DEADLY TEMPTATION #4

Sleep Well at Night with Your Risk Under Control

Standard financial advice often includes a few misguided prescriptions that are intended to help control your investment risk. We’ll now explore some of these, and the reasons they’re misguided. We told you that if you hear that you must diversify among many mutual funds or ETFs and asset categories, you should tune it out. Now we will tell you why you should tune it out.

WHAT MODERN PORTFOLIO THEORY ACTUALLY SAYS ABOUT DIVERSIFICATION

The advice to be diversified comes from Nobel laureate Harry Markowitz’s 1952 paper. Markowitz, as we learned in Deadly Temptation #3, showed that if you diversify by buying a lot of stocks instead of only a few, then some of the stocks’ price fluctuations tend to cancel out, and you’ll have a portfolio that fluctuates less without reducing its expected return. As we explained before, reducing your portfolio’s fluctuations has been interpreted by the modern portfolio theory (MPT) folks as meaning the same thing as reducing your risk. It’s not really the same, though; portfolio fluctuation risk is not the risk that matters—the real risk is running out of money when you need it.

Markowitz’s efficient frontier assumed you’d get more expected return if you took more risk. Nobel laureate William F. Sharpe went further, by trying to quantify how much extra return you’d get by taking more risk (i.e., more variability of returns). But he showed that you would only get more return for that risk if you were completely diversified. If some of that variability weren’t diversified away, you wouldn’t be rewarded for it with a higher expected return.

As this theory developed, it wasn’t too long before people—theoreticians, initially—were starting to think about index funds, because they were as diversified as you could get. The common impression is that index funds were created because they are low in cost; but, in fact, they were first created because theory implied that a total market index fund was the most efficient portfolio possible. This perspective can be extended not only to stocks but to bonds, too, and even to real estate and other assets, creating a total market portfolio of all marketable assets.

There is no support in MPT for a procedure that some advisors now recommend—namely, slicing the equity market into styles such as small value, mid-cap growth, and so forth—and allocating to a fund for each style. This approach can only detract, in theory, from the efficiency of a single total equity market index fund. Moreover, as we explained in Deadly Temptation #3, it will add to the fees and transaction costs. It merely creates a perception of complexity and sophistication in a process that could be done much more simply.

There’s nothing wrong with diversification—it’s generally a good idea. What’s wrong is the way the concept can sometimes be distorted—confusing investors, complicating matters, and helping only to sell more high-priced products and services. Let’s look at some examples.

THE MUTUAL FUND DIVERSIFICATION MYTH

If you combine all stocks, you’ll eliminate the volatile movements that are characteristic of each stock alone—sometimes called that stock’s “idiosyncratic” volatility. You’ll have left only the volatile movements of the whole market. So it’s a good idea to hold a combination of all stocks.

Does it follow that it’s also a good idea to combine combinations of stocks—to combine mutual funds? No, not necessarily. It depends on what’s in those mutual funds. If they all contain the same stocks, what’s the use of combining them? You’ll still have the same basket of stocks as if you’d only bought one fund. It wouldn’t diversify you to combine several funds.

So would it help you to diversify if you bought 25 mutual funds? If you analyzed the stock holdings of most combinations of 25 equity mutual funds, they would tend to be very close to the whole equity market portfolio. Nevertheless, that’s what a lot of financial advisors recommend—25 mutual funds. They recommend it on the principle of “diversification,” as if diversification among equity mutual funds were the same thing as diversification among stocks.

Very often, if you analyze the basket of stocks held by the combination of 25 mutual funds that a specific advisor recommends—which can be done using, for example, the mutual fund evaluation company Morningstar’s “Portfolio X-Ray” program—you’ll find that what you’ve got is a total market index portfolio, but for much, much higher fees.

Why does an advisor recommend such a travesty of an index portfolio, sometimes called a “closet index” portfolio? Two reasons, one of them understandable and one very bad. First, the advisor may not realize that holding mutual funds in several classes is very similar to holding an index fund. Yet this has been the norm of the industry for years. In fact, for over three years, one of the authors of this book worked on asset allocation and manager/index/ETF selection for clients; and for a long while, he believed that he was doing the right thing for his clients.

The second reason a financial advisor might recommend multiple active mutual funds is the higher fees associated with it. Some advisors (though not those known as “fee-only” advisors) get a share of the fees paid to the funds they recommend—a kickback.

