Dear index buyer, you too are an active investor

The “consensus” view of personal finance right now is that we should all be index investors. It’s been well documented that active mutual fund managers have a poor track record of getting above-average returns. According to Standard & Poor’s, the S&P 500 beat 72% of active funds that invest in large companies. So, the theory goes, stick with a mutual fund that simply invests in everything and charges an extremely low fee.

But even if you’re an index investor, you do ultimately have to make choices about your asset allocation. You need to decide how much you’re going to put in a U.S. stock index fund, how much you’ll put in a U.S. bond index fund, an international index fund and on and on.

At first, financial planners and magazines like mine started making recommendations about that allocation based on readers’ ages and risk tolerance. Then “balanced” funds came along. They would let you decide on what mix of stocks and bonds you wanted based on your age or risk tolerance, and the fund manager would maintain that 50-50 (or 60-40, 70-30 etc) mix between a stock index fund and a bond index fund.

I previously wrote about my interview with Chuck de Lardemelle and Charles de Vaulx of IVA Funds. As part of my end-of-the-magazine-cycle clearing up of my desk, I listened through the interview again. De Lardemelle and de Vaulx run active funds that cross all asset classes. They can move money to cash, high yield bonds, U.S. stocks, international stocks, gold…you name it.

For a passive investor trying to build out his asset allocation, such a fund is a nightmare. If you invest in a set of mutual funds and an IVA Fund is one of your picks, you might think you have 50% of your money in stocks and 50% in bonds. But if de Lardemelle and de Vaulx decide to, they could swing the balance in one of their funds from stocks to…gold. Or, recently, to high-yield bonds.

So here’s the question: Should you decide your asset allocation or should an “expert” do it?

You can’t answer, “But I’m a passive investor! I invest based on my age and risk tolerance.” To me, allocating based on age is also an active choice. You’ve decided that in the long-term, certain historical trends will continue, making an age-based portfolio the most likely solution to get you to your goals. 50% of my savings will go into stocks today just as 50% went into stocks at the height of the tech boom and the trough of the tech bust.

I’ve seen enough evidence to convince me that most active managers are poor stock pickers. But I haven’t seen a lot of research telling me one way or the other if active managers are poor asset pickers.

Here’s what de Lardemelle said when I asked, “Since they don’t have much time to devote to thinking about investments, shouldn’t our readers just allocate a certain amount of their portfolio to each asset class and be done with it?” When reading his answer, keep in mind that he’s trying to sell his fund.

You’re right that it’s hard to pick companies to invest in internationally if you don’t spend time doing it. But if you try to do it yourself through index funds, what you’re basically doing is trying to figure out an asset allocation. And that’s not that easy either. You need a lot of data. You need a lot of experience. Usually the stuff you want to be in is the stuff that’s been forgotten by anybody and everybody.

There are few funds that have taken on that challenge of being a fund for all weather and that can shift gears from one asset class to another. Usually you have a mutual fund that does Southeast Asia, another fund that does small-cap value in the U.S. or whatever. That is I think how we differ from so many others. We can do high yield, cash, gold. There are few funds like that. I think it is a small piece of the market that’s going to grow. Basically, financial advisors themselves are looking for funds that take the burden of asset allocation off their shoulders.

Is that the right path? I’m waiting for someone to come out with an actively managed fund that only invests in index funds. “That’ll be the day,” you scoff. But is that much different than hiring a financial advisor to determine your allocation?

Update: After thinking about it for a bit longer, I guess actively managed funds of index funds do exist. Many target retirement funds or balanced funds have investment committees that tweak allocations based on what they see in the marketplace. I never thought of target-based retirement or lifestyle funds as being “active” funds before but I guess that’s not far off base.

– Joe Light


6 comments so far

  1. Bozo on

    OK, spank me. Yes, I’ve been an index hound since forever. However, back in the paleolithic era (2004), I did “take half off the table”. I put that half in a Vanguard money fund (VMMXX) and let it ride for a bit. Then, in August of 2006, I sprayed the bucks around in a ladder of CDs.

    That CD ladder, well, it’s averaging 5.45%. It will go down a tad when I have to shop a rung this August, but that’s life.

    Beat that with a stick.


  2. investwisdom on

    I bet you’re feeling pretty good about that decision. What prompted you to make that move? Was it because of something you saw happening in the stock market? Was it because you didn’t need to take as much risk to achieve your savings goal?

  3. Bozo on

    My tummy. Really, my tummy told me. I was tracking VMMXX and the Schwab counterpart, and they both levelled off. That signalled to me that interest rates were peaking. I bailed from VMMXX and went to a CD ladder.

    Nice tummy.


  4. Bozo on

    I might have mis-underestimated your question. Why did I take half off the table in 2004? In February of 2004, to be exact, I had one of those “come to (fill in the blank)” moments. My 401K was up (from its bottom) and I assumed I was too old to make up the difference if the market crashed (again). Which it did. I was just 4 1/2 years off.

    My wife still thinks I am a genius.

    She just says that so she can go shopping at Whole Foods.

    I caught on to that. She’s pretty smart, though.


    • investwisdom on

      Yeah, that’s what I meant to ask. I like hearing from investors who took a look at their portfolios, said “You know what? I have enough”, and reduced the amount of risk they took, just as you did.

      At the market peak in 2007, I bet there were some near retirees who could have moved most of their money to CD ladders or low-risk investments and still retired with 80% to 100% of their income. They didn’t make that decision because if the market kept moving up, it looked like they could retire with 120% or 140% of their income and leave a nice inheritance to the kids on top of that. Of course, now those very same people should probably keep a lot of their money in equities just to have the chance of not running out of money during retirement. It’s a difficult situation.

  5. Bozo on

    It was a two-step process, actually (our grand-daughter says “actually” when she wants something):

    1. You’ve got to posit “enough” (“actually”)

    2. When you hit the “enough” button, you take at least half off the table (let’s not get greedy, and all that)

    3. Take that “half off the table” and plunk it in really, really, truly, ever-so-truly safe stuff

    4. Remember, “safe” is not safe unless it is FDIC or NCUA insured

    5. Hit the “enough” button again.

    Wash, rinse, repeat.

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