Stock-Picking Mutual Funds Still Lacking in Persistence

It is very tempting to invest in an actively-managed mutual fund that advertises above-average historical returns. Why would you bother investing in the ones with below-average returns? However, there’s something behind the whole “past performance does not guarantee future results” fine print. While there will always be funds that outperform looking backwards, that fact just doesn’t reveal very much about the future.

Index provider Standard & Poor’s publishes something called the S&P Persistence Scorecard twice a year, which examines the persistence of mutual fund performance over consecutive and overlapping time periods. By using quartiles, relative performance is compared, not absolute performance. Do the funds that had top returns in the past continue to have top returns?

The most recent December 2013 study [pdf] reaffirms the general conclusions of many other similar studies on persistence of actively-managed mutual fund performance, namely that it is often nowhere to be found when compared with random chance.

Very few funds can consistently stay at the top. Our studies show that as time horizons widen,the performance persistence of top quartile managers declines. Of the 692 funds that were in the top quartile as of September 2011, only 7.23% managed to stay in the top quartile at the end of September 2013. Similarly, 5.28% of the large-cap funds, 10.31% of the mid-cap funds and 8.15% of the small-cap funds remain in the top quartile.

For the three years ended September 2013, 19.25% of large-cap funds, 20.1% of mid-cap funds and 26.8% of small-cap funds maintained a top-half ranking over three consecutive 12-month periods. It should be noted that random expectations would suggest a rate of 25% and small-cap funds was the only category to exceed the repeat rate.

A good analogy I’ve read is that you don’t drive by only looking at your rearview mirror.

More: Barron’s, Rick Ferri/Forbes

ETF vs. Mutual Funds: Tax Efficiency, Capital Gains, and Index Funds

2013 was a great year for US stocks, and that also means that many mutual funds distributed (taxable) capital gains to their shareholders. ETFs are hot right now and there are many articles like this one which tout the tax-efficiency aspect of ETFs as to why they are superior to mutual funds.

Yes, it is true that ETFs have an inherent structural advantage over mutual funds in avoiding the production of capital gains. (I won’t explain it here, but here is one explanation.) However, the primary reason that mutual funds tend to distribute more capital gains is that most ETFs are passive and thus trade sparingly, while actively-managed funds by definition buy and sell much more frequently (what else are you paying them to do?).

But if you hold a good index fund, it will have very low turnover and thus you’ll rarely have to deal with capital gains either way. For example, both the Vanguard S&P 500 Index Fund (VFINX) and the Fidelity Spartan 500 Index Fund (FUSEX) had zero capital gains distributions in 2013 despite being up over 30% for the year.

On top of all that, at Vanguard their mutual funds and ETFs of the same name are structured as different share classes of the same basket of securities. That means the mutual funds and ETFs have exactly the same level of tax-efficiency. From the Vanguard website:

Are there tax advantages to owning Vanguard ETFs?
Because Vanguard ETFs are shares of conventional Vanguard index funds, they can take full advantage of tax-management strategies available to conventional funds and to ETFs. Conventional index funds can manage tax liabilities by selling high-cost securities to realize losses to offset realized gains. Vanguard ETFs can also limit a fund’s potential capital gains exposure by using in-kind redemptions to eliminate stocks with high built-in capital gains from the portfolio. This advantage gives our Vanguard ETFs management team more flexibility in implementing tax-management strategies.

For example in 2013, both the Vanguard Total Bond Market Index mutual fund (VBMFX) and ETF version Vanguard Total Bond Market ETF (BND) distributed a small long-term capital gain 0.076% of NAV.

Bottom line: If you hold passively-managed index funds, it really won’t matter much tax-wise if you pick ETF or mutual fund. If you hold Vanguard funds, it won’t matter at all. There are other factors like expense ratio differences or intra-day pricing availability that may sway you to either mutual fund or ETFs.

If you hold actively-managed funds, you will be less tax-efficient and that will be an additional drag on performance unless you hold them in tax-advantaged accounts.

S&P 500 Total Dividend Growth Charts


While dividend size is not the primary driver of my investment decisions, I still love seeing dividend distributions arrive in my brokerage account and consider them a critical part of my portfolio’s total return.

