This is the fourth posting in a series on the overall portfolio structure implied by a focus on a dividend-growth portfolio. A previous posting, “A Dividend-Growth Portfolio Isn't a Strategy; It's a Class of Assets,” (A Dividend-Growth Portfolio Isn't A Strategy, It's A Class Of Assets) presented the plan for the entire series on the topic.
Throughout this posting there are references to mutual funds. It should be understood that the term “mutual funds” is used as an abbreviated statement for mutual funds and/or ETFs. One can provide legitimate arguments for either using mutual funds or ETFs. However, they are sufficiently similar that the discussion below can apply to either.
It should be noted that if one intends a buy-and-hold approach to investing, the only difference becomes the costs. The potentially lower ongoing management cost of an ETF is purchased at the minor risk that its price could deviate from the underlying assets in a manner similar to the way the price of a closed-end mutual fund can deviate from its underlying asset value. Also, there's a trade-off between the often higher management costs of a mutual fund and the transaction costs associated with an ETF. If there's more trading in the ETF than in the comparable mutual fund, there is the potential for a higher ongoing cost of transactions as the ETF's manager is forced to buy and sell stocks to meet the obligations implied by investors buying and selling the ETF. That said, it is still legitimate to consider mutual funds and ETFs as similar with respect to the discussion that follows.
One should keep in mind that the objective of the discussion that follows is to focus on mutual funds in relationship to a dividend-growth portfolio. Consequently, there are entire areas of mutual fund investing that will be ignored or breezed over. For example, bond mutual funds aren't addressed at all. Any discussion of a bond mutual fund would have to be in terms of how they differ from holding bonds themselves. Basically, that can be summarized with two statements. With an individual bond, the investor controls the maturity selected and whether the bond is traded. With the mutual fund, the investor has given up that control. Second, a mutual fund that invests in bonds can either be leveraged or unleveraged. Selecting the mutual fund automatically makes the decision regarding whether to deploy leverage, but the investor gives up control of the amount of leverage to the mutual fund manager.
Another area that is breezed over concerns closed-end funds. They are not discussed below, although they can be a useful component in a dividend-growth portfolio. However, they constitute a very specialized area of investing that makes the selection of each individual closed-end fund similar to the selection of an individual stock with the additional complication that the holdings and amount of leverage are not in the control of the investor.
The best way to incorporate them into the discussion that follows is to treat them as just another type of mutual fund that can be used as a diversifier. The diversification can result from a lack of correlation between the assets in the closed-end fund and the dividend-growth portfolio, fluctuation in the relationship between the price of the closed-end fund and its net asset value, and the introduction of leverage into the portfolio. There are closed-end mutual funds that specialize in selecting dividend-growth stocks. They could be viewed as a substitute for a dividend-growth portfolio except that the price can fluctuate due to variations in the relationship between the net asset values and the price of the fund. So, at best, they are weak a substitute, but they can be a valuable component of a dividend-growth portfolio.
The discussion that follows and the previous postings referenced in that discussion used open-end funds redeemable by the fund company as examples and as a model for the discussion. It is my impression, based on limited experience rather than survey data, that most 401(k)s that offer mutual funds are dominated by open-end mutual funds. Perhaps some readers can provide examples of exceptions.
A posting on The Hedged Economist, February 11, 2014, “The Three Fund Portfolios,” (The Three Fund Portfolios.) presented a portfolio of mutual funds that could be used as an alternative to purchases of individual stocks. A Feb. 5, 2016 posting on SeekingAlpha entitled “The 3 Fund Portfolio In 2016” (The 3 Fund Portfolio In 2016) discussed how to manage the three fund portfolio in a year characterized by economic downturn. While a downturn did not materialize in 2016, the discussion of how to handle one is totally appropriate going into a year when many forecasters are again predicting a downturn.
The three funds identified for inclusion in the portfolio were selected to intentionally deviate from the performance of an S&P 500 index fund. Recall that one of the objectives of the portfolio is greater stability than the market in general without underperforming the market over a complete cycle. Clearly, purchasing an index fund that represents the market can't produce greater stability. The three fund portfolio can.
