Archives for March 2012

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Choosing Funds: Low Costs or High Past Performance?

A reader writes in to ask,

“I’ve been doing lots of reading about investing, and things I’ve read suggest using index funds. I understand why I would want to use a fund with low costs, but I’m having a hard time getting on board with the idea of prioritizing low costs over high past performance. What’s the reasoning there?”

It’s certainly counterintuitive to refrain from choosing the funds with the highest return records. But research has shown that, within a given category of mutual funds (e.g., large-cap growth domestic stock funds):

  1. Expense ratios are an excellent predictor of future performance, while
  2. Past performance is not particularly useful as a predictor (with the noteworthy exception being that very poorly-performing funds typically continue to perform very poorly).

For example, in 1997, Mark Carhart performed a study of 1,892 mutual funds. Among his conclusions were that:

“Expense ratios, transaction costs, and load fees all have a direct, negative impact on performance.”

“The only significant persistence [in fund performance] not explained [by expenses, the three-factor model, and momentum] is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers.”

In other words, past performance can be useful for reliably identifying decidedly unskilled fund managers, but not for reliably identifying skilled fund managers. In contrast, fund expenses are a reliable way to select better-performing funds.

More recently, in 2010, Morningstar’s Russel Kinnel did a study to test how useful expense ratios and star ratings (which are based entirely on past performance) are as predictors of future performance. Kinnel summarized his findings:

“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. In every single time period and data point tested, low-cost funds beat high-cost funds.”

“Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.”

“Stars can be helpful, too, particularly in identifying funds that might be merged out of existence.”

In other words, we see once again that expense ratios are quite useful for predicting mutual fund success and that the primary usefulness of past performance is that it’s useful for showing which funds to be sure to avoid.

In addition to their “indices versus active” scorecards, Standard and Poors also puts out “persistence scorecards” from time to time. In the most recent one (from November 2011), they found that:

“12.23% of large-cap funds with a top-quartile ranking over the five years ending September 2006 maintained a top-quartile ranking over the next five years. Only 3.08% of mid-cap funds and 20.22% of small-cap funds maintained a top-quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.”

In other words, picking funds based on superior past performance proved to be less successful than picking randomly.

They also found that:

“While top-quartile and top-half repeat rates have been at or below the levels one expects based on chance, there is consistency in the death rate of bottom-quartile funds. Across all market cap categories, fourth-quartile funds have a much higher rate of being merged and liquidated.”

Once again, past performance does prove useful for one thing: predicting the worst choices.

The above are just a small portion of studies that have reached a similar conclusion: If you want to maximize your chance of picking an above-average fund, your best bet is to pick one with below-average costs.

Changing Bond Allocations

A reader writes in:

“Overall, I’m happy with my 50% stock, 50% fixed income allocation. I don’t fool with the equity side much at all (a Total Stock fund and an international fund at Vanguard).

But I am having a devil of a time settling on my fixed income allocation.  I carry 10% cash (in a 403b fixed account earning 3%). I like that one.  So what to do with the remainder?

I’m currently at 20% Vanguard Total Bond Market and 20% Vanguard Inflation-Protected Securities (TIPS) fund.  But I feel an urge to change it to 25% TBM and 15% TIPS.  I am concerned about the drag that TIPS may present.  And the TIPS fund is the only fund of my four that I question regularly.  I read and read about TIPS but can’t process the information to a solid conclusion.”

As I’ve said before, I don’t like using past performance figures to make estimates regarding what a given fund will earn in the future, but I do think past performance can be useful for seeing how similar/different two funds are.

For example, the following graph shows the total performance of Vanguard Total Bond Market Index Fund (blue) as compared to Vanguard’s TIPS fund (orange) over the last 10 years. As you can see, the two funds are different, but they behave fairly similarly most of the time.

Just for comparison, the next graph shows the same two funds, with Vanguard’s Total Stock Market Index Fund (green) thrown into the mix:

Now that’s a a real difference.

This is not to say that Vanguard’s Total Bond Market Fund and TIPS fund are nearly identical. They aren’t. But they’re still bond funds. And more specifically, they’re both high credit quality intermediate-term bond funds.

Asset Allocation is Not Precise

To get an idea of how a 5% shift typically affects a retirement portfolio, you may want to try out the “Retirement Nest Egg Calculator” from Vanguard. It runs Monte Carlo simulations based on historical data to show the probability of a portfolio surviving through a given length of retirement at a given withdrawal rate.

Frankly, I don’t like that they present the results as “probability that your portfolio will last for __ years.” Because that’s not true unless we assume future returns look like past returns.

But I still think it’s useful for getting a rough idea of how much difference a 5% change in allocation tends to make. And if you spend a little time using the calculator, you’ll see that the answer is usually, “very little.”

For example, for a 30-year retirement with a 4% withdrawal rate, the calculator shows a 90% success rate for a 50% stock, 40% bond, 10% cash allocation. If we bump stocks up by 5% and bonds down by 5%, the resulting success rate is…

[drum roll please]

90%. No visible difference at all.

If we set the withdrawal rate to 5% rather than 4%, the success rate for a 50% stock, 40% bond, 10% cash portfolio is 73%. If we then do the same test by bumping stocks up 5% and bonds down 5%, the success rate moves to 74% — a change of just 1%.

And these are shifts between stocks and bonds — two very different asset classes. A 5% change from one intermediate-term bond fund to another intermediate-term bond fund should make an even smaller difference.

Conclusion: Asset allocation is important. It’s worth taking the time to do some real thinking about your personal tolerance for risk and to set an allocation that’s a good match for you. But it’s generally not worth worrying about whether your results would be improved by shifting your allocation a few percent in one direction or another — especially when we’re talking about shifts within a broad asset class (e.g. stocks or bonds).

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