Eddy Elfenbein of Crossing Wall Street created the chart below, plotting both the S&P 500 index value (blue) and its dividends (red). The vertical axes are scaled 50:1, so that when they cross the dividend yield is 2%. We see that while dividends don’t always go up in the short term, they have been bouncing back and growing along with stock prices today (unlike during the dot-com boom).


If you take a step back and look at the bigger picture, has a chart showing the dividend growth for the S&P 500 on a real (inflation-adjusted) basis since 1870. While the dividend yield remains at historical lows, the total amount of dividends still appear to grow faster than inflation over longer (10+ year) periods. Note the vertical axis is on a log-scale.

Retirement Portfolio Update – Year-End 2013


Here’s a 2013 year-end update of our retirement portfolio, which includes employer 401(k) plans, self-employed retirement plans, Traditional and Roth IRAs, and taxable brokerage holdings. Cash reserves (emergency fund), college savings accounts, experimental portfolios, and day-to-day cash balances are excluded. The purpose of this portfolio is to eventually create enough income on its own to cover all daily expenses.

Target Asset Allocation

This has been mostly the same for over 6 years, although I did make some slight tweaks in my last June 2013 update.

I try to pick asset classes that are likely to provide a long-term return above inflation, as well as offer some historical tendencies to be less correlated to each other. I don’t hold commodities futures or gold because theoretically their prices should only match inflation. In addition, I am not confident in them enough to know that I will hold them through an extended period of underperformance (and if you don’t do that, there’s no point). 2013 turned out to be a tough year for both gold and commodities funds.

Our current ratio is about 70% stocks and 30% bonds within our investment strategy of buy, hold, and rebalance. With low expense ratios and low turnover, we minimize our costs in terms of paying fees, commissions, and taxes.

Actual Holdings

Here is our year-end asset allocation snapshot:

Stock Holdings (Ticker Symbol)
Vanguard Total Stock Market Fund (VTI, VTSMX, VTSAX)
Vanguard Total International Stock Market Fund (VXUS, VGTSX, VTIAX)
WisdomTree SmallCap Dividend ETF (DES)
WisdomTree Emerging Markets SmallCap Dividend ETF (DGS)
Vanguard REIT Index Fund (VNQ, VGSIX, VGSLX)

Bond Holdings
Vanguard Limited-Term Tax-Exempt Fund (VMLTX, VMLUX)
Vanguard High-Yield Tax-Exempt Fund (VWAHX, VWALX)
PIMCO Total Return Institutional* (PTTRX)
Stable Value Fund* (2.6% yield, net of fees)
iShares Barclays TIPS Bond ETF (TIP)
Individual TIPS securities
US Savings Bonds

The holdings haven’t changed through the latter half of this year, just some additional purchases of existing funds.

In terms of performance, in general stocks had a great year while bonds pretty much went nowhere or slightly down. I don’t expect everything to go up every year, not to mention my portfolio is bigger than I could have expected just a few years ago, so I can’t complain. Here are some 2013 YTD total returns for selected representative funds as of 12/27/13:

Total US VTI +33%
Total International VXUS +14%
US Small Cap Value DES +37%
Emerging Market Small Cap Value DGS -5%

Short-term Muni VMLUX +0.5%
Intermediate-term Muni VWALX -3%
Inflation-protected bonds -9%

Robinhood App: Unlimited Free Stock Trades… But Will It Work?


Is the endgame for stock commissions really free trades? Silicon Valley startup wants to try, this time in smartphone app form. Recently approved by finance regulatory agency FINRA to become a broker-dealer, this comparison chart shows their ambitious plan to offer unlimited free trades with no minimum balance requirement.

This has been tried before. Zecco stood for Zero Cost Commissions. They had no physical branches, free trades had to be placed online. They had a “lean engineering team”. They used social media. They tried to make enough money from margin interest and order flow to cover everything else. But it wasn’t enough, and they gradually had to raise commissions.

I have my theories why. If your main selling point is “free commissions”, you’re going to get a lot of inexperienced “newbie” investors. Being a broker-dealer has a lot of compliance and regulatory overhead, so together you’ll need a lot of call center workers to provide good customer service. Skilled employees cost a lot of money. (Sometimes I think it was actually efficient for Scottrade to spread these people out in physical branches.) Plus, newbies with low balances won’t generate much order flow and are unlikely to pay much margin interest.

