How to Blend Index Funds

index fundsBy David John Marotta

I don’t favor stock-picking as the best way to meet your financial goals. But even if you favor index funds, as I do, that doesn’t mean you have to use them exclusively.

You have probably heard the statistic that most actively managed funds fail to beat their indexes. Here’s why. Most mutual funds are laden with loads, fees and expenses. It is nearly impossible to recover from the drag of high expenses. This is why most mutual funds have to be sold by mutual fund salesman. They could never compete when there are funds that are just as good with half the expenses. Most funds have no hope to beat their indexes because they are gouging their investors. But be aware, there are even index funds with high fees.

However, if most actively managed funds fail to beat their index, nearly all 100% of index funds fail to beat their index. Even if an index fund tracks their index perfectly, they too have expenses and even if their expenses are as low as 0.2% then they will still under-perform the index by 0.2%.

Even if you are a die-hard believer in the efficient market hypothesis, that doesn’t mean you have to invest only in index funds. If the efficient market hypothesis is correct, then you won’t do any worse (on average) with a random collection of stocks within an index than you will by holding the index. If stock picking doesn’t matter, then you are free to pick any collection of stocks within the index that vaguely represents the index.

Some index funds perform poorly against the index not because they have high fees, but because they are trying to track the index too closely. When a stock is added to S&P 500, millions of dollars invested in S&P 500 Index funds must all buy that stock in order to track the index exactly. Stocks added to the S&P 500 do very poorly the year after this surge of automated buying. Funds that delay purchasing these stocks can perform better than those who purchase them immediately and pay a premium. Similarly, stocks that are being removed from the S&P 500 will out perform the index over the next year because all the index funds dumping the stock drive the price down needlessly. Delaying the sale of this stock until it has had a chance to recover produces superior returns.

In fairness, there are a few index funds which use these actively managed techniques to purposefully not track the index as closely as they could in order to try to beat their index. Vanguard 500 Index Fund (VFINX) uses some of these trading techniques and has beaten the S&P 500 Index over the past 3, 5, and 10 years. This past year, though, they under-performed the S&P 500 Index by 0.18%, which it just so happens is exactly their expense ratio.

Even if you believe in the efficient market hypothesis and investing in indexes, you have to ask the question “Which index?” Take for example the allocation you invest in foreign stocks. The EAFE Index is a cap-weighted index of a collection of countries that are in Europe, Australia, and the Far East, hence the initials EAFE. EAFE had a return of 27.00% over the year July 2006 through June 2007. The EAFE Index is split into EAFE Value and EAFE Growth. On average Value produces higher returns than growth, so you may want to buy some EAFE Value to provide this emphasis. Over the past year EAFE Value had a return of 28.65% vs. 27.00% for EAFE. EAFE Growth only returned 25.29% over this same time.

If you want to tilt your EAFE investment toward value, you would still want to invest the majority of your investments in the index and then add a portion in value specifically rather than just buying more EAFE Value than EAFE Growth.

The iShares EAFE (EFA) has an expense ratio of only 0.35%, while iShares EAFE Value (EFV) or Growth (EFG) have expense ratios of 0.40%. So you can reduce your expenses ratios by investing the bulk in iShares EAFE (EFA) and a portion in iShares EAFE Value (EFV) in order to keep expense ratios lower and still tilt toward value in order to boost your returns on average.

EAFE, however, does not include Canada. Many investors forget or don’t know this, so they only invest in the United States and EAFE. A more sophisticated investor would add an appropriate share of Canada, such as iShares Canada (EWC). Canada is a good investment to include in your portfolio. Canada, not China, is America’s biggest trading partner. Rich in natural resources, Canada’s oil reserves are second only to Saudi Arabia’s. In fact, Canada is the largest foreign supplier of energy to the US. Canada’s returns over the past year were 28.3% vs. 27.00% for EAFE.

You may also want to invest in the emerging market countries. These are 26 countries of the developing nations that are not part of the EAFE Index but are part of the emerging market EMU Index. This past year the EMU Index had returns of 36.63% vs. 27.00% for EAFE. The iShares has Emerging Market Index exchange traded fund (EEM) provides an easy way to invest in this index. In addition to EAFE, EMU and Canada, those countries with the most economic freedom produce superior returns. We just finished our analysis and found this collection of a dozen countries produced an average return of 34.02% over the last year vs. 27.00% for EAFE. This technique requires another dozen country specific indexes most of which can be purchased through iShares exchange traded funds.

Just as Value indexes do better than Growth indexes, so also Small Cap indexes do better than Large Cap indexes. There currently isn’t an iShares for small cap foreign, though this would also boost your returns, if it existed.

So far I have mentioned several indexes you should be investing in to provide the right mix just for your foreign investments. Even if you use all index funds, we recommend blending dozens of them in an asset allocation aimed at reducing risk and increasing returns to best meet your specific financial goals.

Rather than judging a fund solely on whether it is an index fund or not, funds should be judged by a whole set of criteria. Look for funds with low expenses, a broad collection of stocks, superior execution and low turnover.

And also, judge a fund by what index is follows most closely, does it drift outside that index, and what correlation that particular index has with other investments in your portfolio.

Building an asset allocation which is a blend of dozen indexes based on their expected risk, return, and correlation to other investments in the portfolio is what comprises the analytic analysis even for those who believe in mostly efficient markets.

David John Marotta works at Marotta Asset Management, Inc. of Charlottesville which provides fee-only financial planning and asset management.

Image courtesy of thelastminute

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