Bring It On Home

In the past few years, investors with significant foreign exposure outperformed those who relied solely on U.S. equities.  There were two reasons for this. First, foreign stocks held up much better during the credit crisis of 2008.  U.S. stocks plummeted following the collapse of Lehman Brothers, the GM bankruptcy, and the government rescue of AIG.  Foreign stocks suffered, too, but not nearly to the same extent.

Secondly, throughout it all, the euro has remained remarkably strong relative to the dollar.  This favorable exchange rate helped to further boost foreign returns when repatriated back into dollars.  Essentially a 10% gain on investments on the Continent translated into a 14% gain in dollars.  As a result, those willing to invest overseas only had to pick good stocks to receive great returns.

Now, few question the seriousness of the European sovereign credit crisis.  With major countries teetering on the edge of default and severe austerity programs proposed as part of the solution, economies are certain to be under strain.  To believe in Europe in 2012 is to believe the EU’s credit crisis can quickly be put aside without slowing economic growth.  This is virtually impossible given the depth of the problems and the amount of capital that must be allocated to their resolution.  Austerity measures will also take their toll on individual as well as government spending, weighing on overall growth.  In this case, the consensus would appear to be quite well founded in foreseeing an economic slowdown overseas.

If this is correct, investors should retrain their focus on the U.S.  Rather than looking for Coca-Colas or Caterpillars which generate the majority of their revenues abroad, they should consider utilities and regional banks that are domestically focused.  Rather than seeking equity mutual funds with heavy multi-national weightings, they should be seeking those with centered in the U.S.  Now, more than ever, it’s critical to review and understand the funds’ portfolios and their foreign exposure.

Also this is not the time to put excessive weight on one or even three-year performance.  Stocks and funds that were top performers in the past few years because they depended on foreign exposure are precisely the ones investors should avoid now that the balance appears to be swinging back in favor of domestic stocks.  If this thesis is correct, this is definitely a situation where past performance is clearly not indicative of future returns.

Gross Errors

At the start of 2011, the yield on the benchmark 10-year U.S. Treasury Note stood at 3.29%, just above its 40-year low.  At that level, it was hard to imagine it could decline much further.  As a result, analysts and most investors planned to avoid bonds and look elsewhere for return.  That seemed the reasonable response at the time.

The most notable adherent to this this theory was none other than Bill Gross, manager of Pimco’s flagship Total Return Fund.  Mr. Gross made no secret that he was actively dumping Treasuries from his $240 billion fund which placed addition pressure the bonds.

But a funny thing happened on the way to December 31, 2011:  The 10-year Treasury yield continued dropping, hitting a 60-year low of 1.67% in September.  At the close of the year it wasn’t much higher, yielding just under 2%.  Its value, which moves in the opposite direction of its return, continued to move up resulting in a better total return than most stocks.  Throughout the year, Mr. Gross stuck by his guns, leaving the Total Return Fund’s total return well below that of its benchmark as well as other funds in the category.

Mr. Gross, and those who followed him, made a classic quantitative error:  They relied too heavily on the future being like the past.  This is a fundamental belief of quantitative investing, but it has to be tempered with the facts of the current environment.  All else being equal, Treasury yields probably would have risen had the Federal Reserve not made clear it would do everything in its power to keep borrowing rates low.  Active intervention in the market through quantitative easing and then later in the year through “Operation Twist” meant all else was not equal.  Bond traders have an old saying, “Don’t fight the Fed,” and in this case, that’s precisely what Mr. Gross and his followers did.

There are several lessons to be learned here.  Among them is the fact that following the current market guru is no guarantee of success.  Even more importantly, investors shouldn’t blindly believe the future will be like the past when there are clear indications it won’t be.

Why Bond Funds are So Bad

As stocks continue to suffer through increased volatility, many investors are turning to the safety of bonds.  Despite last summer’s downgrade by S&P, U.S. Treasury securities are still the destination of the world’s flight to safety.  While larger investors build bond portfolios, individual investors generally rely on bond mutual funds.  Not only are they easier to buy and price, they also provide immediate diversification across a wide range of holdings and maturities.