Many free online services and apps can get away with minimal staff because they can effectively just ignore the high-maintenance customers and hope they go away. Robinhood won’t be able to do that.

I want Robinhood to succeed. I signed up on their early access waitlist (use my link and supposedly I’ll move up in line) and I’ll likely open an account to try them out. But I just don’t see where the alternative revenue will come from.

Added 12/26: Their fee schedule includes a $50 account closure fee. This is not a common fee and hopefully some public pressure will get them to remove it?

Added 1/8/14: The $50 account closure fee is no longer shown on the fee schedule.

Visualizations of Investment Performance by Asset Class 2011-2013


The blog Short Side of Long has a nice post discussing the relative performance of several different asset classes over the last few years. The charts especially caught my eye, and I went over to to make my own with the asset classes that I prefer to follow.

Here are 2013 year-to-date price charts for selected major asset classes (using representative ETFs): total US stock market (ticker VTI), total international stock market (ticker VXUS), total US bond market (ticker BND), inflation-protected US bonds (ticker TIP), and gold (ticker GLD). Dividends are not included. As mentioned earlier, 2013 was year where assets didn’t move in sync (lower correlations).

(click to enlarge)

The chart below shows the same ETFs over all of 2012. Looking back, it felt like every asset class ended positively and everything was recovering in 2012.

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Picking Municipal Bond Funds & The Importance of Low Fees


Due to a lack of tax-deferred space, my current tax bracket, and the current interest rate spread over US Treasury bonds, I started investing part of my portfolio in Vanguard’s tax-exempt municipal bond funds. As a result, I try to read every single muni bond article that Vanguard puts out. In this month’s blog post Municipal debt, Detroit, and diversification, one of the topics covered was the importance of minimizing fund fees.

Research shows that lower-cost mutual funds have tended to perform better than higher-cost funds over time. So instead of worrying about things we can’t control (e.g., how a judge in a municipal bankruptcy is going to decide a case), we should focus on controlling the one variable that we can, which is cost.

The article included the chart below, which plots the net fund expense ratios of municipal bond funds against their 5-year annualized returns.

Source: Vanguard Blog, Morningstar

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Investing Charts for 2013: Looking Beyond a Great Year For Stocks


More charts! The Atlantic has a big collection of 41 economic charts for 2013. Some are neat, some I don’t understand, and some I don’t think anyone really understands. ;) Here are two investing-related graphs that caught my eye. The first one shows that correlations between multiple asset classes have dropped significantly recently. Submitted by Joe Weisenthal of Business Insider, who states that “one of the characteristics of a crisis is extreme correlation between multiple asset classes: everything trades up or down together.”

The second one shows the cumulative investment inflows into stock and bonds funds over the last year. Submitted by Joshua Brown of The Reformed Broker, who suggests that this shows “America is regaining confidence in the institution of investing again”.

When I see low correlations, it feels like a good time to rebalance your asset allocation. At the same time, it certainly looks like stocks have some momentum right now. Perhaps it’s best just to take a long nap until 2014.

Asset Allocation Revisited: How Much International Stock Exposure For Your Portfolio?


In the post Foreign Stocks For The Long Run, author Rick Ferri recently revisited the topic of how much international stock exposure you should add to your portfolio’s asset allocation. I also have an older post about this – Choosing An Asset Allocation: Deciding On The Domestic/International Ratio – as part of my Rough Guide to Investing series.

One of the reasons to invest in international stocks is for the diversification benefit. While both have historical average returns of 8-10% annually before inflation, they don’t always move in sync (not perfectly correlated). As a result, Markowitz showed us you can attain a higher risk-adjusted return by holding some of both as opposed to just one or the other. So how much of each should you hold?

In my 2007 post, I posted this chart taken from the then-current edition of the bestseller A Random Walk Down Wall Street by Burton Malkiel. It maps the risk/return for portfolios that range from 100% US stocks to 100% EAFA (Non-US Developed countries) for the period January 1970 to June 2006:

From 1970-2006, foreign stocks outperformed US stocks, while the point of optimal risk-adjusted returns was a split of 76% US and 24% Foreign (70% is a typo).

