One of the more recent “innovations” (if you call even call it that) in the mutual fund industry is the “target date retirement funds”. How this works is as follows : You pick the year which you want to retire and then select the funds simply based on that. How simple. There are some pros and good points about these type of funds.

1. Set and forget - Investing in these funds is so simple and you can set and forget about it in your retirement accounts or taxable accounts.

2. Asset Allocation determined for you - How wonderful. You do not have to worry about picking large cap growth or value funds, international funds, reit fund etc. Asset allocation is done for you.

3. Rebalancing - When you manage your own portfolio, you have to periodically rebalance them when different asset classes get out of line. With a retirement target date fund, this is automatically done for you.

4. Asset allocation changes as you approach retirement date - Another great feature of such funds is that asset allocation gets more conservative as you approach you retirement date.

Despite these great features, there are a couple of things you have to be aware of.

1. Present asset allocation model may be unsuitable for your risk tolerance - If you are a very conservative investor and have 25 years to retire, chances are that you target date retirement portfolio will consist of all equity. If you have low risk tolerance, perhaps and 50% stock, 50% bond allocation is more appropriate. This in my opinion, is the biggest issue I have with target date retirement funds - which is the inconsistency of their model versus your risk tolerance.

2. This only works perfectly if retirement is your only goal - But if you have other financial goals like saving to start a new business, then such a portfolio is not suitable.

Alternative - Asset Allocation Funds - An alternative to retirement target date funds is the asset allocation funds. If you know your risk tolerance, you can then choose an asset allocation with a volatility that you can live with. There are many such funds around and I think this is a much better alternative.

Asset allocations funds essentially offer the same set and forget, automatic rebalancing features and but gives you the flexibility to choose an appropriate portfolio based on your level of risk tolerance for market fluctuations.

Asset allocation funds also have portfolios with tax-exempt bonds if you are in a high tax bracket. I have not seen such features in retirement date funds yet.

Has anyone reading this have target date retirement funds or asset allocation funds? Please share your views.

This is an account of my first stock investment. This happened way back in 1995.

The first stock I bought was Timberland - yes, the shoe Timberland. What is more important is that process which I went through to choose this stock. Truth is, there was very little process.

The first criteria that I chose was that it was a brand and a product that I understood and use. This was essentially the Peter Lynch principal. It was also a product and brand that was not frequently mentioned in the mainstream media.

I then decided to get the balance sheet and do some research. But hey, I just graduated from college and was one year into my new job and didn’t know anything about doing stock research. Still, I read the report cover to cover. I then decided to call their investor relations department and get research reports that brokerages have written on them. It took a couple of weeks for them to reach me. I read them (like just read them), kinda knew what the P/E ratio was. I also knew what the analyst ‘target price’ was and decided to take the plunge and buy some timberland.

It was sure an exhilarating feeling when you first make your first stock purchase. I went on to buy more stocks for myself. But if you’ve been reading this far, you will realize that the process is absolutely ameteurish. Yes, I knew the brand, read analyst research reports. But was enough?

I did not input their financials in a spreadsheet. I did not come up with the numbers myself. Instead, I relied on street analyst. I simply did not have any edge. I also should have asked the following questions :

1. Was Timberland’s sale seasonal

2. How was revenue recorded? When it goods are sold to retailers?

3. How did they get paid by wholesalers?

4. What was their main materials?

5. Are they hedging their material cost?

6. How much debt they had?

7. What was the rating on their debt?

8. What was the true value of the company if a private equity investor looked at it.

9. Who were their main distributors?

10. Which was their best selling models?

11. What was their new model pipeline?

These are just a few of the things that the research reports did not touch upon and on hindsight, things I should investigate before investing in a company. But I think not many of us will know how to truly investigate and do proper research on a company. And yet, there are many of people who are still ‘trading’ and ‘investing’ on their own doing haphazard research. This is the main reason why all of us should never do our own investing. We simply are not experts. And if you are, you should be working for a hedge fund and making seven figures every year!

