Model Indexed Account - How Are We Doing?

If you’ve been following your investments over the past five years, you might feel like a white collar boxer who suddenly found himself in the ring with a bruising welterweight champ.

But there’s a reason to be optimistic.  The welterweight’s best round was 08 and 09 and you’re still standing.

Of course, I’m referring to the beating that the stock market took in 2008/2009 and if you kept your head, and didn’t sell during the panic, you’d still be firmly on your feet today.

In September, 2006 I gave a seminar on indexed investing at Singapore American School.  I suggested that even a fifth grader could beat the vast majority of investment professionals by doing the following:

1. Creating a low cost, diversified portfolio of index funds
2. Rebalancing the account once a year

Perhaps more importantly, I suggested that they would never have to follow economic news.

All they would need to do is spend 10 minutes a year rebalancing their portfolio.

Back in 2006, I created a model portfolio for my attendees.  It was comprised of a total U.S. stock market index, a total international stock market index and a total bond market index.

Plenty of financial advice looks silly, in retrospect, years after it’s given.  But I wouldn’t have to worry about that.  Regardless of where the markets were going to go, I knew that a low cost account such as this, would beat the vast majority of professional investors over time.

First… A Peak At The Landscape Covered

The past five years have been tough. 

The five year total return of the Vanguard U.S. total stock market index was just 5.92% and the total return of Vanguard’s total international stock market index was just 2.9%.  You can see their charted progress here.  Yeah, the markets recovered from the slaughter they experienced in 2008/2009, but after the more recent drop that we experienced over the past two months, the markets have their heads barely above water.

The world’s stock markets have been bouncing like an unconscious tourist on a bungee.  But rebalancing between stocks and bonds can generate generous profits.

Actively managed balanced mutual funds can take advantage of this kind of volatility.  They keep a portion of their fund in stocks and a portion in bonds.  When stock markets bounce upwards, they can sell some of their stocks and buy bonds.  When stock markets drop, they can sell some of their bonds to buy stocks.  The people running these funds research economic news, stocks, interest rates and political news…supposedly basing their investment decisions on their findings.

So let’s have a look to see how some of America’s biggest balanced funds would have performed during the last five years, to September 20^th, 2011.

+11.3% Fidelity Balanced Fund

If you haven’t heard of Fidelity, you’ve probably been squatting in a remote tent for the past 30 years.  There’s nothing wrong with that.  You could live on a beach, access the internet once a year, and beat the backsides off most of the professional investors working at Fidelity. 

An investment, five years ago, in Fidelity’s flagship balanced fund would have increased by 11.3% during the past five years.

Do you want to know how the Johnson Family (owners of Fidelity) got so darn rich?  They didn’t invest in their own funds.  They own the fund company that reaps annual fees every year from investors.  Abigail Johnson and Edward Johnson are each independently wealthier than Steve Jobs, and they make Donald Trump look like a pauper.  Check out the Forbes 400 list of richest Americans to see for yourself.

And if you invest with Fidelity, you make the Johnsons richer.

+5.75% American Funds Balanced Fund

I have a brilliant, occasionally hot blooded friend I work with who has a MBA from Harvard.  He realizes that the fund company, known as “American Funds”, pays its sales force a 5.75% fee of what its clients’ invests. 

He’s a bit hard-core, but he suggests that salespeople taking a 5.75% cut on deposited invested money deserve to be in jail. 

Yeah…that’s a hard-core judgement, but it does make me laugh every time he says it.  Over the past five years, the American Funds Balanced Fund actually made 11.5%. 

But that doesn’t include the 5.75% sales fee that the salesperson reaps. 

Deduct that from the return, and the investor who invested money five years ago, would have made a paltry 5.75% over the past five years.

+11.8% T. Rowe Price Balanced Fund

Another one of America’s most renowned actively managed fund companies is T. Rowe Price.  Author, Louis Lowenstein, allocates much of his energy towards hammering T. Rowe Price, in his book The Investor’s Dilemma:

Investors hurt themselves by bringing to their portfolio decisions an attitude of childlike trust, even of naiveté.  Indeed, when one considers the fierce attention that consumers devote to the cost, and to the quality, of their weekly groceries or, say, to the purchase of a new washer and dryer, their nonchalance when it comes to mutual fund cost and quality is remarkable.  Perhaps, and this might be a third factor, the investors assume that TROW [T. Rowe Price] being a financial intermediary, will rise above the minimal standards of honesty that one expects from ordinary commercial enterprises (pg. 73).

Invest in T. Rowe Price if you want to make its shareholders rich.