Mutual fund fees often have breakpoints at which the expense ratios go down. For example, some mutual funds charge one expense ratio for investments up to a breakpoint of perhaps $25,000, or $100,000, but a lower expense ratio for investments over the breakpoint. If an advisor recommends a large number of funds, the dollar amount in each fund may be below the breakpoint for lower fees, resulting in higher fees overall. This is one way (not a very pretty way, to say the least) to jack up the fees.

THE MYTH OF SCIENTIFIC “STYLE” OR “ASSET CLASS” DIVERSIFICATION

The “style” or “asset class” diversification myth would not be all that bad except that sometimes it provides support for the mutual fund diversification myth—and it’s also related to the myth of mathematically optimized asset allocation. The idea is that to be diversified in your equity portfolio, you have to diversify among several equity styles or asset classes with names like large growth, small growth, large value, small value, and mid-cap.

These are all subclasses of the whole set of stocks. If you buy a fund that concentrates on each of these styles, together your funds are fairly likely to approximate the whole stock market—in other words, they will add up to a closet index fund. However, the fees will be higher than if you bought only one total market index fund. Furthermore—as we explained earlier—the trading costs will be higher.

The only reason to buy a style fund would be if you wanted to “tilt” toward that style—if you believed, for example, that small-value stocks will do better than the market, so you wanted to overweight them. This is a form of active management, because it believes that a particular asset class will beat the market as a whole—usually because it beat the market in the past. But the Schwert rule suggests that there is no reason to believe such an anomaly will persist.

If, however, that’s what you believe, and you really want to follow that belief—and if you only want to “tilt” your portfolio in that direction—the best way to do that is to buy the total market index fund with most of your portfolio, then buy a small value index fund with the rest. That will overweight you in small value stocks more efficiently than distributing all your purchases among many style funds.

THE HEDGE FUND DIVERSIFICATION MYTH

One of the ways hedge funds are sold is as “diversification” for an investor’s portfolio. Hedge funds sometimes lay claim to diversification value through the very names of their funds. For example, “absolute return” is the name of a whole so-called asset class of hedge funds. Absolute return funds were meant to provide a return that wasn’t correlated with the stock market—that is, a return that wouldn’t go up when the market as a whole went up, and down when the market as a whole went down. They were supposed to provide an “absolute” return instead of a return that was “relative” to the fluctuations of the market. Their name implied the promise that they would go up in value whether the stock market went up or down.

Funny, they didn’t turn out that way. Absolute return funds were among the worst-performing hedge funds when the market as a whole plummeted during the financial crisis.¹ But they managed to get sold on their name, anyway.

Let’s take another kind of hedge fund sold as diversification. One category of hedge funds is called “long-short equity.” This was the type of hedge fund pioneered by hedge fund manager Alfred Winslow Jones, whom we will encounter in Deadly Temptation #6. In a long-short equity fund, the idea is to buy stocks you think will go up, and “short” stocks—that is, sell them—that you think will go down. If you’re right (a very, very, very big if!), you make money whether the market as a whole goes up or down.

Oddly, most long-short equity hedge funds don’t do it in equal amounts; typical is 70% long and 30% short. So they’re—on balance—“long” the market; that is, they’ll tend to fluctuate with the market. No matter: if they get the buys and sells right, the fund will do well, of course.

But there’s a big problem with the idea right out of the box. Mutual funds have shown quite clearly that professional investment managers don’t get it right. Mutual funds can only buy stocks or sell stocks that they own—they’re not allowed to short them—but as we showed in Deadly Temptation #1, they’ve proven from their record that they don’t get the buys and sells right any better than the proverbial chimpanzee throwing darts at the stock page of the Wall Street Journal.

Even though mutual fund managers can’t short stocks, if there’s a stock they don’t like, they could just not buy it and buy more of a stock they like instead. If they really knew which stocks were going to go down, they could easily beat the market that way. But they don’t. Their record of failing to beat a market index shows that they don’t know that.

So why would a long-short equity hedge fund know it if mutual funds don’t? The hedge funds’ argument is that before becoming hedge fund managers, these financial services pros were the best of the breed of mutual fund managers. They quit to start hedge funds because they have more investment freedom with unregulated hedge funds, and they’ll be paid more. Therefore, they say, because they’re the best managers and they’ll be freer to pursue their strategies, they’ll do much better than the average mutual fund manager.