To illustrate the three fund portfolio, examples of offerings from Vanguard were used in the postings cited above. To quote from the previous posting the examples were:
1. Vanguard Total Stock Market Index Fund--Vanguard Total Stock Market Index Fund is designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks. The fund’s key attributes are its low costs, broad diversification, and the potential for tax efficiency. Investors looking for a low-cost way to gain broad exposure to the U.S. stock market who are willing to accept the volatility that comes with stock market investing may wish to consider this fund as either a core equity holding or your only domestic stock fund.
2. Vanguard Windsor II Fund--Like many individuals making a big purchase, Windsor™ II Fund’s investment managers are mindful of price. While this large-cap value stock fund carries the same risk associated with the stock market, this “value” conscious approach may provide a less bumpy ride. That said, the fund may not keep up in a strong bull market. If you have a long-term investment goal and want less market volatility than might be present in a more aggressive investment, the fund could be a good fit for you.
3. Vanguard Wellington Fund--The fund offers exposure to stocks (about two-thirds of the portfolio) and bonds (one-third). The fund tends to invest in large cap or mid-cap firms for its equity allocation. The bonds that it holds are generally highly rated. Thus, it is a very conservatively managed fund. Another key attribute is broad diversification—the fund invests in about 100 stocks and 500 bonds across all economic sectors. This is important because one or two holdings should not have a sizeable impact on the fund. Investors with a long-term time horizon who want growth and are willing to accept stock market volatility may wish to consider this as a core holding in their portfolio.”
Many investors believe the cost of trying to have a portfolio of mutual funds that reflects their risk tolerance is too expensive. Instead, they just let the lower costs of an index fund determine their investment objectives. To do so requires ignoring the risk component of planning the risk and returns one wants to achieve. It's essentially just giving up and deciding that one just has to accept market risk as if it were somehow the appropriate amount of risk to bear. Basically, it involves deciding that tailoring a portfolio to one's own needs is just too hard. Interestingly, often that philosophy will be married to an effort to use asset allocation to manage risk. That approach involves having index funds that represent different asset classes as defined by the investor. In many respects, it's better than just investing in one index fund in that it at least represents an effort on the part of the investor to reflect what he or she really wants in terms of risk and return.
Individuals working for employers offering 401(k) plans, or their equivalent, can benefit from holding a portfolio like the three fund portfolio. It should be the mainstay of the 401(k) holdings: A total market index fund or a small-cap fund, a value fund, and a balanced fund provide returns comparable to an S&P 500 fund through the cycle with less volatility. Rebalancing is required. An approach that eliminates some of the arbitrariness of fixed rebalancing schedules is to rebalance when any fund deviates from its target weight by a set percentage. I've reviewed about a dozen different 401(k) programs. In only one instance was I unable to find three funds comparable to those described in the three fund portfolio. All of them, except that one, offered mutual funds or ETFs that represented the total market, a value orientation, and a balanced portfolio.
A subsequent posting in the series on mutual funds dated February 17, 2014, “Funds for Asset Class Diversification,” (Funds for Asset Class Diversification), discussed a portfolio of three mutual funds that provide a potential supplement to a dividend-growth portfolio. They can also be used to provide a supplement to the mainstay funds illustrated by the three fund portfolio described above.
For diversification (i.e., as a supplement to a dividend-growth portfolio), foreign equities, with developed and developing economies’ markets treated separately, and small capitalization fund are logical candidates for inclusion in the portfolio in the form of mutual funds. If one is a good value investor, a mutual fund that focuses on growth rather than value may be useful. That will let the investor focus his or her efforts on the area where they excel and let others manage in other market segments. If REITs are not included in the dividend-growth portfolio or the mutual fund holdings, a REIT fund can also be a useful diversifier.
To provide examples of funds that could provide diversification, three funds were selected from Fidelity's offerings. As described in the posting cited above, they were:
1. Spartan Extended Market Index -- The first fund included in the portfolio is the Spartan Extended Market Index. It seeks to provide investment results that correspond to the total return of stocks of mid- to small-capitalization United States companies. It normally invests in common stocks included in the Dow Jones U.S. Completion Total Stock Market Index. That index represents the performance of stocks of mid- to small-capitalization U.S. companies. It excludes companies in the S&P 500® Index.
