Week 98 - Mutual Funds

Situation: Mutual fund managers invest your hard-earned money in assets traded on exchanges around the world. Those assets are assembled and sold to you on the basis of Net Asset Value (NAV) per share. Your money is being invested in a derivative product that is priced by assembling the prices of exchange-traded assets. Mutual funds are marketed on the basis of past performance and their current expense ratio (transaction costs/NAV).

Because the stock market is rising 2/3rds of the time, managers tend to assemble their mutual fund from stock in companies that outperform the S&P 500 Index during a “bull market” (i.e., have a 5-yr Beta greater than 1.00). That bias is eliminated in the case of an index fund where a computer does the managing (usually rebalancing the portfolio to maintain capitalization weighting). That means the “managed” mutual fund will perform worse than average 1/3rd of the time, i.e., during a “bear market.” Long-term performance graphs will look better though. But no one is interested in owning stocks that do worse than the indices during a bear market. You’ve been there, done that.  

We encourage you to own a stock portfolio that is less risky than the S&P 500 Index, one with a capitalization-weighted 5-yr Beta of 0.65 or less. That means that in a bad year, like 2008 when the S&P 500 Index lost 37.4%, your stock portfolio would lose no more than 25%. Since that is a greater loss than anyone can stomach if over 55, bonds need to be added for safety, not profit. Remember: stocks are “dead money” 2/3rds of the time. This is because the first half of a bull market only makes up for losses incurred during the previous bear market. Investment-grade bonds allow you to bridge that “valley” because they pay interest twice a year at a fixed (or inflation-adjusted) rate until the bond matures and principal is returned to the investor. There are no “ifs” and you’ll even beat inflation by 1-2% over the long haul. The key problem for shareholders is that after a 25% loss, a 50% gain is needed just to break even. That's how math works.

Looking at Lehman Panic returns (Column D of this week's Table), if you had half your money in the lowest-cost investment-grade bond index fund (VBMFX) and half in the lowest-cost S&P 500 stock index fund (VFINX) your loss was only 19% instead of 45.6% for VFINX alone. If you had money in the lowest-cost bond-heavy balanced mutual fund (Vanguard Wellesley Income Fund or VWINX), your loss fell to 16% (Table).

But what about long-term growth? Over the past two market cycles (since the S&P 500 Index peak on March 24, 2000), the 50:50 stock:bond index combination has returned 4.1%/yr, which is 1.7% more than inflation. VWINX has returned 8.1%/yr because it is 60% bonds and 40% stocks. Remember, bonds keep paying interest the whole time that stocks are down in the “valley.” Bonds also rise in price during recessions, so managers of VWINX can sell those at a profit. If you’d held only the S&P 500 Index (VFINX), your returns would only have been 2.3%/yr meaning you’d have lost 0.1%/yr to inflation.

So what is the point we are making? If you like the convenience of mutual funds, play defense by holding a bond-heavy, actively-managed balanced fund like Vanguard’s Wellesley Income Fund (VWINX). It's a hedge fund in disguise, since it has a low 5-yr Beta (0.58) and outperforms the S&P 500 Index on rolling 5-yr periods. (The managers aren’t allowed to use the main tool of a hedge fund, which is short sales, a risky tactic that often backfires.)

What we’d all like to find is a low-cost stock mutual fund that has mediocre performance during bull markets but outstanding performance during bear markets, i.e., a hedge fund for the masses. For the foreseeable future, hedge funds will continue to be private investment contracts available to the wealthy. Why? Because the retail investor (you and me) won’t buy something that has a sales pitch of mediocre performance during a bull market. We’re thinking: Why invest my money in a fund that is limping along 2/3rds of the time? Hedge funds get around this by saying: “Well, we think we can beat the S&P 500 Index over the long term because of our superior performance during bear markets.” According to Warren Buffett (Week 46), that is impossible because of their high fees: a typical hedge fund keeps 20% of any money it makes for a client as well as charging her a 2% annual fee.

