Using The Investment Centre’s Funds For Your 401(k) And Portfolio Options For Non-American Teachers

Picking funds for a 401(k) might seem like tricky work. 

But if we combine The Investment Centre’s fund selections with statistical probabilities and behavioral science, the selections are much easier.

This article offers suggestions for Americans and non-Americans with respect to an international school sponsored plan, using the funds offered to Singapore American School.  If you’re too busy to book time with one of the Investment Centre’s advisors, hopefully this might help.

Americans

Scan the investment options.  You’ll see that the Investment Centre offers Vanguard’s Target Retirement funds, among a list of other funds.  Using probability and behavioral science, I’ll explain why you might choose a single, target retirement fund and ignore the other funds.

Vanguard’s Target Retirement funds are complete portfolios wrapped up in a single fund.  They each contain U.S. and international stocks, also known as equities.  They also contain U.S. and international bonds, also known as fixed income. Investing in such a fund is like putting your eggs in different baskets. Diversification increases safety.

Most target retirement funds have a date in their name.  For example, Vanguard’s Target Retirement 2030 fund is well suited for most people who plan to retire close to 2030. About 71 percent of the fund is allocated stocks and about 29 percent is invested in bonds.

Younger investors can afford to take higher market risk.  Market risk refers to the degree that the portfolio will fall when the stock market does. For example, a young investor planning to retire around 2050 might choose Vanguard’s Target Retirement 2050 fund.  About 88 percent of the fund is allocated to stocks. That means its market risk is higher than with Vanguard’s Target Retirement 2030 fund, which has 71 percent allocated to stocks.

While other investors often sweat over which funds to pick, target date fund investors don’t have to decide.  That might sound lazy.  But it’s appealing for several reasons.

First, most investors like to pick individual mutual funds based on past performance.  But yesterday’s winners don’t always win.  It’s similar to sports. Stan Wawrinka won the 2016 U.S. Open tennis championships.  He beat the great Novak Djokovic in the final.  If you had bet money that either man would win in 2017, you would have been disappointed.  Both men were injured.  Rafael Nadal raised the trophy.

Unfortunately, most people pick mutual funds by looking at past performance.  That might seem intuitive.  Paradoxically, however, it’s the wrong thing to do. The SPIVA Persistence Scorecard shows that high-performing funds during one time period rarely maintain their winning ways.  For example, 641 U.S. stock market funds were among the top 25 percent of mutual fund performers in March 2014.  By March 2016, just 7.33 percent of them were still among the top 25 percent of performers.

Even funds with long-term winning records eventually disappoint.  Larry Swedroe is the director of research for Buckingham Strategic Wealth.  He explains this well in his 2015 book, The Incredible Shrinking Alpha. 

I presented a practical example in my April 2017 story, Investing With American Funds Is Like Betting On Tiger Woods.

But most people pick mutual funds based on how well they have done in the past.  When those funds disappoint investors, they often sell.  Such a process ensures that the average investor buys high and sells low.  This is why most investors underperform the returns of their funds.  

According to Morningstar, the typical investor in actively managed funds under-performed their fund’s posted return by an average of 0.79 percent per year over the ten-year period ending December 31, 2016. 

That might not look like much.  But let me show the long-term effects.  Imagine a fund that posted a compound annual average return of 8 percent, after fees.  Unfortunately, the average investor in that fund would have only earned about 7.21 percent.  Such an investor would have added more money after the fund had good years and less money after the fund had bad years.  As a result, the typical investor would pay an above average price. 

The difference between 7.21 percent and 8 percent might not look like much.  But over time, it would have presented a difference greater than the value of a car.

If somebody invested $1000 per month over 25 years, they would end up with $838,664 if they earned 7.21 percent per year.  But they would end up with $947,452 if they earned 8 percent per year.  That’s a difference of $108,788.  Even if you couldn’t buy a brand new car with that, 25 years from now, you could buy a pretty nice used one in the United States.

Investors in Vanguard’s Target Retirement funds (which are among The Investment Centre’s options) don’t suffer the same fate.  In fact, if one of their funds posts an 8 percent return, the odds are that the typical investor in that fund would perform a little bit better.

Most target retirement fund investors succeed because they don’t chase the past. According to Morningstar’s 2017 Target Date Landscape Report, target retirement fund investors beat the posted performance of their funds by an average of 1.4 percent per year during the decade ending December 31, 2016. 