But if they were previously mutual fund managers—and it’s true that many hundreds, even thousands of them have quit to start or to work for hedge funds—and if they were so good, how come they couldn’t raise the mutual fund performance average so it was at least better than the average of untrained individual investors? The argument simply doesn’t add up.

But it gets worse than that. Let’s just stipulate for a moment that maybe a long-short equity hedge fund might possibly give you a better-than-market return even after its ginormous fees. That, of course, wasn’t the sales pitch, though; the sales pitch was that it offers diversification.

If you’re getting into this hedge fund to diversify your investments, that must mean that you have other investments, too, that you want to diversify—among them equity investments. In fact, those other equity investments probably own some of those same stocks that this long-short equity hedge fund sells short.

You know, there’s a better way to do this. If one of your mutual funds (or maybe even one of your hedge funds) bought a stock, and then you invested in another fund, a hedge fund that shorts the stock, you could achieve the same objective by just not buying the stock. The effect of the diversification the hedge fund was supposed to give you is that in your combined portfolio you don’t have the stock because the buys and sells washed out. Yet you’re paying two different managers high fees, one to buy it and one to sell it.

What kind of ridiculous diversification is this? But that’s what actually happens.

THE TOTALLY MIS-SOLD TARGET-DATE FUNDS

Another effort to provide risk control, specifically to individual investors, has been offered by so-called target-date funds. At some point, target-date funds became very popular in the United States for people investing in their 401(k)s (though they might have been making a mistake investing in their 401(k)s in the first place, as we’ll point out in Deadly Temptation #5).

Target-date funds became popular because they can be used as the “default option” in a 401(k). If an employee who invests in a 401(k) has a choice of investment options but doesn’t choose one, the fund administrator can—by default—place her investments in a target-date fund. Target-date fund managers loved this because they wound up with all the investors who didn’t know what to do, which was most of them. And, of course, they charged significant fees for their target-date fund “expertise.”

Target-date funds are certainly not inherently harmful. But they suffer from the usual two problems: they don’t really do much for you, and they provide an excuse for higher fees. So let’s summarize these two points, which we’ll explain later:

Target-date fund strategies are so simple that anyone familiar with the websites of their mutual fund providers could execute the strategy on their own in a time measurable in minutes per year; so there is little reason for target-date funds to charge higher fees.

Every target-date strategy is equivalent to an even simpler constant-mix strategy; that is, a constant-mix strategy will produce the same probabilities of the same levels of wealth at a given future date, such as retirement.

The Target-Date Fund Principle

The idea of a target-date fund is that you want to take less investment risk as you age. When you’re young, you can invest in risky stuff—stocks, basically—because there will be plenty of time for things to work out. The assumption is that stocks can be very volatile in the short run, so if you invest in them for a short time period like a year or two, you could lose a lot (but you could gain a lot, too); but in the long run, their fluctuations will even out and you’ll have a high probability of gaining.

When you’re older and getting ready to retire (or maybe you’re already retired), you don’t want to take much risk. And you don’t have as long-term a time frame left to invest, so maybe stocks aren’t such a good idea anymore.

The idea of a target-date fund is very simple: invest a higher percentage in stocks when you’re young than when you’re old. One popular formula is that your asset allocation should be “100 minus your age”—that is, your allocation to stocks should be 100% minus your age, and the rest should be in bonds. For example, if you’re 30 years old, you should allocate 70% of your portfolio to stocks; if you’re 40, you should allocate 60%; and if you’re 60 years old, you should allocate only 40%.

This is awfully easy to do. If you invest in stocks by investing in only one world stock index fund, as you really should—or perhaps only one total U.S. stock index fund and one international stock index fund—and one bond fund (or one domestic and one international), you could do it yourself online, in a few minutes a year. (Well, that’s if you’ve already figured out how to navigate the funds’ website.)

As investing formulas go, this is certainly not terrible. It has the virtue of being simple. You could do it yourself easily. Marketers of target-date funds came up with a name for this formula for winding down your asset allocation—they call it the “glide path.” This creates the impression of coming in for a safe landing. It gives people the feeling that their risk is under control. It’s great for selling the funds.

There are, however, lots of other simple formulas that would be just as good and are easy to execute yourself. In fact, purveyors of target-date funds are all over the map on what strategy a target-date fund should use. Some of them wind down your allocation to stocks to almost zero when you’re 65; others wind you down only to about 60%.