It’s a pity then that managed funds’ performance tends to be less than adequate.  As you’ll notice from the chart below, actively managed intermediate government bond funds – as measured by the Morningstar Intermediate Government Category – have consistently trailed the unmanaged Barclay Intermediate Government Index throughout its 37-year lifespan.  In other words, an index fund or ETF would have been better than the comparable actively managed fund.

Why have actively managed bond funds performed so poorly?  First, you have to realize the Morningstar’s Intermediate Government Category represents the return of the average fund.  Analysts on the other hand, profess to find above average funds which, of course, would look better.  Yet studies show managers fail to consistently outperform their unmanaged indexes over periods longer than one or two years.  Not only would the analyst need to find the best fund this year, he or she would need to find the best one in every coming year and move clients accordingly in a timely manner.  The odds of that happening still make the unmanaged index look like the better alternative.

Overall market conditions have also posed a problem for active managers.  Since hitting highs approaching 20% in the 1980s, intermediate government bond yields have headed down.  Their prices, which move in the opposite direction, have been on an upswing.  Managers holding any cash or low yielding bonds were penalized and have fallen behind.  When prices are falling, cash offers an easy way for them to beat the index, but in this environment it consistently worked against them.

This year was even worse as even bond guru Bill Gross of PIMCO bet against Treasuries on the belief that yields would be on the rise and prices would suffer.  Actually the opposite occurred when this summer’s U.S. national debt debate and the European credit crisis sent the world’s investors streaming into the safety of U.S.  Treasuries.  Managers who followed Mr. Gross’ lead lost ground to the index and remain there today.

Finally the biggest hurdle holding actively managed bond funds back is the persistently low yield.  Historically 83% of intermediate Treasury return has come from yield.  With rates now at historically low levels and holding, the average Intermediate Government fund’s expense of 0.98% virtually wipes them out.  Sure, some funds charge less than that but the fact that this is the average means there’s roughly as many charging more.  With further capital gains limited by government bonds’ already high prices, yield will be even more important.  Managers who missed some of this summer’s run-up or worse, those who were essentially out of Treasuries like Mr. Gross, will have an extremely difficult time making up lost ground.

As the chart above illustrates, this year’s reason for active bond funds’ poor performance may have been different, but the results were the same.  Until U.S. bonds enter a prolonged bear market, investors are better off relying on bond index funds or index ETFs.  It’s ironic that equity fund managers are most frequently portrayed as incapable of beating their indexes when bond fund managers are even worse.  Sometimes it’s better to remain out of the spotlight.

Hot Potato Season

It’s that time of year again, time for mutual funds to pay out their annual capital gains.  Over the past decade, this hasn’t been much of an issue because many funds were able to offset gains with carried over losses from the tech stock meltdown or the 2008 credit crisis.  Now, three years on, most of those carry-overs are gone and capital gains distributions are likely to be up.  Many investors and unfortunately, some advisors, either don’t understand this or won’t act proactively.

When you buy a stock and it goes up, the difference between your purchase price and selling price is your taxable capital gain.  To a great extent, you can control this liability by timing when and if you sell.  In the meantime, it doesn’t matter how large the difference is between the purchase and potential selling price, you won’t be liable for tax on it until you actually sell it at a profit.  The same is also true for mutual funds.  But there’s also one other thing you can’t control and that’s the fund’s sale at a gain of stocks that it holds.

Here’s how that works:  When you buy shares in an equity mutual fund, you’re actually buying an undivided interest in the fund’s portfolio.  The size of your interest is proportional to the size of your investment to the overall value of the fund.  Throughout the year, the fund’s manager adjusts the portfolio by buying and selling stocks in order to take advantage of profit opportunities or because of cash flows dictated by fund shareholder purchases and redemptions.  Like an individual investor, the fund racks up capital gains and losses every time it trades.  Also like an individual investor, the fund can offset gains with losses to eliminate or reduce taxable gains.  However, unlike an individual investor, the fund must distribute its gains to its shareholders at least annually.  Most funds tend to do this in the final two months of the calendar year.