Target date fund investors usually dollar-cost average (investing a constant sum) every month.  They don’t jump around, chasing yesterday’s winning fund.  As a result, when their fund unit prices drop, their regular monthly contributions buy a greater number of units.  When their fund unit prices rise, their money buys fewer units.  As a result, they pay a lower-than average price. 

Target date funds also maintain a relatively stable target allocation.  In other words, if the target retirement fund contains 60 percent stocks and 40 percent bonds, the fund company rebalances the holdings to maintain that allocation.  If stocks fall hard, the fund holdings get rebalanced.  The fund managers would usually sell bonds and buy the lower-priced stocks to maintain the target allocation.

What’s more, target retirement funds slowly increase their bond allocations as investors age, reducing risk in the process. 

Most investors in individual actively managed funds do the opposite. They pay a higher than average price because they chase past performers.  They also fail to rebalance after the market tanks.

Non-Americans

Target retirement funds aren’t among the Investment Centre’s options for non-American teachers.  In a school-sponsored plan, such investors need to build a diversified portfolio of individual funds. 

Non-Americans will, however, have to accept higher currency risk.  Here’s why.  The Investment Centre’s options don’t provide exposure to investors’ home currencies.  For example, there isn’t a Canadian stock or Canadian bond market option.  As such, Canadians take currency risk when their portfolio doesn’t include any Canadian stocks or bonds.  The same can be said for British, South African, Australian and Kiwi investors, among others.

Non-Americans who use The Investment Centre’s funds can’t eliminate currency risk.  But they can reduce its impact by building a global portfolio.  Such a portfolio would have exposure to global currencies, without heavy weightings in a single currency or market.

For example, assume a Canadian built a portfolio that just included U.S. stock market funds.  Such an investor would be taking currency risk.  The investor wouldn’t have any exposure to the Canadian dollar.  Instead, they would have 100 percent exposure to the U.S. dollar.

If, of the other hand, a different Canadian built a portfolio that just included global stock market funds, the currency risk would be lower.  Such an investor wouldn’t have exposure to the Canadian dollar (so they would still take currency risk) but their money would be globally diversified across a wide variety of currencies–not just the U.S. dollar.

Here are The Investment Centre’s Fund options for non-Americans at Singapore American School.

The Two-Fund Option

The simplest portfolio would contain just two funds. 

1. Franklin Templeton Global [Stock Market] Fund (0690) provides global stock market exposure. It costs 1.83 percent per year.
2. Templeton’s Global Bond Fund (0623) provides global bond market exposure. It costs 1.41 percent per year.

A portfolio that included such funds would cost about 14 times more than investors could pay for a do-it-yourself portfolio of low-cost index funds.  My personal portfolio, for example, costs about 0.11 percent per year.   That’s why cost-conscious non-American teachers might use the Investment Centre’s funds to maximize their school’s matching contribution–but that’s it. 

For example, if the school offered $3,500 of free money for teachers to invest with The Investment Centre, cost-conscious non-American teachers might invest the minimum required to receive the maximum matching contribution from the school.  Such teachers could invest the remainder of the their monthly savings in a lower-cost platform.  Those who want a guide could contact PlanVision’s Mark Zoril, or borrow a copy of The Global Expatriate’s Guide To Investing.  Mark Zoril charges $96 a year to help expats build portfolios of low-cost index funds.

But let’s get back to that two-fund portfolio.

Below, I’ve listed portfolio allocations for those with different risk tolerances.  The most aggressive portfolio doesn’t contain bonds.  Over long durations (15 years or longer) such a portfolio should outperform the others.  But it will also fall more heavily when stock markets fall.

The most conservative option below has 30 percent exposure to stocks and 70 percent exposure to bonds.  This will be the least volatile portfolio.   When stocks fall, this portfolio will barely dip.  But such investors would give up stronger long-term growth for this lack of volatility.

Using The Investment Centre’s Funds: The Two-Fund Portfolio Option

How Do Fees Affect Performance?

Choosing a portfolio of actively managed funds is more difficult that choosing a portfolio of index funds.  For example, an investor buying a global stock market index fund is saying, “I accept the return that global stocks will provide.”  If an investor chooses an actively managed global stock market fund, the investor is saying, “I think my actively managed fund will beat the global stock market index, or at least beat most of the other actively managed global stock market funds.”

That’s a tall order–especially when trying to pick an actively managed fund that will beat its equivalent index fund.  For example, a $10,000 investment in Templeton’s Global Fund, 15 years ago, would have turned into $29,137, after fees.  That’s a compound annual average return of 7.39 percent.

