What Would You Say You 'Do' Here?

One of my favorite scenes in the movie Office Space is when Tom Smykowski is interviewed by the consultants hired to help Initech downsize. During the interview it becomes painfully obvious that his position isn't necessary. When he's finally asked point blank, “What would you say you do here?”, Tom replies, “…I have people skills! I am good at dealing with people! Can’t you understand that?!?”

As an investor it’s important to look at each of your holdings like a consultant and ask what it’s doing in your portfolio. Each investment should have a clearly identifiable role in the overall risk/return of your portfolio. This post covers some of the asset classes commonly used in portfolios to see what they might do to affect a portfolio's return potential.

The portfolio mixes discussed are for educational purposes only and are not recommendations. The portfolios are divided evenly between the investments used in each example and are rebalanced annually.

US Stocks

I tend to think of large-cap US stocks as the first building block of an investment portfolio, so that’s where I’ll start. An investment in Vanguard 500 Index (VFINX) — a mutual fund designed to track the S&P 500 index, one of the more popular benchmarks for large-cap US stocks — would have earned an annualized return of 7.66% for the 10-year period ending June 30, 2014.

The next asset class we might consider adding to our portfolio is small-cap US stocks. Although they tend to be more volatile, stocks of smaller companies have historically outperformed large-cap stocks.

One of the more cost-effective ways to add small-cap stocks to your portfolio is to use a mutual fund that invests in the entire US stock market like Vanguard Total Stock Market (VTSMX) instead of using a separate small-cap stock fund. The average annual return of Vanguard Total Stock Market was 8.31% for the 10-year period ending June 30, 2014, which is 0.65% more per year than Vanguard 500 Index.

International Stocks

Although they’ve underperformed US stocks recently, as a long-term investor it’s a good idea to consider having international stocks in your portfolio. Not only could you benefit during times when international markets outperform the US market, but you could also benefit from international investments if the dollar declines against other currencies. For this asset class I’ll use DFA Large Cap International (DFALX) which invests in large-cap stocks in developed international countries.

Moving 50% of our portfolio to DFA Large Cap International and keeping the other 50% in Vanguard Total Stock Market for large- and small-cap US stock exposure would have earned 7.80% per year from June 2004 through June 2014. Although this mix produced a lower return than Vanguard Total Stock Market by itself, splitting your portfolio evenly between these two funds did produce better results than only holding an S&P 500 index fund over the same timeframe.

Emerging Market Stocks

Emerging markets like Brazil, India, and China don’t always move in lockstep with developed markets, so adding emerging market stocks could be a great way to diversify your portfolio. For this asset class I'll use DFA Emerging Markets (DFEMX).

A portfolio with one-third in Vanguard Total Stock Market, one-third in DFA Large Cap International, and one-third in DFA Emerging Markets would have averaged 9.45% per year through June 2014. This is 1.14% more per year than Vanguard Total Stock Market and a whopping 1.79% more per year than Vanguard 500 Index!

Real Estate Investment Trusts (REITs)

Many investors consider REITs to be an important addition to a portfolio. The historical return from REITs has been similar to large-cap US stocks, but REITs offer great diversification benefits since they don't move in tandem with the overall stock market.

Moving 25% of your investment assets to Vanguard REIT Index (VGSIX) — while holding 25% in US stocks, international stocks, and emerging market stocks — would have increased our theoretical 10-year average annual return to 9.76%. That’s quite a boost over a portfolio of only large-cap US stocks!

Value Investments

The last thing I’d like to do to our hypothetical portfolio is to add separate holdings for US and international small-cap value stocks. For domestic small-cap value stocks I’ll use DFA US Small Cap Value (DFSVX) and for international small-cap value stocks I'll use DFA International Small Cap Value (DISVX).

Just like small-cap stocks offer a higher return potential than large-cap stocks, value stocks have historically outperformed the market as a whole. But in order to capture the potentially higher returns from small-cap and value stocks, you have to be patient enough to hold them for the long-term. And this can be difficult to do when other segments of the market are outperforming value stocks.

So our final theoretical portfolio is evenly divided between Vanguard Total Stock Market Index, DFA Large Cap International, DFA Emerging Markets, Vanguard REIT Index, DFA US Small Cap Value, and DFA International Small Cap Value. This mix would have generated an average annualized return of 9.91% from June 2004 through June 2014, surpassing all of the other mixes we've discussed.

You can see that each of the mutual funds in this hypothetical portfolio serves a specific purpose. They each each represent a specific asset class — or a segment of the market with higher potential return in the case of DFA US Small Cap Value — and mixing them together is a way to have something that “zigs” when other holdings “zag.”

Don’t make the mistake of thinking that you’re diversified just because you have several different holdings. Take time to review each investment you have and ask, “What would you say you do here?”

To learn more about our company - and find out how we are different from other financial advisors - call (210) 587-6433 or visit www.VannoyAdvisoryGroup.com.

Investments mentioned in this post and throughout this blog are for educational purposes only and are not recommendations. Seek investment advice from your personal financial advisor before making any investments.

Who Moved My Small-Cap Fund?

Actively-managed mutual funds have a lot of flexibility over the types of investments they hold. One problem with this flexibility is that it often leads to style drift, which is a term used to describe a gradual change in investment style within a fund. Style drift is important to understand since a change in the investment style of a single fund could change the expected risk and return of your overall portfolio.

I wasn’t concerned about style drift when I first started investing. I believed that a good active manager could outperform the market by changing investment styles as the market changed. However, after years of trial and error - and stumbling across the efficient-market hypothesis in 2005 - and realized that style matters much more than skill.*

Avoiding style drift is one of the many reasons investors select index funds over actively-managed funds. Since index funds track specific indexes, their holdings and investment strategies are completely transparent. Managers of index funds aren’t able to change the investment style since they are required to replicate the performance of the index they follow.