What was the first stock you ever bought? Share your experience and comments here.

Lots of debate in the investment world centers around the idea of whether indexing is superior to active management. However, the truth, like most things in life is a clear black or white situation. The are benefits to both styles of investing. Rather than argue for or against either one, the most sophisticated money managers in the world (endowment funds, defined benefit pension plans) all use a combination of both strategies. If the people managing these funds use a combination of both active and passive investment strategies, then why is the mainstream media (including pf blogges) wasting our time arguing about this. Rather, let’s take a look a the pros and cons of both investment methods.

The case for indexing

Transparency - Index funds are easy to understand and are transparent. They

Tax Efficient - Because of the low turnover, indexing is more tax efficient.

Low Cost - Pretty Self Explanatory.

No style drift - If you invest in a value ETF or Index Fund, you can be assured that you are 100% invested in a value fund (subject to the definition of value). Contrast this in the late 90s when every value fund had “growth stocks” in them or they risked more underperformance!

Many (but not all) actively managed funds underperformed their respective indexes

Below is a table shown by Vanguard that shows the performance of funds outperformed by their respective indexes.

While indexes outperform many funds, there are certain sectors where active managers have a tougher time beating their respective index. You can see that in the value space, the MSCI value index outperformed more active managers than in blend or growth sectors.

But is this the case for just using indexes in your portfolio. Certainly not. The reason is because the best managers beat in the indexes in certain years while indexes will outperform in other years.

Advantages of Actively Managed Funds

There are Managers who consistently outperforms their Index

This one needs little explanation. In fact, in the world of instituitional investing, only managers who consistently outperform their index will even be considered by instituitional money. Many of these managers have funds that are unfortunately not available to ‘retail investors’ like us. Hence, you see the statistics that the vast majority of managers underform the broad index. In the instituitional world, only managers that outperform their indexes (style index) stay in the game. The truth is that there are many managers who consistently outperform their bench marks.

Allows Superior Risk Adjusted Returns

Studies have shown that a portfolio with identical returns with the S&P500, but with lower risk (ie volatility) will massively outperform the S&P over long periods. This is because during bear markets, portfolios with lower volatility preserve your capital better and hence coming out of a bear market, you are already ahead. An index fund does not allow the opportunity for you to seek better “risk adjusted” returns. You essentially accept market risk.

Exploit anormalies

One of indexing’s main flaw is that if every indexes, then large cap stock tends to get more overvalued. This was certainly what happened in the late 90s. Hence investing indices could result in having ‘overvalued securities’. In fact, studies have shown that overvaluation of securities persist simply because they are included in the indexes. When these securities are removed from the index, valuation returns to ‘industry average’.

Below is a study done by Vanguard on the relative performance of an all index, active managed funds and a passive combination of both active and index funds.

Analysis of Performance of Active, Index and Combination Portfolios

An analysis was done with seven possible portfolio combinations from 1981 to 2005. The total market index consisted of the Wilshire 500 index. There were three active portfolios (call them A, B, C) which were complied by Lipper with the following characteristics. The active portfolios were well diversified combinations of Lipper fund category averages in proportions that approximated the market capitalizations for the broad market. Next, we had a passive 50/50 combinations of the index with each active portfolio.

Results

Let’s see what happens when we use an all index portfolio, active portfolios and a passive 50/50 mix of both active and passive portfolios.

As you can see, a passive combination of active and index portfolio will not gave the best or worst performance in any period. But over a long period, it gives you the equivalent performance of either an all index or all actively managed account but it smoothes out the ride and lowers your volitility.

We can see now that it is pointless to argue over the merits of either strategy over the other. Both have their pros and cons. Combining them in your portfolio is something perhaps we should all consider.