A $10,000 investment in a global stock market index would have turned the same $10,000 into $39,013 after fees.  That’s a compound annual return of 9.50 percent.

Below, I’ve provided a table showing Templeton’s Global Fund’s performance compared to the global stock market index, after fees. 

Templeton’s Global Fund Performance vs. Global Stock Market Index – Ending September 30, 2017

Source:  Franklin Templeton Investments Luxembourg (Returns measured in USD)

When looking at the above performances, you might wonder if Templeton’s Global Fund is a dud.  But that wouldn’t be entirely fair.  Nobel Prize winner, William F. Sharpe says the aggregate return of all actively managed mutual funds will equal the market’s return, after fees.

The Templeton Global Fund costs 1.83 percent per year.  The global stock index averaged an annual return of 9.70 percent over the past 15 years (a retail investor’s index would have earned 9.50 percent, after its 0.20 percent fee). 

If the global stock index, before fees, averaged 9.70 percent, the typical fund that charged 1.83 percent (as the Templeton fund does) would have earned the market’s return of 9.70 percent, minus the 1.83 percent fee for the actively managed fund.  As a result, the after-fee return would be about 7.87 percent per year.  Some actively managed funds would have done better.  Others would have done worse.  But 7.87 percent would have been the average return, based on the premise described by Nobel Prize winning economist, William F. Sharpe.

During the past 15 years, ending September 30, 2017, the global stock index averaged 9.70 percent.  The Templeton Global Fund averaged 7.39 percent.  This puts the fund’s past performance in the average range for actively managed global funds, considering that the average would have been about 7.87 percent (for a fund that cost 1.83 percent per year).

Beating an index isn’t easy.  In fact, the SPIVA Europe Scorecard determined that just 1.63 percent of actively managed global stock market funds beat the global stock market index over the 10-year period ending December 31, 2017.  That means a full 98.37 percent underperformed the global index. 

This doesn’t mean the Templeton Global Fund won’t beat the index over the next year.  It might.  But it would have lower odds of beating the index over the next three years, and still lower odds of beating the index over the next ten years.  Time is the enemy of the high-cost fund.

Consider Management Risk

An index fund investor taking equivalent currency risk could buy a global stock market index and a global bond market index.  Such an investor would take stock and bond market risk.  But the investor wouldn’t take manager risk.  Investors in actively managed funds take stock and bond market risk and manager risk. 

Let me explain.  When we invest in any kind of stock market fund, we’re at the mercy of the market.  If stocks fall, our funds will fall.  Some advisors suggest that an actively managed fund can protect investors from stock market risk.  But that’s wishful thinking.  For example, when U.S. stocks crashed in 2008, almost 65 percent of actively managed U.S. stock market funds fell further than the U.S. stock market.   

When choosing an actively managed fund, we’re hoping that the manager does well, without badly screwing up.  By choosing just one global stock market fund, we put our money’s faith in a single fund manager or single fund management team.  That’s why, to reduce risk, non-Americans who use the Investment Centre’s funds might choose diversified portfolios that include different actively managed funds.

I’m not saying such a strategy would beat the performance of the two-fund portfolio above.  It might.  It might not.  But investing is about odds and risk.  A multiple-fund portfolio, such as those listed below, won’t eliminate stock and bond market risk.  But it does reduce manager risk.

Using The Investment Centre’s Funds: The Four-Fund Portfolio

Source: Franklin Templeton Investments Luxembourg

But Why Did I Choose The Above Allocations?

You might think I chose the above weightings based on some kind of prediction.  Notice that the U.S. stock market has a higher weighting (in each portfolio) than the European stock market or the Asian stock market.

This isn’t based on a prediction of which market will perform best.  The allocations of stock market exposure above are based on something called, global stock market capitalization.  The U.S. market is the world’s largest.  As a result, investors take higher global capitalization risk when they don’t include more U.S. stocks, for example, compared to Asian stocks.

Some new investors might be tempted to build a portfolio based on which geographic sector of stocks they think will do best, and weight their portfolio to reflect such speculation.  But once again, that’s one of the reasons most investors do poorly.  They chase yesterday’s winners.  Yesterday’s winning geographic sector is often tomorrow’s (or next decade’s) loser. 

That’s why smart investors don’t speculate.  They build diversified portfolios.  They rebalance once a year.

They get on with their lives.  I hope you found this helpful.