Mutual Fund Strategists Take Different Approaches No-Brainer Approach Fits Passive Investors

Analysis paralysis can grip mutual fund investors trying to decide where to invest. Choosing among more than 5,000 funds seems so daunting to some folks that they freeze and do nothing.

To shed light on fund selection methods, three financial planners were asked to design three fund portfolios, each with a distinctly different long-run objective. A fourth portfolio, the “no-brainer,” was added for the long-term investor who doesn’t want to put a lot of effort into fund selection.

During the year, each planner will be allowed to make changes in a portfolio’s investment mix and suggest why an investor should or shouldn’t make changes in the mix.

Since these portfolios have different aims - ranging from aggressive growth through a growth-and-income combination to a pure income mix - they can’t be expected to produce similar results.

Each planner assumed the portfolio was owned by an investor with a time horizon of 10 years or longer. Each assumed the portfolio belonged to an investor in the 28-percent federal income-tax bracket.

If the portfolio were in a taxdeferred investment, such as an individual retirement account, some fund choices would have been different. For example, tax-exempt bond funds don’t belong in a tax-deferred account.

Now, on to the four portfolios.

Aggressive Growth

Roy T. Diliberto, president of RTD Financial Advisors Inc., in Philadelphia, had a specific goal in mind in selecting this portfolio: an annual return 8 percentage points over inflation.

That’s an ambitious target, since inflation has averaged about 5.7 percent a year over the past 25 years.

To own this sort of portfolio requires patience and the ability to take a roller-coaster ride without succumbing either to giddiness or gloom, Diliberto said.

This portfolio might produce anything between an annual loss of 10 percent and an annual gain of 34 percent. “While you’ll be excited if it goes up 34 percent, and upset if it does negative 10 percent, you can’t get overly excited or overly depressed,” Diliberto said.

It’s also important, he said, not to focus on the performance of any particular fund among the dozen in the mix. An investor who pours more money into the hot fund or sells out of a losing fund will destroy the diversification that Diliberto designed into the portfolio.

Diliberto’s first step was to decide a mix of assets. The goal was a portfolio that would produce the highest possible return with the lowest possible overall fluctuations. One way of reducing fluctuations is to add foreign bonds and stocks to the mix, since they historically have not moved in lockstep with the U.S. stock market.

He also wanted a mix of stockpicking “styles” in the portfolio, with some funds run by managers who use a “value” style of stock selection and some that like to buy “growth” stocks.

Diliberto looks for consistency in investment management, so he can be reasonably sure that when he picks a fund to fill a specific niche in a portfolio, it will fill that niche. He doesn’t want a fund’s manager to give up on a style just because stocks in that type of portfolio are out of favor.

He looks at a fund’s past performance, Diliberto said, but thinks it is among the least useful indicators of the fund’s future performance. The investment style, the fund’s expenses and the fund manager’s experience and consistency are more important variables, he said.

Although considerable research and thought goes into choosing a portfolio mix, Diliberto says a financial adviser’s biggest contribution is often to keep a client from changing the mix because one part of the portfolio does especially well or badly.

“It’s not difficult to buy a portfolio,” he said. “It’s difficult to keep it. I tell my clients, you’ll like me better when the market’s going up. But I’ll be worth more to you when it’s going down.”

Growth and Income

Alan J. Cohn, of Sage Financial Group in Bala Cynwyd, Pa., tried to select “an all-weather portfolio … not doing as poorly as the stock market as a whole in down markets, yet matching the stock market’s performance in up markets.”

Although Cohn expects the portfolio to grow, he also focused on protecting principal.

He said this mix of funds is appropriate for long-term investors who are still accumulating assets for retirement, and who want to accept only a moderate risk of a fall in principal.

If he’d been investing a larger sum, Cohn said, he would have added some funds to the mix but would have kept the same basic proportion of money in bonds and in domestic and foreign stocks.

Like Diliberto, Cohn prefers a mix of both “growth” and “value” stockselection styles.

He chooses funds that consistently rank among the top 25 percent of funds with a similar objective and that never finish in the bottom 25 percent.

He also looks for funds that have relatively low expenses (the average U.S. stock fund has annual expenses equal to about $13 per $1,000 of assets or 1.3 percent), so that these ongoing costs don’t eat up too much of a fund’s returns.

To keep current taxes low, Cohn likes funds that do relatively little buying and selling over the course of a typical year. The average fund sells, or turns over, in a year stocks equal to 75 percent to 90 percent of its total assets. Funds with low turnover tend to produce smaller distributions of capital gains, on which shareholders have to pay income tax even when the distribution is reinvested to buy more shares.

Cohn looks for funds whose managers have at least a five-year track record that he can judge for consistency and level of performance. And he’s leery of funds that have a sudden and large influx of money.

Income

Jack Brod, manager of personal financial services at Price Waterhouse, built a portfolio for the investor looking for high income with only moderate risk.

He could have added some stock funds to the mix in hopes of getting growth in principal, but decided to select only bond funds to maximize current income.

First he had to decide whether to use funds that invest in taxable bonds of the U.S. government and corporations or funds that invest in taxexempt bonds issued by states and local governments. For taxpayers in the 15 percent marginal tax bracket, taxable bonds usually make sense, while taxpayers in the highest brackets are almost always better off with tax-exempt municipal bonds.

But our hypothetical taxpayer is in the middle bracket of 28 percent. At times, taxpayers in the 28 percent bracket are better off buying taxable bonds. But right now, Brod said, the spread between yields on taxable bonds and tax-exempt bonds is narrow, especially for bonds with maturities of five years or more.

So he picked tax-exempt funds.

Next he spread the $25,000 among funds that invest in different maturities. This was to reduce the damage from further increases in interest rates. Higher rates reduce the market value of already-issued bonds and bond funds.

Brod put a fifth of the money in short-term bonds. He split the rest evenly between intermediate-term bonds (four to 10 years average maturity) and long-term bonds (average maturity exceeding 10 years).

He used computer software to find funds that held bonds with high credit ratings, in hopes of avoiding losses that can be caused by a city or state’s financial troubles.

He ruled out funds that charge sales commissions, or loads, and ruled out any fund with annual expenses of more than $5 per $1,000 in assets or 0.5 percent.

His final choices are from the same fund family - the Vanguard Group. When choosing among bond funds of similar average maturity and similar credit quality, expenses are the key determinant in returns to the investor, Brod said.

As the lowest-cost fund provider, he said, Vanguard has “a competitive advantage” in bond funds.

The No-brainer:

The portfolio leans heavily on index funds, which by design should do as well as, but not better than, the overall markets they mimic.

Half the portfolio is in a fund designed to match the performance of the Wilshire 5000, an index that represents the performance of more than 5,000 stocks traded on the New York and American Stock Exchanges and the Nasdaq National Market system.

Though index funds are certain never to be ranked first in performance for any period, that doesn’t mean they are mediocre. Most professionally managed funds fail to match the indexes. In four of the last 10 years, the Wilshire 5000 index beat more than two-thirds of all stock mutual funds.

Because an index fund doesn’t pay for a fund manager’s stock-picking expertise or for lots of research, and because index funds do relatively little trading of stocks, their expenses can be very low - about $2 per year per $1,000 of assets.

Index funds also tend to be tax efficient. Since they don’t do lots of trading, index funds produce low capital-gains distributions on which shareholders are taxed.

The no-brainer mix includes bonds for steady income stream. Small stakes in foreign stocks and bonds add diversification.