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BY WARREN BOROSON
NEWJERSEYNEWSROOM.COM
BOROSON ON MONEY
Index funds aren't perfect. One reason: Whenever word gets out that a new stock is entering the index (because, perhaps, another stock got merged away), the price of that newcomer zooms up 6 percent in the week before it makes its entrance. So index funds have to buy the new stock at a somewhat lofty price.
Besides which, many index funds are really momentum investors. They hold onto high-flying stocks until they (sometimes) crash.
Even so, Donald Humphreys, president of Voyager Wealth Management in Harrington Park, is a fan of passive investment strategies, such as index funds. A vast majority of the portfolios of his clients are invested in passive strategies, mainly Dimensional Fund Advisors (DFA) funds. Such funds, of course, mirror an asset class – like the stock market.
One reason Humphreys favors passive strategies: their low cost. They don't spend any money researching stocks; they have low trading costs because they seldom buy and sell.He pointed out that if you put $1,000 into a fund for 30 years, and get a 6.5 percent yearly return, you'll wind up with $4,983.95 – if you paid a 1 percent fee. If you paid a 3 percent fee, you'd wind up with only $2,806.79.
The average expense ratio of all U.S. funds, he went on, is 1.45 percent. The average of all index funds: 0.73 percent. As for international funds, there the expense ratio of all actively managed funds is 1.59 percent – versus a mere 0.94 percent for index funds.
Besides which, few actively managed funds beat index funds year after year – one famous exception being Warren Buffett's Berkshire Hathaway (who believes that average investors should buy index funds). In 2004, 33.2 percent of actively managed funds outperformed their most similar index fund. By 2008, only 1.4 percent of such funds (38 out of 2,619) had emerged victorious in five of those five years. And during those five years, 28.5 percent (1,043) of the actively managed funds had ceased to exist – typically because their performance was so lousy.
What's the problem? When a gifted money manager does well, he pointed out, money pours in – and to invest all that money, the manager has to buy almost everything in sight – in short, to almost turn his portfolio into an index fund.
The same discouraging results hold true for bond funds. Some 27.3 percent of bonds funds don't survive over five years. The percentage of the survivors that actually outperforms their most similar index funds over five years: 0.5 percent.
Not all index funds are alike. DFA happens to focus on small-company stocks - because, over the years, small-company stocks have done better. (One reason: They have more room to grow.) DFA also focuses on "value" stocks, those that seem to be bargains, based on their low price-earnings ratios. Humphreys warned, however, "small cap and value stocks are still subject to extended periods of underperformance."
On the subject of bonds, Humphreys recommended short maturities – up to five years. If you want to take risk, he advised, do it by investing in the stock market.
Dividend-paying stocks also seem to be blessed – to do surprisingly well. Humphreys said that DFA in effect takes dividends into account by stressing value stocks, which beaten down and in some cases have higher dividend yields.
Humphreys, before founding Voyager a year ago, held executive positions at J.P. Morgan, Bear Stearns, and Merrill Lynch. He spoke last week before the Investors Club of Hobbyists Unlimited in Ridgewood.
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Question: My brother took over the handling of my father's company funds when my father died from a heart attack. A local stockbroker knows my brother and started managing the funds once dad died. As soon as the broker got the account, he announced that he was retiring at a very early age (he just turned 50) after having no previous plans of doing so.
My concern is that I know this account is by far his biggest, and is way more money than he had ever managed before.
Is there any way of finding out what type of compensation this stockbroker got from this new volume, and if that was the reason he could suddenly retire?
Answer from Scott Noyes, CFA, CFP, president of Noyes Capital Management, New Vernon:
Write a letter to the compliance officer of the brokerage firm expressing your concerns. Also, send a copy to the attorney for the company. In this post-Madoff world, there is likely to be an investigation.
Write to Warren Boroson at This e-mail address is being protected from spambots. You need JavaScript enabled to view it if you have financial questions.
