The mutual fund industry keeps telling us that constant attention and skilled management is the key to our financial future. Pay here now.
It’s a comforting mantra. Too bad it isn’t true.
In theory, the trauma and upheaval of the last three years would have been the ideal time for those brilliant managers to demonstrate their magic. But they didn’t. A close look at how managed funds that invest in both stocks and bonds did compared to similar portfolios that you and I can build in our spare time at home showed that Home Brew rules. The results show, yet again, we can do well on our own, simply by being lazy, thrifty and diversified. When the time came for those attentive and well-paid managers to duck or dodge, they didn’t. More important, they did worse than passive, unchanging portfolios. Here’s how it happened.
While many pundits are saying diversification didn’t protect investors in the downturn because everything went south, a little patience shows a different result. If you had invested in the Vanguard 500 Index fund over the last three years your annualized return would have been a loss of 2.9 percent a year, even with dividend reinvestment. The return of the Vanguard Balanced Index fund, a traditional 60/40 mix of domestic stocks and bonds, however, provided a return of 1.85 percent a year over the same period— an annualized difference of 4.75 percent a year. The low-cost (try 0.25 percent a year for expenses) index fund also did better than 83 percent of its managed competitors. Not a bad start for cheap, rote investing.
If you divide all 248 of the funds Morningstar calls “moderate allocation” into two piles, the more expensive half and the less expensive half, guess which pile does better? The less expensive half. Over the last three years the funds with expense ratios under 1.12 percent returned an average annualized 1.18 percent. Funds in the more expensive pile returned only 0.06 percent. That’s quite a difference.
It gets even better if you pinch a little more. The least expensive 25 percent of these funds, those with expense ratios under 0.89 percent, provided an annualized return of 1.18 percent. The most expensive 25 percent of all funds, those with expense ratios over 1.40 percent, provided an average return of minus 0.15 percent. Year after year, the data shows that high cost management takes money out of your pocket and puts it into its pocket.
Home Brewed Portfolios
The easiest way to get low-cost diversification is to build a home-brew lazy portfolio. You can build one of my Couch Potato portfolios. You can also build one of many “lazy portfolios” offered by others. The recipes and trailing performance figures for 30 of these portfolios, all easy to build, can be found on my website.
The returns you’ll earn on these portfolios will vary from period to period. Some will be better at some times than at others. But these portfolios will generally do better than more expensive managed portfolios. You can do this even if you haven’t got the vaguest idea of what you are doing or why you are doing it. Avoid listening to crystal ball readers and you will be home-free.
Suppose, for instance, that we compare the performance of the lazy portfolios that allocate 60 to 70 percent of their assets to equities to managed fund portfolios with the same broad allocation— what Morningstar calls “moderate allocation” funds. How would you have done?
Fans of the Five Fold Couch Potato portfolio enjoyed an annualized return of 1.84 percent over the last three years, right up there with Vanguard Balanced index and Vanguard Wellington. It was also nicely ahead of the average moderate allocation fund annualized return of 0.16 percent. The Six Ways from Sunday Couch Potato portfolio returned an annualized 1.39 percent.
The best lazy portfolio return over the last three years came from the Coffeehouse Vanguard Index portfolio. Its 3.29 percent return put it well into the top 10 percent of the moderate allocation category. The odds are good that you’ll do relatively well no matter which lazy portfolio strikes your fancy. In this group of 14 portfolios, 11 beat the average return for the category. The average return for the 14 lazy portfolios, an annualized 1.44 percent, scored at the 24th percentile— better than 76 percent of the category.
Home Brew Portfolios Rule!
This table shows the rank ordered performance, by 3 year annualized return and decile, of 14 Lazy portfolios whose asset allocations match what Morningstar calls “moderate allocation” mutual funds.
|Portfolio||3 Year Annualized Return||Performance Decile|
|Coffee House Vanguard||3.29 percent||1|
|Coffee House ETF||2.62||1|
|Vanguard Balanced Index||1.85||2|
|Couch Potato Five Fold||1.84||2|
|Ultimate Buy and Hold||1.71||2|
|Aronson Family Portfolio||1.47||3|
|Avg. 12 Lazy Portfolios||1.44||3|
|Couch Potato Six Ways||1.39||3|
|Avg. of 25 Largest MA funds||1.17||3|
|Frank Armstrong Index||1.10||4|
|Avg. of all MA funds||0.16||6|
|Couch Potato Margarita||(0.16)||7|
|Andrew Tobias Lazy||(0.16)||7|
|Coffee House 3 ETF||(0.50)||7|
|Source: Morningstar data for 12/31/2010|