2. Spartan International Index Investor Class -- It seeks to provide investment results that correspond to the total return of foreign stock markets in developed economies. Normally it invests in common stocks included in the Morgan Stanley Capital International Europe, Australasia, Far East Index. Spartan International Index Fund seeks to provide monthly results, before expenses, that match the returns and characteristics of the MSCI® EAFE® Index as closely as possible. It includes large- and mid-cap companies in 21 developed countries, excluding the U.S. and Canada.
3. Lazard Emerging Market Equity Blend Portfolio -- This fund is offered through Fidelity, but is not managed by Fidelity. It is a managed emerging markets fund. The investment seeks long-term capital appreciation. The fund invests primarily in equity securities, including common stocks, ADRs and GDRs, of non-US companies. Under normal circumstances, it invests in equity securities of companies whose principal business activities are located in emerging market countries. The fund may invest in companies of any size or market capitalization.”
These funds are provided as examples, which should not be taken as recommendations. Quite frankly, I find it very curious that people think it is easier to select a mutual fund than an individual stock. In both cases, one has to assess the quality of the management, but in the case of an individual company, one can analyze the market for their products and know that there is a certain amount of continuity in the business operations. By contrast, a mutual fund can completely turn over its portfolio, meaning it now represents a totally different mix of businesses. The examples used in this posting are simply those with which I have some experience. They may not be the best, but none would qualify as a disaster for a long-run investor.
At the time those postings were written, the portfolio included holdings in all of the categories mentioned: small-cap, international developed economies, international developing economies, plus a growth mutual fund. The use of the REIT fund had been abandoned a number of years before then in favor of purchasing individual REITs. Once the limitations of participating in the 401(k) were eliminated, purchasing individual stocks rather than mutual funds became a viable option. Over time, in order to control dividend flows, other mutual funds were liquidated and direct individual stock investments were substituted. The growth mutual fund and the small-cap fund are the only mutual funds currently being used for diversification. The value of those holdings is approximately equal to the value of a holding in a single stock. Thus, they are used in the same way that stocks of companies in industries with different cyclical behaviors are used to hedge each other.
To replace the international stock funds, some international stocks in the form of ADRs have been added to the portfolio. The major diversification impact of those foreign stock holdings arises more from the currency diversification than from a systematically different level of performance of the foreign markets versus the US market. The international markets have become increasingly correlated as international capital flows have increased over time.
There is also some diversification that arises from the difference in the performance of the economies of different countries. However, many of the stocks that trade as ADRs are multinationals. Thus, the diversification that results from differences in the performance of different economies is weak. The currency diversification could have been achieved within an unhedged international stock fund, but that would have resulted in a loss of control of the dividend flows.
When considering the diversification benefit of foreign stocks, it is good to remember the relative significance of differences in the performance of various national markets versus the significance of currency markets. The size of the foreign exchange market and the amount of leverage involved make changes in exchange rates far more risky than changes in any other prices. In fact, foreign-exchange market fluctuations can create systemic risks that can only be hedged by exposure to multiple currencies or some of the alternative assets (e.g., precious metals, perhaps cryptoassets, etc.) discussed in subsequent postings.
The net effect may be a reduction in the diversification within the equity portion of the portfolio because the mutual funds often had less concentration risk than what has been used to replace them. That sacrifice of diversification was a trade-off against better control of the dividend flow. At the same time, the two funds that were retained, the growth fund and the small-cap fund, are two that provide the most important diversification benefits. They are only weakly correlated with the dividend-growth stocks. However, their correlation with the dividend-growth stocks can be quite high during market crashes. Assets that provide diversification against the risk of a market crash will be the subject of the future postings. However, first it makes sense to summarize an approach applicable to four more conventional assets discussed so far.
Disclosure: I am/we are long THE SPARTAN EXTENDED MARKET INDEX FUND.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As discussed in this posting, I have eliminated most mutual fund positions. I retain a position in a growth mutual fund intentionally not named in this posting for fear that someone might think it represented a recommendation despite my frequent protestations that I am not a growth stock picker. By extension, I don't feel I'm qualified to pick a growth stock fund. As disclosed above, I am still long the extended market fund. Those two funds are held for diversification not as recommendations.