But the proof that both index and active managers have a place in your portfolio can be found in what the largest pension plans are invested in. Below are two articles that will prove this point. The first one highlights the Top 200 Funds with Defined Benefit Indexed Assets. Also check out the growth of index securities among Defined Benefit Plans. These are taken from Pensions and Investments website, the premier website for news on latest news on pension plans and the money management industry.

I hope this post will highlight the fact that there are both pros and cons to index and active management. However, the mainstream media and many pf bloggers tend to favor one against another. The truth is that the smartest and largest money managers in the world utilize both active and passive index strategies. It’s about time we learn from asset allocators rather than listening to “mainstream media”.

I have just enrolled in a new 401K plan. One of the important decisions I had to make was the fund to choose. Obviously, asset allocation had a big part to play in my decision. But as I looked through all the mutual funds that was available, I found myself not looking at whether the fund outperformed the index, or the fees that the fund charged. But before I explained how I chose my fund, let’s review what mainstream advice is.

Check Past Performance

Well, this really isn’t a correct headline. Past performance does not indicate future performance. But you certainly want to look at past performance because you do not want to fund to have too many negative years.

Performance Relative to the Index

If 90 something percent to active fund managers failed to beat the index, the theory goes that if you choose an active manager, he or she better outperform the index. Otherwise, just buy the index? Well, for reasons I’ll explain below, this argument has major flaws in it that too few people bother to discuss. This relates to the fact that an index may be “overvalued”.

Fees

Pretty self explanatory. Fees have to be reasonable and not outrages.

Method of choosing investments

I paid close attention this. The reason for this was my experience with most of my funds from 2001 to 2002, when the major market indices as well as most mutual funds suffered massive negative performance for a couple of years.

I tossed out funds that chose “stocks that showed potential for capital appreciation or growth”. I seriously considered on funds that bought “cheap stocks that were perceived to be undervalued by the market”. Reason for this, as I’ll explain later relates to my experience during the last bear market.

How I chose my fund?

Well, let’s get to how I chose my fund. Firstly, this is what I did not bother to check.

1. I did not bother about beating the index. Why? Simply because I want fund managers not to overpay for stocks. I want to buy cheap and safe stocks because only by having a disciplined approach in buying can you minimize your “permanent loss of capital risk”. This is the type of risk that hardly anyone talks about. Most mainstream articles and financial talk about volatility risk. But there are other risk to consider as well.

2. I did not bother about fees. Because I am not bothered about beating the index, but more about making sure the fund manager only buys stocks at an appropriate discount to where he thinks their value should be, I believe in paying a manager to buy only cheap stocks to minimize the risk of a permanent loss of capital.

3. I did look at past performance. But like I said earlier, I did not look at whether the fund outperformed the index. I looked at how the fund did during 2001 and 2002. This was the period when the S&P had negative returns and most funds had negative returns too. It did not matter to me if the funds “outperformed the market”! A negative return is a negative return.

Why Did I place so much emphasize on returns during the last Bear Market?

It is simply because it tells me how the manager chooses his investments and stocks. It tells me that the manager does not “overpay” for stocks even for “good long term holdings”. Bear in mind that fund managers who had postitive returns in 2001 and 2002 probably “underperformed the market” in the previous years of the technology boom. But they had the discipline of not “joining the crowd”.

But I do not care less if they underperformed the market in the 90s as long they had decent positive returns. Even Warren Buffet underperformed the market in the late 90s. There were articles in the press questioning if “he had lost it!”. It was simply the case that he did not join the hype and buy “overvalued stocks”. In my opinion, any fund manager that outperformed the index in the late nineties ought to be fired because they bought expensive stocks and were counting on another “fool paying a higher price”.

So at the end, I ended up choosing Dodge and Cox Balanced Fund. Their worst year in 2000 was down 2%, better than those who were down 25% or so, but still “outperformed the index”!. Another fund that I have been watching is Marty Whitman’s Third Avenue Fund, which is now unfortunately closed to new investors.