However, the updated data collected by Ferri shows a different yet similar story (see chart below). From 1970-2013, we see that now US stocks outperformed foreign stocks instead, with the point of optimal risk-adjusted returns at 70% US and 30% Foreign.

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Howard Marks Oaktree Client Memo, November 2013

Howard Marks is famous among many investors for his Client Memos as the chairman and cofounder of Oaktree Capital Management. He even weaved many of the older ones into a book, which I read and reviewed. I now try to read every one that comes out. Here’s the most recent client memo dated November 26th, 2013 [pdf]. Below are a few selected excerpts. First, a quick lesson on risk aversion:

Risk aversion is the essential element in sane markets. People are supposed to prefer safety over uncertainty, all other things being equal. When investors are sufficiently risk averse, they’ll (a) approach risky investments with caution and skepticism, (b) perform thorough due diligence, incorporating conservative assumptions, and (c) demand healthy incremental return as compensation for accepting incremental risk. This sort of behavior makes the market a relatively safe place.

In short, it’s my belief that when investors take on added risks – whether because of increased optimism or because they’re coerced to do so (as now) – they often forget to apply the caution they should. That’s bad for them. But if we’re not cognizant of the implications, it can also be bad for the rest of us.

What about now? Marks does see an increase in risk tolerance recently. But how bad is it?

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Blog Flashback: 5 Years Ago, S&P 500 at 750


How time flies. Almost exactly 5 years ago on November 21st, 2008, I was sitting alone in yet another hotel on a business trip in a city that I can’t even remember. CNN was on TV as I wrote the following in a blog post with the title S&P 500 at 750:

While the present looks bleak, the potential for future returns is looking brighter and brighter for long-term investors. The opposite was true a few years ago. If you’re young and still putting money away, this is a good thing! (Although adequate emergency funds should be your first goal.)

Here are selected comments on that post that I admit gave me some doubt:

However, EPS estimates, and therefore valuations, are ridiculously high.

Putting money into a market that represents the old model right now seems like pure folly.

This bear market will last 3-12 years!

I think it’s funny that many of you are down 50% and think that you will break even in a few years, or justify by saying “I’m for the long term”. [...] Also, most of the dividends being advertised are based on fantasy (again), just like the EPS, because companies will be cutting them a lot to survive. So no, the S&P isn’t cheap to buy and buy-and-hold is really dead.

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Unexpected and Wise Advice From Financial Advisor Ann Kaplan

I’d never heard of Circle Financial or Ann Kaplan before reading this Businessweek interview, but I found myself bookmarking it for later as she gives a lot of unexpected advice that you usually don’t hear from a financial advisor. For example, let’s take “What’s the biggest financial mistake people make?“. I would say that the majority of advisors would focus on some part of investing as that is how they justify their fees. Something like “they should manage risk better, like I do with my smart-alpha-low-beta asset allocation system”. Instead, Kaplan’s response focuses on spending and priorities (emphasis mine):

The biggest mistake isn’t bad investment choices, it’s overspending. Most people are very surprised when they analyze their spending to discover that a lot of it doesn’t reflect their priorities. Maybe they’re eating out a lot when their priority is travel. Most can cut one-third of their budget by eliminating things they don’t really need, whether that’s buying jewelry or theater tickets. The goal of thinking about this isn’t to encourage you to necessarily cut back but to understand that you can. That helps eliminate fear.

I agree wholeheartedly. From another 2009 Forbes article :

When we study what diminishes wealth, down markets and manager selection are not key figures,” says Kaplan. Instead, it is lack of diversification, overspending and borrowing too much. Build an effective checklist for your road to a healthy portfolio that includes planning, diversifying, monitoring investments, securing tax efficiencies and arranging for appropriate wealth transfer. “All these factors have one thing in common,” says Kaplan. “They are all things we can control.”

Even though she is a former Goldman Sachs partner (which at least to me suggests skill at ruthless profit-seeking), she focuses on the personal/social/behavioral aspect of financial advising and is known for exchanging advice in a group environment:

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