One might think if a fund is down for the year, it probably won’t have any gains to distribute.  One might also think if a fund is purchased one week and it distributes gains the next, there will be little or no tax liability given the short holding period.  Both beliefs are dangerously wrong.

Funds that are on track to post annual losses are often brimming over in capital gains.  This can happen for a number of reasons, but here’s a likely one:  When the market itself suffers a sharp decline (as it did in August of this year), nervous investors flee to the safety of bonds or cash.  When they sell their shares, the fund manager must sell parts of the portfolio to cover redemptions.  Initially, at least, managers often try to minimize the capital gains impact by attempting to offset the sale of winners and losers.  But if redemptions are too sizeable or if selling offsetting losers would result in bad investment decisions, it becomes necessary to sell appreciated holdings and realize the gains.  At the end of the year the fund itself may show an annual loss, yet the remaining shareholders will get a second, negative surprise, when the fund’s taxable capital gains are distributed to them.

That’s also why the second misconception is so dangerous:  It doesn’t matter how long you’ve been a shareholder in the fund, if you own it on the “record date” (usually just a week or so before the distribution), you’ll get your proportional share of the taxable gain distribution.  This is like the children’s game of hot potato – whoever ends up holding it at the end gets burned.  As in the example above, most of the fund’s capital gains were incurred during the year in order to pay out shareholders who are no longer in the fund at the record date.  Their holdings are redeemed without the tax liability incurred to make that payment possible.  Instead, shareholders as of the record date – whether long-term shareholders or simply those who invested in the fund the day before – get stuck with the taxable gains.

There is a way around this, but you must be proactive.  First, most funds post information about potential gains at their websites.  This includes the expected size of the distribution as well as the record date. Investors and their advisors should take note of this and not make any new fund investments until after the record date.

Existing shareholders can consider selling the fund before the record date, and investing in a similar fund or better yet, ETF, with a similar objective.  If owning this particular fund is important, they can consider repurchasing it after the “wash sale” period ends (basically a month later) with no negative tax consequences.  Be careful taking this approach however, because the gains realized in selling the fund may be greater than the upcoming distribution.  This can easily be the case if the fund has been a long-term holding.  If so, the decision should come down to which gain is less?  The distribution or the shareholder’s gain?

By the way, ETFs (at least traditional ones) don’t have this problem.  By their very nature, they don’t accumulate capital gains.  Shares are created on purchase or destroyed at sale.  Large redemptions can be paid out in kind to avoid leaving taxable gains for remaining shareholders.  It’s something to keep in mind during hot potato season.

Morninigstar Goes Beyond the Stars — Or Do They?

In mid-November, Morningstar will begin publishing Analyst Ratings for a segment of the mutual fund universe.  These will replace and go beyond the current Analyst Picks and Pans, assigning one of five ratings (Gold, Silver, Bronze, Neutral, and Negative.)  Three of the ratings are positive and only one is neutral and one is negative because Morningstar reasonably assumes investors want more granularity in evaluating positively ranked funds.  The goofy Olympic medal scale is used to avoid confusion with quality rankings or Morningstar’s traditional “star ratings”.

This naturally brings up the question, “If the star ratings are so pervasive and so well known, why introduce another set of ratings?”    Morningstar addresses this in their FAQs:

The Morningstar Rating, most commonly referred to as the “star rating,” is a purely quantitative, backward-looking measure of past performance. It is based on a fund’s risk- and cost-adjusted performance over three-, five-, and 10-year periods and helps investors to quickly and easily assess a fund’s track record relative to its peers. However, the Analyst Rating is a qualitative, forward-looking measure, based on analyst research, and can be used in conjunction with the quantitative Morningstar Rating. Together with the fund reports, they provide investors with a powerful tool to assess funds and make informed decisions.

It’s always interesting to see Morningstar deny the predictive ability of the star rating.  They often do when questioned about the generally mediocre return of four- and five-star funds.  Nevertheless, there’s never been a concerted effort to correct investors’ mistaken belief that star ratings are predictive of future performance.  As a consequence, many advisors report that despite the level and quality of their research, clients still balk at owning funds that aren’t four- or five-star rated.