For example, an index fund that tracks the S&P 500 Growth Index isn’t going to start to invest in emerging market stocks because the manager thinks they look cheap relative to US stocks. Likewise, a mutual fund that tracks the MSCI World ex-USA All Cap Index isn’t going to hold US stocks. With a portfolio of index funds, you’re in control of how much exposure you have in a specific asset class. And not having to worry about style drift in your portfolio helps you keep the hot side hot, and the cool side cool.

Okay. So now that I’ve told you that you don’t have to worry about style drift in your index funds, I’m now going to explain why you have to worry about style drift in your index funds. Confused? I’ll explain.

Let’s consider US small-cap stock indexes to illustrate how an index fund might drift off course. There are several indexes that track US small-cap stocks, and each individual index has a specific set of criteria to determine what constitutes a “small-cap stock.” The stocks of companies that meet the criteria will be added to the index, and the mutual funds that track that index will be required to buy that company’s stock. In the same manner, index funds have to sell stocks that are removed from an index.

Instead of having strict breakpoints to define “small-cap”, many indexes have bands that allow the index to continue to hold a stock after it migrates out of the small-cap portion of the market. This happens when a small company continues to grow and enters the “mid-cap” area of the market. The basic idea behind bands in an index is to reduce turnover and trading costs for the mutual funds that track that index.

Certain indexes from the Center for Research in Security Prices (CRSP) use bands instead of breakpoints. (You can read more about banding and migration at the CRSP website here.) Vanguard recently changed the indexes that many of their funds follow to CRSP indexes, and this index change resulted in a style change for the Vanguard Small-Cap Index mutual fund.

The table to the left shows the percentage of stocks in the Vanguard Small-Cap Index fund that were considered large-cap (L), mid-cap (M), and small-cap (S) as of 2/28/14. At that time, only 54% of the fund’s holdings were classified as small-cap stocks.

Dimensional Fund Advisors (DFA) is another provider of index funds. Unlike Vanguard, DFA offers funds only through approved financial advisors. After years of following their research, I was recently granted access to DFA funds for myself and for clients. We’re now in the process of updating client portfolios to include DFA funds where appropriate.

The table to the right shows the holdings of the DFA US Small-Cap mutual fund as of 2/28/14. The fund held 91% of its assets in small-cap stocks, much more than the Vanguard fund that tracks the same segment of the market.

The average market cap (i.e. company size) of the two funds helps illustrates how different they are. Vanguard Small-Cap had an average market cap of $2.87 billion on 2/28/14. The market cap for the DFA fund at that time was $1.45 billion, or 49.5% smaller than the Vanguard Small-Cap fund.

So when it comes to US small-cap stock funds, my opinion is that DFA US Small-Cap is a much better option than Vanguard Small-Cap. Both are index funds, but the DFA fund keeps a much stronger exposure to small-cap stocks and their potential to outperform larger stocks over time.

*A few years ago I gave some background into my transition away from active management in a post titled “To Index, Or Not To Index: That Is The Question.”

To learn more about our company - and find out how we are different from other financial advisors - call (210) 587-6433 or visit www.VannoyAdvisoryGroup.com.

Mid-Year Financial Tips

My wife and I are huge baseball fans, and as such, the All Star Game marks the middle of summer and hence the middle of the year for us. Now that the All Star Game is over (Go National League!), it's a great time to review your finances and make midyear adjustments as needed.

Check your retirement plan contributions

If you have a retirement plan like a 401(k) or a 403(b) through your work, take time to review how much you’re contributing. Start making contributions if you haven’t started yet. And if you are contributing, make sure you're contributing enough to get the full match offered by your employer. (Repeat after me: Never turn down free money!)

The 401(k) and 403(b) contribution limit for 2011 is $16,500, or $22,000 if you're age 50 or older. This limit applies to your contribution, so your employer's match is on top of this amount.

Check your IRA contributions

Anyone with earned income is eligible to make contributions to an IRA. Contributions to a Traditional IRA are tax-deductible when made and taxable when withdrawn. Contributions to a Roth IRA aren't deductible but withdrawals are tax-free. Pairing after-tax Roth IRA contributions with pre-tax 401(k) or 403(b) contributions is a great way to balance current and future taxes.

The IRA contribution limit for 2011 is $5,000, or $6,000 if you're age 50 or older. You have until April 15, 2012 to make a contribution for 2011.

Check your portfolio allocations

The recommended mix of stocks and bonds for your portfolio will depend on things like your age, time horizon, and risk tolerance. But whatever your ideal mix is, your actual allocations will vary over time due to market fluctuations.

Rebalancing your portfolio back to your ideal allocation helps manage risk since it forces you to "sell high" (i.e. decrease exposure to investments that have gone up) and "buy low" (i.e. increase exposure to assets that have gone down).

Evaluate your estimated tax situation

Do you normally receive a large tax refund? Then you should consider changing your withholding to have less money withheld throughout the second half of the year. On the other hand, if you usually owe money at tax time, then you could increase your withholding to avoid having to write out a check to Uncle Sam next year.

Since taxes can be complicated - and penalties incredibly steep if you make mistakes - consider having a CPA or EA review your situation and make recommendations.

Start budgeting for the holidays
It’s no secret that the holiday season can strain our budgets. By starting to plan for now for the expenses associated with travel and gift giving at the end of the year you can avoid getting yourself into financial trouble. You can use www.bankrate.com to find a great high-yield savings account for your holiday savings fund.

To learn more about our company - and find out how we are different from other financial advisors - call (210) 587-6433 or visit www.VannoyAdvisoryGroup.com