Drop the S&P index fund for asset-class investing
(The opinions expressed here are those of the author, a columnist for Reuters.)
By John Wasik
CHICAGO (Reuters) - You can get most of what you want for your investments from off-the-shelf index funds, but you may have to dig deeper to make your portfolio more productive.
For most mainstream investors, a focus on S&P 500 index funds and a general bond market index serves them well. Yet what if you concentrated on a mixture of different asset classes instead of only picking the usual suspects in conventional index funds that hold the most popular stocks and bonds? You may be able to boost returns while insulating yourself from off years.
An "asset-class investing" approach still relies upon low-cost, passively managed funds as core vehicles, but it puts a greater focus on diversification, which could enhance returns. Giving yourself a piece of every corner of the market means investing in large-, medium- and small-sized companies in developed and emerging markets, plus a broad selection of U.S. and global bonds.
How does it differ? Take the standard approach to indexing the U.S. stock market. Most financial advisers would tell you to buy an S&P index fund, which holds the most popular stocks in the U.S. A good choice would be the SPDR S&P 500 ETF, which holds a mostly passive portfolio at an expense ratio of 0.09 percent annually.
Since many index funds hold stocks that investors have assigned the highest values to, you may not be getting the best prices on them.
What if you shifted to a value approach, and sought bargain-priced stocks?
Then you'd want to buy a fund like the DFA US Large Cap Value I fund, which has beaten the S&P 500 index by almost 4 percentage points in annualized return over the past 15 years through March 14. Charging 0.27 percent for annual expenses, the fund has top holdings like Bank of America Corp, Citigroup Inc and Chevron Corp. Over the last three years, it's posted an annualized return of nearly 16 percent through March 14.
With this approach, you may realize more upside because these companies aren't valued as highly as companies like Apple Inc and ExxonMobil Corp, which top the popularity contest for U.S. stocks at the moment and sit on top of the holdings for most big-stock index funds.
Another aspect of the asset-class approach is to spread your stock allocation across companies of all sizes throughout the world. Combining a value and small-company stake can also be potent.
Over time, the return advantage of small-cap value over the S&P 500 index is impressive.
The DFA US Small Cap Value Portfolio, for example, has outperformed the S&P index by more than 8 percentage points in annualized returns over the past 15 years. But you probably wouldn't recognize most of the holdings of this fund, which include companies like CNO Financial Group Inc and Esterline Technologies Corp. It costs 0.52 percent annually in expenses.
THE BIG PICTURE
If there is one theme in asset class investing, it's ignoring what's popular at the time - whether it's a fund or a stock - and hewing to a broad picture of the entire universe of stocks and bonds.
Assuming that the mix of funds matches your stomach for risk and can beat inflation, pulling everything together is a matter of finding the best funds in each asset class.
DFA funds, which I've cited above, are good vehicles, but are only available through advisers. You can find comparable funds within the iShares, SPDR or Vanguard Groups.
Eric Nelson of Servo Management in Oklahoma City employs asset class investing for his clients. His approach is mostly passive, but he tailors each portfolio.
Part of the strategy is holding funds that are sagging at the moment, like emerging markets or large-company value. This approach may also entail lower risk since you're not over-concentrated in the highest-priced stocks on the market.
Nelson estimates that asset-class investing has returned about 8 percent annually over the past decade, through February, compared to 6 percent for active management and 7 percent for a "tactical" strategy that bounces between hot and cold sectors.
"Asset class investing is customized to what you are trying to accomplish," Nelson says. "And there's no benefit in buying actively managed funds."
The other key element in the strategy is to be true to the kind of risk you want to take. The trade-off for investing in small companies looking for high return is that they involve more risk in the short term. That's where diversification comes in. By investing in a wide mix of stocks and bonds, Nelson's asset-class portfolio lost only 22 percent in 2008, compared to about 32 percent for active portfolios.
Making this strategy work might entail working with an adviser to set up a portfolio of low-cost passive funds or finding a pre-designed portfolio online from services such as Betterment, Wealthfront.com, folioinvesting.com. Just make sure that you have a piece of everything: Large, medium and small companies across the globe and bonds from the U.S. Treasury, corporations, and emerging markets.
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Editing by Stephen Powell)
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