Perhaps we’ll hear more about this distinction now that Morningstar is launching its “forward-looking measure, the Analyst Ratings.  The differentiating factor appears to be the fact that the latter is “qualitative” rather than strictly quantitative like the star rating.  Let’s see how this works.  Again from the FAQs:

The Morningstar Analyst Rating evaluates funds on five key pillars, considering both numeric as well as analyst-driven factors. This approach notably puts only partial weight on past performance and backward-looking risk measures and does not dismiss funds that have underperformed or have limited track records. It will also be more responsive to significant changes at a fund or parent organization. The five pillars are:

• People: Quality of a fund’s investment team, based on factors including its experience, stability, structure, communication, and alignment of interests with fund shareholders;

• Process: Quality of investment process—in terms of both security selection and portfolio construction—and whether it is sensible, clearly defined, and repeatable.  Also judges whether the process is effectively implemented and whether the portfolio is consistent with the stated process;

• Parent: Quality of the parent organization, including capacity and risk management, recruitment and retention of talent, incentive pay, and culture of stewardship;

• Performance: Evaluation of long-term returns, consistency of performance in different market conditions, and performance relative to manager changes and changes in asset size; and

• Price: Evaluation of annual expense ratios, and performance fees if appropriate, within the context of the relevant market or cross-border region.

OK, the first thing to note is the last two “pillars”, Performance and Price, are strictly quantitative.  They are already considered in the star ratings and receive no qualitative enhancement.  The differentiating factors must therefore be in the first three items.

Pillar 1 is People.  Analysts often visit money managers to get a feel for the investment team and how well they work together.  This is truly a qualitative measure.  Teams that work well together tend to stay together, providing a consistent approach.  But a quantitative measure known as “manager tenure” also addresses this and, not surprisingly, can be quantified.  The “Alignment of interests with fund shareholders” can best be evaluated by compensation schemes and ultimately the fund’s expense ratio – both highly quantitative factors.  Maybe that qualitative insight is in the remaining two pillars.

Pillar 2 is Process.  Is there a clearly defined repeatable approach to security selection and portfolio construction?  Again, this is often emphasized by analysts seeking qualitative information from investment managers.  Essentially it’s an effort to determine if performance up to this point has been the result of skill or luck.  Most investment managers will be able to provide a written security selection and portfolio construction policy.  Speaking from experience, in creating it, the goal is to make it sound as specific as possible while not limiting the managers’ options.  This results in general statements that do little to cast much light on the actual investment process – particularly in turbulent markets.  Arguably, the best way to measure this is by looking back at how the fund’s holdings and portfolio actually changed during periods of market stress.  This, by the way, also helps assess “whether the portfolio is consistent with the stated process” and is – you guessed it – a quantitative factor.

That leaves the final pillar, Parent.  This one’s a real head-scratcher for quants.  It’s hardly arguable that you don’t want to place money in a fund with a parent on the verge of going under, but does this really take a major investigation?  Presumably the “capacity and risk management, recruitment and retention of talent” refers to administrative staff because these factors were already considered in the other pillars for the investment team.  How’s that helpful?  Incentive pay should also be covered in Price and People pillars.  Finally, the “culture of stewardship”:  How does that possibly help the fund investor?  Does the highly rated parent firm send excess profits to the fund as a charitable contribution?

At this point it’s hard to see what benefits the qualitative factors in the Analyst Ratings add over purely quantitative approaches such as the traditional star rating.  Perhaps more puzzling is why the former is expected to be more predictive than the latter?  On the contrary, one might reasonably conclude one is not more predictive than the other because neither is.

Dividends Come with More Than Yields

One of the first things an investor learns is to buy bonds for income and stocks for gains. Sure, bonds occasionally go up in price and some stocks do pay dividends, yet over time the lion’s share of bonds’ total return still comes from their coupon and that of stocks comes from price appreciation.

