1: Before considering costs, each passive investor will earn the market return (because he/she holds the market portfolio). Similarly, before considering costs, active investors will as a group earn the market return (because, as a group, they hold the market portfolio).

Conclusion Part 2: After considering costs, each passive investor will earn the market return, minus whatever they pay in investment costs (say, 0.2% for a decent index fund). And, after considering costs, active investors will as a group earn the market return, minus whatever they pay in investment costs (sales loads, brokerage commissions, actively managed fund expenses, etc.).

Conclusion Part 3: Because active investors pay significantly higher costs than passive investors, they must earn a lower average return per dollar invested.

Takeaway: For each portion of your portfolio (U.S. stocks, international stocks, bonds, etc.) if you invest in a low-cost index fund, you will outperform the average actively managed dollar for that category of investment.

It’s Mathematical Certainty

There are very few things in the field of investing that can be said with certainty. But this is one of them. It holds true in every market. And it holds true over every period of time, regardless of whether that period is a bull market or a bear market and regardless of whether that period is a day or a decade.

It doesn’t depend on market efficiency. And it doesn’t depend on active fund managers making stupid decisions. All it depends on is plain, simple math. (John Bogle calls it the “relentless rules of humble arithmetic.”)

Picking Mutual Funds

Of course, due to the sheer number of funds in existence, there will always be plenty of funds that outperform their index over any particular period. (The shorter the period, the more outperforming funds there will usually be.)

But as the Standard & Poor’s Indices Versus Active scorecards have been showing us for several years now, most actively managed funds do not manage to beat their benchmarks–even during bear markets.

And there’s an abundance of data showing that sticking with low-cost funds is a winning strategy. As Russel Kinnel (Morningstar’s Director of Mutual Fund Research) puts it, “If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. … They are still the most dependable predictor of performance.”

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