It is a myth that people saving for life purposes need actively managed funds to comfortably reach their financial goals. In fact, it can be argued that actively managed funds significantly slow progress and reduce their lifestyles, both now and later, compared to efficient portfolios.
Technically defined, an efficient portfolio delivers the highest return for a given amount of risk. Think of risk as the volatility of the portfolio, but more specifically, the chance of losing money at any given point in time.
Risk and volatility have both practical and theoretical applications. We are hardwired to understand the practical. When we see our investments decline, we may get concerned. But when they are down by what we consider a lot, we become vulnerable to emotional or behavioral mistakes, like pulling out only to miss rebounds. Efficient portfolios in this sense provide a smoother ride through inevitable market storms.
The chart below demonstrates how the indexes that represent our model portfolios performed following BREXIT announced the evening of June 23rd. The portfolios are named for their equity, or stock market exposure. Notice how flat, or relatively undisturbed the Beacon 30, 45, and 60 are compared to the all-stock DJ US Total Stock, FTSE Global, and S&P 500 indexes at the bottom. The Beacon 30 was down less .2% at the worst point, while the S&P 500, by comparison, was down 5.3% at the lowest point.
The decline of 5.3% was what everyone was reporting, but the average of the three more ‘efficient’ Beacon models 30-60* was down a mere 1% – hardly a blip on the emotional radar. As of last night’s close the average of the top three Beacon portfolios* was up .43%, while the S&P remained down .63%
Another important consideration of volatility, but a bit more theoretical, is what we call timing risk. You would have more wealth today and compounded into the future if you invested your money on June 27th rather than on June 23rd. Simply put, planning confidence rises when volatility is reduced. This fact is particularly acute when planning horizons are shorter, indicating the need for reduced equities as one approaches funding requirements for things like college, a second home, or retirement.
The chart below shows the returns of Beacon portfolios* in a number of time frames to illustrate how they deliver reasonable returns with less risk or volatility. During the past five years (recovery from the Financial Crisis) the Beacon 30 has averaged 6.3%, compared to the Beacon 99 at 10.53% and the S&P 500 at 12.57%. But include the Financial Crisis in a 10-year time-frame and the differences between risk portfolios narrows substantially. Over the past 10 years the Beacon 30 has averaged 6.12%, compared to the Beacon 99 at 6.97% and the S&P 500 at 7.31%.
And perhaps, more importantly, look at the significant emotional and timing risk of 2008 for the more equity-heavy portfolios. The S&P 500 and Beacon 99 were down 37% and 38%, respectively, while the Beacon 30, 45, and 60 were down a much more tolerable 2.6%, 10.6%, and 18.6%, respectively.
Efficiency means gaining as much of the capital markets’ returns as possible. By far the most prevalent way for individuals to access those returns is through actively managed mutual funds. Unfortunately, they are not getting their money’s worth. Studies show that over 10-year periods, more than 60% of actively managed funds fall short of market returns. Stretch that to 20 years, and the number explodes to 80% under-performers.
Taxes can be another significant efficiency leak for investors. According to a Wall Street Journal study, some notable funds last year distributed capital gains of as much as 30% of their asset values last year. That means that taxable holders of these funds were exposed to significant capital gains taxes whether they sold their shares or not. A recent study by Morningstar’s Jeffrey Ptak demonstrated that the average number of actively managed funds (tracked by Morningstar) over 10-year cycles that beat their Vanguard counterparts were just 4.3%! On average, mutual funds’ reported performance is reduced by 1% when held in taxable accounts.
One percent here one percent there, what does it matter? We took at an actual couple 55 years old, saving about $25,000 a year, with $1.4 million. Using Monte Carlo analysis we can see that at the 85th percentile of trials run (approaching the worst markets and returns) our couple will have $1.4 million less money when they are 75 years old if they lose just 1% in their returns to unnecessary taxes, expenses, and under-performance.
Lastly, the fewer moving parts in a portfolio, the more efficient it can be. We use just three exchange traded funds to build our portfolios. This elegantly simple structure facilitates low-cost rebalanceing, asset location, allocation, and tax-loss harvesting. Our domestic equity covers the entire US stock market, providing total diversification – far more than we have seen elsewhere. Complexity does not justify high fees when a simple portfolio of ETFs gets the job done as well or better. If, as virtually all credible studies indicate, efficiency is the only true controllable in the investment process, then shouldn’t that be your focus?
*Beacon model returns are simulated by using actual returns from indexes represented by the three exchange traded funds we use in our model portfolios. Actual client results are reduced by internal ETF costs which range from .05% to .15% and management fees, and will also vary by investment flows into and from their accounts. Past results are not indicative of future performance.