But now, with bond yields at fifty-year lows, it’s time to revisit that reasoning. Over the past quarter, as yields have melted, intermediate term government bonds have seen their prices jump 25%. Their coupons certainly won’t top that this year. Even more surprising is the fact that the dividend yield of the S&P 500 now exceeds that of intermediate term government bonds (see nearby chart). It’s not that dividends are so high as much as bond yields are so low.

Some advisors are urging income investors to consider dividend-paying stocks instead of bonds. Not only do stocks enjoy the current positive differential, bond prices are set to fall whenever yields finally return to historical norms.

But some advisors are overselling the benefit by saying stocks not only offer higher current yields, they also come with “a call on the stock market’s potential appreciation.” This is partially true, but in a very important way it’s not. A call option gives the buyer the right (but not the obligation) to purchase the underlying security at a stated price. By owning a dividend paying stock, the owner not only gets the income stream, he or she also will enjoy any price appreciation as well. On the other hand, they’ll also suffer any loss, too, whereas the owner of a call never loses more than the price of the option itself should it expire worthless. A steep decline in the stock market can easily wipe out more than a year’s dividend, a risk that shouldn’t be overlooked.

Equity volatility — especially now at its elevated levels — should also give income investors pause. Although higher dividends may increase current income, the accompanying volatility also increases risk. The search for higher short-term yields can quickly change the complexion of a strategic long-term investment allocation. At the very least, this decision shouldn’t be taken lightly.

There’s an argument that dividends are just as secure as bond yields. Companies don’t want to risk the negative publicity of cutting dividends so once established, they’ll do everything possible to maintain them. There’s a lot of truth to that, however no company — no matter how strong and well-established — can do much to guarantee its share price. That’s why dividends come with considerably more risk than government bonds that can be held for a return of principal at maturity.

Know Your Commodity Index

As stocks tumbled through the summer, more and more pundits touted the benefits of adding commodities to traditional stock and bond portfolios. Not only have commodities maintained better returns, their relatively low correlation with more common asset classes offers potential portfolio risk control as well. Most of this is true (although often subject to hyperbole) however building efficient portfolios — even with commodity indexes — isn’t as easy as simply slipping in a widely traded exchange traded fund or note.

There are a number of well known commodity indexes including the Thomson Reuters/Jefferies CRB Index, DJ-UBS Commodity Index, Deutsche Bank Liquid Commodity Index, the Rogers International Commodity Index, and the S&P GSCI Commodity Index. Not all are created equally. As a result, it’s critical to know its composition and to use a proxy for that specific index.

Consider the efficient frontiers on the first chart nearby. We started with an efficient mix of four asset classes: Large Cap stocks, Small Cap Stocks, Foreign Stocks, and US Bonds (illustrated by the red line). We then added each of the five commodity indexes listed above to create the other five frontiers. Quite a noticeable difference. Clearly the index used in the model has a definite bearing on the results.

Now, consider the effect of using the wrong proxy investment. The frontier reaching the highest returns was created using the Rogers index while the one with the lowest set employed the DJ-UBS index. Their differing compositions are shown in the second chart. The iPath DJ-UBS Commodity Index ETN (DJP) is a popular exchange traded note. One might think it could be used in commodity model portfolios, even those created using other commodity indexes.

But here’s what happens in this case: Using a balanced mix with a standard deviation of 14.3% in the middle of the Rogers curve creates a portfolio that is actually much more conservative on the DJ-UBS curve (12.4%). Return is considerably less, too (12.17% vs. 9.99%, respectively). That might not look too bad given that risk is lower. However, on a risk adjusted basis you still lose because the Sharpe Ratio falls from the Rogers’ 0.85 to 0.81.

Here’s the saddest part: At that risk level, you would have been better off sticking with traditional asset classes. With only stocks and bonds, the portfolio with a 12.4% standard deviation not only has an expected return of 11.03% but also a Sharpe Ratio of 0.89. With the proxy mismatch, the commodity exposure actually diminishes expected return.

Oh, by the way, in addition to knowing the composition of your commodity index, you should also get familiar with such exotic sounding concepts as contango, backwardation, and roll premium. These are actually the source of the majority of commodity returns.

Now go forth and diversify.

Is Asset Allocation Oversold?