Hedge funds use various strategies (check Wikipedia for an excellent entry explaining these). The best hedge funds have been able to beat the S&P 500 Index over a 5-10 yr period while losing less than 65% as much during a bear market (Week 46). It is hard to know just when a bear market is going to transpire, so hedge funds tend to maintain a 5-yr Beta of 0.65 or less during the run-up to a bear market. It all gets pretty complicated but the better hedge funds tend to be stuffed with bonds and shorted stocks (i.e., betting against stocks). The bonds are often risky, paying several % more interest than a 10-yr Treasury Note, which is all right since a risky bond is less risky than a “safe” stock because the risk of default is less and the money recovered in a default is substantial (vs. the total loss that a shareholder must endure).

There is a very low cost mutual fund for Treasury Notes (VFITX in the Table). Or you can buy US Treasuries in amounts as small as $100. There’s no cost, just point-and-click (go to treasurydirect). The money will be withdrawn from your checking account and every 6 months an interest payment will be sent back. At the end of the bond’s term, your original investment is returned.

You’ll complain that “the current interest rate is lower than the rates for corporate bonds or bond funds.” Correct, because you’re buying a “zero-risk” product that will keep paying interest during a bear market and even during Armageddon assuming the U.S. Marine Corps still exists. The extra interest paid (called the “spread”) on non-Treasury bonds compensates you for their extra risk (i.e., the risk of default). It's still true that there is no free lunch.

In the end, you are best off selecting some low-risk DRIPs for your stocks and balancing those with Treasury Notes or Savings Bonds, which are the same as Treasury Notes except that interest accrues automatically and is lower because you’ll pay no tax on the accrued interest until you sell.  

What is a low-risk DRIP? For safety’s sake we will use an extreme example and call it a virtual mutual fund (Table): the 8 Dividend Aristocrats that have not only increased their dividend annually for at least 25 yrs and are also “blue chips”, i.e., members of the 30-stock Dow Jones Industrial Average. These are: Wal-Mart Stores (WMT), McDonald’s (MCD), Johnson & Johnson (JNJ), Procter & Gamble (PG), Coca-Cola (KO), Exxon Mobil (XOM), Chevron (CVX) and 3M (MMM). Four of those (WMT, MCD, JNJ, KO) are what we call “hedge stocks” because they fell less than 65% as far as the S&P 500 Index during the Lehman Panic, have beaten the S&P 500 Index over the past two market cycles, and have a 5-yr Beta of 0.65 or less. Those 4 stocks are enough like bonds that you don’t have to backstop their risk with an equal investment in Treasury Notes or Savings Bonds. The other 4 stocks (CVX, XOM, MMM, PG) include two (PG and XOM) that almost qualify as hedge stocks, have the highest S&P stock rating (A+/L, with the “L” denoting low risk), and have high credit ratings (AA- and AAA, respectively). There is no chance of either going bankrupt or falling as fast in value as the S&P 500 Index during a bear market, so you won't need Treasuries as a backstop.

To sum up: Your virtual mutual fund is 60% in 6 “safe” DRIPs, 20% in 2 riskier DRIPs (CVX and MMM), and 20% in a Treasury Note fund (VFITX) to backstop CVX and MMM. There are 10 units (8 DRIPs plus 2 units of VFITX). Assigning $50/mo to each results in an investment of $6,000/yr. Costs for investing  $50/mo electronically from your checking account for WMT and JNJ are $1/mo. Costs are higher for KO, CVX, MMM and MCD, so annual or semiannual investments have to be made: one-off electronic transfers into those DRIPs. There are no costs for the XOM and PG DRIPs, or the $100 that goes into VFITX each month (aside from the expense ratio of  0.2%).

Your virtual mutual fund lost 10.3% during the 18-mo Lehman Panic bear market but returned an average of 8.6%/yr over the past 13+ yrs and beat both the S&P 500 Index and inflation by 6.2%/yr. The 5-yr Beta is 0.5, indicating that your virtual mutual fund is perfectly balanced between stock and bond risk.

Bottom Line: For the most part, stocks are a gamble but bonds aren’t. Make sure your retirement savings are balanced between stocks and bonds in terms of the aggregate 5-yr Beta, i.e., close to 0.5. You can design a balanced stock and bond portfolio by using DRIPs for the stock investments balanced with Treasury Notes, or a bond mutual fund that only holds Treasury Notes (VFITX). From a tax-savings standpoint, you’re better off using Inflation-protected Savings Bonds.

Risk Rating: 3.

Full Disclosure: I use this plan to supplement my workplace retirement savings.

Post questions and comments in the box below or send email to: irv.mcquarrie@InvestTuneRetire.com