If you invested in T. Rowe Price shares in 1990, and your friend bought shares in Apple, who do you think would be richer today? 

See the surprising chart below.  The green line represents Apple, and the blue line represents R. Rowe Price.

Splits: Jan 2, 1990 [2:1], Dec 1, 1993 [2:1], May 1, 1996 [2:1], May 1, 1998 [2:1], Jun 26, 2006 [2:1]

+11.7% Franklin Balanced Fund

A look at the Franklin Balanced Fund reveals a startling trend.  Over the past five years, the balanced funds listed above all have ranges of return between 11.3% and 11.8% (if you don’t count the gouging that the American Funds salesperson would take from their clients).

 Why are the returns so consistent?

This comes down to something called “closet indexing”.  In crude terms, these fund managers are lacking a dangling part of the male anatomy.  They are essentially shadowing the holdings within their respective indexes, and charging fees to do so.

This will prevent them from earning returns that deviate too far from their competitive peer group.

Fund managers, after all, who grossly underperform their peers, typically get fired.  But closely following their professional peers prevents these fund managers from actively seeking opportunities, and it also prevents them from acting responsibly with their respective funds. 

For instance, when the stock markets fell in 2008/2009, did these fund managers have the guts to rebalance their funds, selling off some bonds to buy discounted stocks?  As balanced funds, they should have… that’s what a balanced fund is supposed to do.  But as you’ll see when reading further, the answer to that question is almost certainly, no.

+10.9% Goldman Sachs Balanced Fund

There’s nothing golden about Goldman Sach’s 5 year total return.  Again, it’s within a very tight range of the other funds above…revealing the reluctance of these fund managers to branch out on their own and think independently.

The Singapore American School Fund

OK, this isn’t really a fund that represents my school.  But the portfolio I’ll show you below is exactly the same as the one I outlined (and promised to track) in September 2006, using www.SmartMoney.com.

I suggested then, and I’ll reinforce it again, that this portfolio will (over a lengthy period of time) beat the vast majority of actively managed money.

Unlike the American Funds Balanced Fund, there are no atrocious fees charged to investors who buy Vanguard’s funds.  And the expense ratios are a fraction of what they would be if investors had chosen actively managed products instead.

Five years ago, I suggested that investors should rebalance their portfolio annually… spending just 10 minutes on their investments.

I’ll admit that I was pretty lazy about rebalancing this portfolio.  I rebalanced it today, and I rebalanced it at the beginning of 2009.  In total, I have spent no more than 10 minutes (total!) on this portfolio in the past five years.

Yet if this portfolio was a boxer, it would have knocked out the balanced funds from Fidelity, American Funds, T. Rowe Price, Franklin and Goldman Sachs… blindfolded!

Five Year Overall Portfolio Gain:  +19.08%

Initial Investment in September 2006:  $200,000 (including cash)

Current Account Value, September 20, 2011:  $238,166.48

 No money was added to this account, and it was rebalanced on two occasions.  Rebalancing can be a very powerful tool during volatile stock markets.

If you think that I got lucky, think again.

If I had spent just ten minutes a year rebalancing this portfolio (instead of 10 minutes over 5 years) it probably would have done a lot better.

Want proof? Check this out:

The company, Assetbuilder, creates portfolios of indexes for investors who don’t want to manage their own money.

They charge a small annual fee, and they aren’t afraid to rebalance without emotion.  They don’t have peers that they’re trying to keep pace with.  The folks at Assetbuilder just build diversified portfolios of indexes, at a very low cost, and they rebalance those indexes.

If you’re an American (even an American living overseas) you can use their services.

Based on investors’ ages and risk tolerances, they offer 14 model portfolios.

On their website, they track the performance of those portfolios.  And here are the portfolios that combine stock and bond indexes, with varying degrees of risk.

Every single one of them beat the overall return of the Singapore American School Portfolio.  Looking below, you can see that their Model Portfolio 14 has a five year compounding return of 4.42% (the lowest of the bunch below).

But compounded, that’s a five year total return of 24.14%.

In contrast, their portfolio model 7 returned 5.53% for a five year total return of 30.88%.

As of August 2011

 Will the Assetbuilder portfolios continue to beat the Singapore American School portfolio that I created?

Maybe.  Maybe not.

But there’s one certainty.

As an aggregate, indexed portfolios pull further and further ahead of the vast majority of actively managed portfolios over an investment lifetime.

Academic evidence supports that notion.

So if your money is mired in actively managed funds, what’s keeping you there? If you’re an American, give Vanguard or Assetbuilder a ring.  You’ll be glad you did.

For more information, please order my book, Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School.