In all my years in the investment management industry probably the two questions I have gotten the most are what is the stock market going to do and what funds should I buy.

The first question is the hardest and unknowable with any sense of accuracy. I might have my predictions of how the market should behave over the long term but in the short term (which is what most people are interested in) I don’t have a crystal ball and neither does anybody else.

So, I usually move on rather quickly to the second question as to what funds should you buy.

Of course, before you get to this topic you need to consider your target allocation among the major asset classes such as stocks, bonds, alternatives, and cash, but for purposes of this note, I am going to assume that you already decided on your target asset allocation.

A Typical Situation:

Say, you want to allocate 60% of your total assets to equities and 40% to bonds. OK, now what? You search online for the best equity and bond funds and you leave even more confused.

Or, you might be looking at your menu of choices in your 401K. Daunting, right? I wouldn’t blame you if you decided to take an early lunch and forget about it.

Maybe your plan defaults to a target date fund based on your age. Problem solved, right?

But what if you do want to pick your funds rather than on a one-size-fits-all solution? You want to build your portfolio but where do you start?

Narrowing Down the Field:

Having spent over 30 years managing large investment pools at firms like MFS, Pioneer, and Invesco, I've worked with lots of portfolio managers and seen lots of different approaches. I have managed strategies that were available in 401K’s as well as variable insurance options.

Fun Fact: Do you know that according to the Investment Company Institute, there are approximately 3000 exchange-traded funds and 8000 mutual funds in the US alone?

Picking the right fund feels to most people like picking a needle out of the haystack, but with the right approach, you’ll be able to quickly whittle down your choices.

I am going to walk you through a pragmatic approach that offers clarity amidst the chaos - emphasizing passive index funds. These cost-effective, consistent performers not only fit seamlessly into most portfolios but also empower investors to confidently navigate the ever-evolving investment landscape.

It might surprise some that while I spent most of my career on the active portfolio management side, I believe that for most investors especially those managing their own money passive index funds is the way to go.

Picking active funds requires a more detailed level of due diligence which most normal human beings are not prepared for.

Also, to be perfectly frank, in many categories or styles of investing passive approaches often outperform active approaches especially once you take into account all fees.

So, for this note, I will deal with passive index approaches and explain how I go about choosing which passive investments to own.

On a high-level basis, I focus on four key factors:

1. Strategic Fit

2. Costs

3. Performance Consistency

4. Fund Size

Let’s go over each one of these factors in a bit more detail.

Strategic Fit

When assessing the strategic fit of a fund, I start with the index it tracks. For example, if I were interested in choosing a US Large Cap fund, I would consider only funds tracking either the S&P 500 or the Russell 1000. These two indices are highly correlated resulting in similar performance patterns and characteristics.

Here are my default indices for the ten asset classes I include in my asset allocation model portfolios:

• US Large Cap: S&P 500 Index

• US Small Cap: Russell 2000 Index

• Developed International Equities: MSCI EAFE Index

• Emerging Market Equities: MSCI Emerging Markets Index

• US Bonds: Bloomberg Barclays US Aggregate Bond Index

• International Bonds: Bloomberg Barclays Global Aggregate ex USD Index

• Emerging Market Bonds: J.P. Morgan EMBI Global Core Index

• Commodities: S&P GSCI(R) Total Return Index

• Real Estate: Cohen & Steers Realty Majors Index

• Cash: ICE U.S. Treasury Short Bond Index

Each fund company uses its own list of index providers. I tend to gravitate toward indices used by large institutional investors, but in reality, there will be more similarities than differences in how alternative indices perform over time.

Costs

On the cost front, mutual funds have expense ratios set by the fund company while ETFs have both expense ratios and trading spreads determined by market forces.

I always consider total annual fund expenses, which encompass operating expenses, management fees, transaction fees, and any sales loads or redemption fees. Among ETFs, I also look at the bid-ask spread as a percentage of total transaction size. This spread reflects additional trading costs to enter or exit a fund.

As an example, the iShares Russell 2000 Value ETF (IWN) carries a total expense ratio of just 0.24% with average spreads of only 0.03%. Contrast this to an active small-cap value mutual fund like the DFA US Targeted Value Fund (DFFVX) which has a much higher 0.37% expense ratio.

Over decades, those additional costs compound and can add up. All else being equal, the lower the cost of ownership the better.

Performance Consistency

Here I am assessing metrics like the fund's long-term returns relative to its benchmark, tracking error, volatility, and behavior during crisis periods like 2008 and 2020.

I want to see consistent outperformance across full market cycles, not just sporadic large returns in some years.

Some funds use a replication approach to match their benchmark index. Not all securities in the index are held either because such a practice may be cost-prohibitive or technically infeasible given the liquidity of the underlying security.

This tends to happen more often in smaller capitalization and international equities than in US large or midcap securities.

Most bond funds use a replication approach given a lack of depth in fixed-income markets.

The tracking error of a fund is a metric that examines how tight the fund performs relative to its benchmark.

A fully replicated fund has a tracking error of zero. An acceptable tracking error would max out around 0.5% per annum. The lower the tracking error the better.

Fund Size 

All things being equal, bigger is generally better when it comes to index ETFs and mutual funds.

Higher assets under management bring greater scale on the trading and expense side.

Bid-ask spreads tighten while management fees decline.

As a counterexample, a newer $20 million "flavor of the month" thematic ETF likely has wider spreads and higher operating expenses than $20+ billion stalwarts like SPY or IWM tracking foundational indexes.

Some Useful Resources:

iShares - my first stop when looking for low-cost funds

State Street Global - one of the original “biggies” of the ETF world

Vanguard - the gold standard of index investing and extra low costs

Morningstar - I especially like their fund comparison tool

Asset Allocation Performance Review

High-Level Observations:

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities. The GF High-Risk strategy is up 2.3% on an annualized pre-cost basis over the last three years and 7.4% over the last 5 years.

• Over the last 5 days, bonds have underperformed relative to equities. More conservative asset allocation strategies have therefore lagged their more aggressive alternatives by a wide margin.

• Given the hit that all asset classes took yesterday after the release of a slightly higher-than-expected inflation release, all of the asset mixes that we monitor have had small losses over the last week.

• Longer duration bond strategies have taken the biggest hit as yields on the benchmark 10-year Treasury note have jumped over 0.2% in the last week.

• Real Estate Trusts (REITs) have similarly taken a big hit -down 1.4% - in the last week. Reits are traditionally very sensitive to the direction of interest rates.

• On the positive side, Commodities are up 2.7% over the last week as oil prices jumped up over 5% in the last week. With Commodities, it’s a seesaw pattern - one week up, the next down, and so on.

• In general, one would expect commodity prices to be fairly stable as inflationary pressures around the globe dissipate. This week’s CPI upward surprise is generally credited to higher costs of shelter. Over the last year, WTI Crude Oil prices have been flat.

• Yesterday’s bloodbath in capital markets was more of a reflection of overexuberant expectations on the part of investors than a real shock to the general direction of inflationary trends. Our proprietary Risk Aversion index (RAI) stood last Friday at near-all-time lows indicating an overly bullish investor sentiment.

• As of this morning, the VIX - a measure of near-term volatility in S&P 500 stocks - is still below 15%. This is less than a point higher than as of the close of Monday’s trading session.

Weekly Performance Attribution

Source: iShares, as of 2/13/2024

A Bit of Humor Never Hurts

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