Sunday, April 15, 2007

Bob Vila Would Not Invest

I suppose it was only a matter of time before I started ranting on the blog about financial matters. Last week I examined Vanguard's "lifecycle" funds, one of Lori's options for her 401k. I like these funds, but the comparable idea at Fidelity ("Freedom" funds) are just awful...the devil is in the details.

The idea of these "fund of funds" is rooted in Modern Portfolio Theory (MPT). Basically:
  • If markets are efficient, you only get paid to take risk.
  • Furthermore, you only get paid to take risk that you can't diversify away.
When you add these together, it becomes clear that the true controller of your portfolio's performance is what mix of asset classes you have, not what specific assets you have.

I am not saying that you can buy just any stock...we have to consider how diversification works. If a market is truly efficient, the expected return on any one stock should be the same as any other. (If it wasn't, smart people would buy the undervalued stock, driving its price up until the expected return matched.) If we think Coke is solid and American Home Mortgage is screwed, we should see a big difference in price that exactly equalizes their differing situations.

But that doesn't mean that investing in either one is the same. On average, they should return the same, but if you invest in only AHM there's a good chance that the company will go broke and you'll have nothing. The solution is of course to invest in both, or better yet, to invest in all stocks.

In other words, MPT says there is (to paraphrase Burton Malkiel) exactly one free lunch - diversification. We don't get paid extra to hold fewer stocks so we might as well hold a lot and cut down the fluctuations in our portfolio. (Thus what's going to matter is the ratio of stocks to bonds, not which stocks, because we should be holding them all.)

As a side note, when I told my friend Seth this, he said I was full of crap, because the highest return I could possibly get was in just one stock. This is true, sort of. The highest return I can get is in one stock, but not the highest expected value. The difference is between what will probably happen and what does happen. The problem with a concentrated portfolio (if you have one good stock idea, put all of your money into it) is that you have to know that that stock will do well. So if you're a "Mad Money" fan and believe that you can value stocks better than the market, it makes sense to concentrate. If you're an Efficient Market Theory nerd like me, you figure that your stock picks are probably average (or maybe worse than average) and therefore not worth concentrating in.


So MPT says we can trade off our risk and reward by changing what we invest in, and we should diversify whenever possible. The idea of the Lifecycle funds is pretty simple: you invest in the fund and the fund changes its ratio of assets over time to match a risk profile that's appropriate to your retirement date.

Consider the Vanguard 2040 retirement fund (VFORX). This is a retirement fund for people who still have on average 33 years in the workforce, so it's mostly invested in higher-risk, higher reward stock indices. Over time they'll start converting to bonds, lowering returns, but reducing the volatiliy of the fund. (That is, as you get closer to retirement, you'll expect to earn less, but the chances of your money being half-gone due to a market crash will go down.)

What I like about this fund is its low expenses. Mutual fund expenses are your money that the management company takes from you every year for the honor of fondling your money. How much you make is basically how much you theoretically would have made, minus what they pocketed. Costs are really tricky, because typically mutual funds do not charge you more if they make you more money. They simply charge you money all the time. Your interests and your fund's interests are not at all aligned.

I will comment more on expenses later, but there are two things to note about the Van Guard Lifecycle fund:
  • The effective fees are 0.21% and
  • It's invested entirely in index funds.

By comparison, I can only describe Fidelity's Freedom Fund 2040 (FFFFX) as a bit of a disaster.
  • The fund is made up of a who's-who list of large, expensive and poorly performing stock funds. I know this because (blushes) I was invested in these. The top holdings were available to me for my 401k at a previous employer. I'll have to rant separately about these funds.
  • There are so many stock funds that what we really have is "closet indexing". Basically, if you buy enough different stock funds, you've got so many stocks, and so littel of each one, that you basically get the average performance of the whole market. I don't believe that "Fidelity Growth and Income" is a better investment than the S&P 500 (hrm - it correlates with the market by 89% and yet earned 2% less on average every year) but even if you do think it's a good idea, it's only 10% of the Freedom Fund, so any unique value it has is being washed out by other funds.
  • The expense ratio of this fund is 0.76%. In other words, we're paying almost a percent for the honor of holding a little of each of these train-wrecks.
To be clear: I'm saying diversification is good, and it's better to have a lot of different stocks than a few. But it's better to buy, say, the Spartan Total Market Return (FSTMX) index fund, expense ratio 0.10% than to glom together a ton of underperforming equity funds, expense ratio 0.76%.

The other side of this equation is bond funds. Fidelity has very cheap index funds (the "Spartan" index funds). Now it may be that these funds are cheap because Fidelity subsidizes them. (This happened with their international fund...Fidelity actually lost money on it as way to keep the expenses down. International funds are expensive even when indexed due to high transaction costs, etc.) My logic is: I don't care why it's cheap, as long as it is cheap. In the case of Fidelity vs. Vanguard, I would say vigilance is needed to make sure that Fidelity doesn't slowly sneak expenses back up.

But when it comes to bond funds, it's a different situation. Most of Van Guard's bond funds are around 0.20% expenses, while Fidelity's cheapest ones (the "Spartan" bond funds) are 0.45% expenses. I think perhaps the buying public hasn't put 2+2 together and realized that cheap indexed bond funds represent the highest available bond returns to investors.

(Expenses matter even more for bond funds than for stock funds - the actual "risk premium" - that is, the increased returns of the bond fund over a risk-free investment is just tiny, so those expense points eat up a lot more of what you're paying for - improved returns by holding a riskier investment. In other words, it's one thing to steal a point from a 10% return, but a different prospect to steal a point from a 6% return.)

Of course, that's all moot, because like the stock section, Fidelity's life-cycle fund is not invested in index funds, but in actively managed bond funds, with expense ratios that vary from 0.45% up to 0.75%.


In summary, the devil is in the details - life-cycle-style investing represent a reasonable service to investors in principle - a way to buy portfolio asset-class management in a cost effective way, by pooling it with a huge group of people who will all retire at the same age. But the actual value of these offers depends greatly on the costs of the vehicle you use.

A little math to sum it up: assume a very crude model: add $1000 a year to your 401k for 30 years, blending from 68% stocks at the beginning to 10% stocks at the end. We'll use 10% for the stock return and 6% for bonds. (I realize these numbers are arbitrary, but if they were lower, they would only make the point more dramatic. I think there is no risk of the market returning better than 10% on average for the next 30 years.)

The total value of your 30,000 investment should be about $99,068. In a fund with 0.21% expenses, it is reduced to $95,338 - a real drag. But in a fund with 0.76% expenses it is reduced to $86,287. That's around 8% of your money! (If we model this with more depressing returns, the fees play a larger roll and eat 12% of returns.)

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