The ones that did the latter got into big trouble in the financial crisis of 2007-2009. Investors who were invested in a “target-date” fund that they thought would protect them in their retirement, and who were close to retirement, and who were all nice and ready to coast down the runway of life on their glide path, suddenly saw their target-date fund lose 20% or 30% or even 40% of its value. So, after the financial crisis, a lot was written about the “failure” of target-date funds. But the failure was not of the funds—it was the failure of the marketers of the funds to make clear to investors (and to financial journalists) just what the funds’ risks were, and what the funds’ objectives were. Instead, they left investors (and journalists) with the impression that target-date funds protect you against risk when you’re almost retired. (The glide-path meme helped them do that.) After the crisis—after the fact—they backtracked to explain that significant risk taking is a good policy even when you’re at retirement age.

One Wall Street Journal article² on target date funds’ problems during the financial crisis said, “Of course, the selling point of target-date funds is their simplicity: Put your money into one fund based on when you expect to leave the work force, and the experts will take care of the rest.” Experts? What expertise? Target-date funds do the simplest thing in the world. Any idiot could do it—in a few minutes a year, as we said—but most people don’t want to be bothered. But to be led to believe they’re letting “the experts” take care of it? It’s hogwash! The trouble, of course, with believing that kind of bunk is that you allow people who present themselves as “experts” to charge you a huge bundle of money for what is, at worst, snake oil and, at best, a trivial clerical task that you could easily do yourself.

Target-Date Versus Constant-Mix Strategies

No evidence exists that a target-date strategy will ensure you of any specific level of retirement income—certainly not as well as TIPS and annuities do. In fact, the so-called target-date strategy of reducing your allocation to stocks over time, in accordance with a formula, can be shown to give exactly the same likelihood of the same results as keeping your allocation constant.

Suppose, for example, that you’re using the “100 minus your age” formula, and suppose you contribute 10% of your salary a year to your fund from age 25 to age 64. At age 25 your allocation will be 75% stocks/25% bonds. At age 26, it will be 74% stocks/26% bonds, and so forth, until at age 64, it will be 36% stocks/64% bonds. How will your results in retirement with the target-date fund compare with the results you would get if you just used a constant mix?

The answer: the results will be exactly the same. There is a constant mix (in this case 49% stocks/51% bonds) that gives you exactly the same chances of various levels of wealth accumulation at age 64 as the changing mix of the target-date fund.

For example, using reasonable assumptions, Table 3 shows the probabilities of various levels of wealth accumulation at age 65 with the target-date strategy and with an equivalent constant-mix strategy. The table shows that with both strategies, there is a 50-50 chance of accumulating at least $887,000, a 10% chance of accumulating less than about $640,000, a 1% chance of accumulating less than about $500,000, a 10% chance of accumulating more than $1,250,000, and less than a 0.1% chance of falling below $400,000.³

TABLE 3 Comparison of Probabilities of Various Levels of Wealth Accumulation at Age 65 Using Constant Mix and Target-Date Strategies

Source: Study by Michael Edesess.

In short, there’s hardly any difference between the two. So how, exactly, does the target-date fund control your long-term risk, compared to the constant-mix strategy? The answer is it doesn’t. Target-date funds neither improve nor guarantee people’s retirement lifestyles, any more than a number of other arbitrary strategies.

Of course, sellers of these funds don’t make any of that clear—and in truth, much of this may not be known to them. All they have to do is leave the impression that “the experts will take care of the rest,” as the Wall Street Journal reporter wrote. And people believe it—especially when a financial journalist, one who is not sufficiently skeptical of what he is told and doesn’t have time to investigate deeply, says it, too, and in the Wall Street Journal, no less.

The problem is that if you buy into the idea that you need an “expert” to do something for you that is so simple, and if you pay that expert 1% a year to do it, suddenly something that is just a harmless rule of thumb becomes toxic to your finances, depleting your assets by an amount—as we showed in Deadly Temptation #2—that could range from one-third to three-fourths of your investment gains.

SUMMARY OF DEADLY TEMPTATION #4

1. Diversification among many mutual funds or fund sectors is often only “closet indexing”; it is a more inefficient and costly way to diversify across stocks than a total market index fund.

2. Hedge fund diversification is in most cases a myth. Hedge funds charge extremely high fees and will often merely duplicate or cancel out other holdings in the investor’s portfolio.

3. Target-date funds follow a very simple rule of thumb that does not necessarily benefit an investor but may be comforting; it is harmful, however, if it entails higher fees. Target-date investing also offers no greater risk reduction compared with a constant-mix strategy.