Searching for an optimal mix of stocks and bonds, researchers at Neuberger and Berman found that you could get most of the return of common stocks with considerably less risk by adding a healthy dose of U.S. Treasury notes. Specifically, they found that an investor would get the best risk/return tradeoff by using a 5-year Treasury note for the fixed income portion of the portfolio. The intermediate term investment was better than riskless Treasury bills or long-term Treasury bonds. The study covered the period from 1960 through 1998.
Their new study extends the investment period through the end of 2001. They note that we've had two years of losses in stocks. This has caused many investors to flee stocks in favor of bonds while other investors have remained "over-weighted in risky stocks, hoping the market will bounce back."
Robert Firth, Managing Director for the Dallas office of the money management firm, says the research is important because it helps portfolio managers convince clients they should be diversified.
"No one wants to liquidate stock holdings in a down market," he said. "And it's particularly important for us because most of our clients have significant financial assets and are trying to live off withdrawals from their portfolio. You never want to be in a position where you have to sell stocks."
He suggests that clients have at least three to five years of income in fixed income investments and points to their research--- investors are better off with a mix of equities and fixed income that captures most of the return on common stocks but reduces market risk.
So what's the best combination?
Somewhere between 50/50 and 70/30, depending on how nervous you get in market declines. A 50/50 mixture of S&P 500 and 5-year Treasury notes provided 84.5 percent of the return on stocks with only 57.5 percent of the risk. A 60/40 mixture provided 88 percent of the return with 65 percent of the risk. And a 70/30 mixture provided 91.3 percent of the return with 73.3 percent of the risk. Measuring the actual returns, the S&P 500 Index returned 11.05 percent, compounded, over the 42-year period while the 50/50, 60/40, and 70/30 portfolios returned 9.34 percent, 9.72 percent, and 10.09 percent, respectively.
Now let's take a side trip and ask some perverse questions. How did managed equity funds do during the same period? Could you have enjoyed the returns of managed money, with less risk, by indexing?
I found the answers by using Morningstar Principia Pro, the Chicago investment research firm's database and software product for financial planners. First I searched for mutual funds in operation before 1960. I found there were only 125 (things change!). Only 110 were domestic equity funds.
Then I created a portfolio with equal investments in ten of the largest and best known fund names at that time--- American Funds Investment Company of America, American Funds Washington Mutual, American Funds Growth Fund, and American Funds Fundamental Investors, Fidelity fund, MFS Massachusetts Investors, Pioneer Fund, Putnam Fund for Growth and Income, Vanguard Wellington, and Vanguard Windsor. It should be noted that most of these funds have relatively low expense ratios. Eight of the ten carry an above average rating from Morningstar.
All ten have been in the top 50 percent of their peer groups over the last 15 years. Many, particularly the American Funds, have been well into the top 25 percent of their peers over the last 15 years. (The best really long-term performer--- 1960-2001--- in the group was American Funds Washington Mutual, at 10.10 percent; the worst was American Funds Fundamental Investors, at 6.51 percent.)
This is not a randomly selected group of managed funds. Funds that didn't survive the period weren't on the list. In addition, funds with poor performance tend to be at the bottom of asset lists, not the top. When I added another ten funds with less in assets, the performance of the overall portfolio dropped to 8.63 percent, a decline of nearly 50 basis points from the largest 10 funds.
If I have done anything in this comparison, I've stacked the deck against the index fund solution.
Without considering taxes, a portfolio with equal investments in all 10 managed funds produced a 42-year return of 9.1 percent. In other words, a 100 percent commitment to managed equity funds provided a lower return than the least risky passive portfolio--- a 50/50 combination of S&P 500 Index and 5 year Treasury notes. The index portfolio provided a return of 9.34 percent, excluding any fees. Subtract 20 basis points (2 tenths of 1 percent) for low cost index funds and low risk passive investing still has a tiny edge over a portfolio of ten leading managed funds.
|Top Managed Funds versus Passive Investing: 42 Year Test|
|S&P 500 Index (100%)||10.85%*||14.85%|
|10 Managed Funds Avg.||9.10*||14.13|
|Top/Bottom Managed Fund||10.10/6.51||13.82/14.08#|
|Sources: Neuberger and Berman, Morningstar. (* 0.20 percent has been subtracted to adjust for actual cost of managing an index fund; # for last 10 years figure).|