With the rise of index funds and exchange traded funds (ETFs), many advisors are employing passive investments in their clients’ portfolios.  Rather than presenting themselves as stock pickers, they’re claiming to add value though asset allocation and portfolio monitoring.  They point to the fact that a seminal 1986 academic study suggested over 90% of the variance in portfolio return results from asset allocation.  (Interestingly, this is often misquoted to say, “Over 90% of portfolio return is the result of asset allocation.”)

Even if the results of the study are quoted correctly, are the benefits of asset allocation still over-sold?  Certainly a grandmother has no business in an aggressive stock portfolio and her young grandson should have equally little interest in one based on Treasury bills, but wouldn’t they realize this themselves?  Just how much value does an advisor add when steering clients to the appropriate asset mix?  In practice, most end up in some sort of blend of stocks, bonds, and cash, anyway.  Sure, the individual weightings may vary from one alternative to another, but does an additional 5% in small cap value really make that much difference in long-term performance?

Once the client is assigned an allocation, advisors continue to earn their keep by monitoring and periodically rebalancing back to the original mix.  This is supposedly worth paying for because without it, that carefully crafted asset allocation would end up being nothing more than a simple buy-and-hold portfolio, subject to the whims of the market.  To avoid that, the advisor periodically reviews the mix and rebalances it back to the original allocation as needed.  Some use trading rules (e.g. only rebalance when at least one asset class strays more than X% from the original mix) while others simply rebalance on a regular basis regardless of how little the mix has changed.  Sure clients could do that themselves, but they probably won’t; so it’s worthwhile paying the advisor to do it for them.

But just as the initial selection of the allocation may be oversold, so may the benefits of monitoring and rebalancing.  To see why, consider an actual balanced portfolio of 25% U.S. Government Bonds, 48% Large Cap Stocks, 21% Small Cap Stocks, and 6% Foreign Stocks created on January 1, 2004.  Over the next 7-1/2  years, this portfolio was rebalanced in any calendar quarter when at least one of its constituents was more than 5% over or under its initial allocation.  The market experienced quite a bit of volatility between 2004 and June 2011.  The first few years were bullish ending with the credit crisis in 2007.  The following year saw steep losses in virtually all asset classes, and then another recovery from 2009 through the end of the period.  Certainly those conditions would make for a good test of the static asset allocation vs. the naïve buy-and-hold approach.

 

The performance of the static allocation portfolio (green line) is compared to a simple buy-and-hold alternative (red line) in the chart below.  You may wonder why it looks like there’s only one line on the chart for most of the period.  The simple answer is, the initial rebalancing wasn’t required until April 2006, two and a quarter years after its inception.  There were only three other rebalancings throughout the remainder of the time.  By June 2011, the static allocation’s cumulative return was 26.3% vs. 22.4% for the buy and hold.  Subtract transaction charges and the gap narrows.  Subtract the advisor’s management fee and it may disappear entirely.  Didn’t you expect more than this?

Maybe this was just an odd portfolio.  Perhaps the past seven and a half years have been unique in the sense static allocation wasn’t as effective.  Or perhaps the benefits of asset allocation are simply overhyped.  If nothing else, it suggests clients are probably better off spending a few minutes each quarter to review their asset mix than constantly paying an advisor to do it roughly once every two years.

At the Fund Manager’s Mercy

Last week we encountered an advisor with an interesting approach to portfolio construction and allocation. Like many advisors, he devises asset allocation models with varying degrees of risk for use with his clients. Unlike others who do this, his funds don’t align — at least directly — with his models. Here’s an example:

In this case, the equity funds all align with the asset classes they represent. Fund A’s (Large Cap) weight is 30%, exactly matching Large Cap in the allocation model. The same is true for Small Cap (Fund B) and Foreign Equity (Fund C). Domestic Bonds (Fund D) also match the allocation (20%). But then things get a little weird with Foreign and Emerging Market Bonds. The asset allocation model assigns them 16% and 4%, respectively, but the the actual portfolio has two funds (Funds E and F) which are “Foreign Bond” funds at 10% each. There is no Emerging Market Bond fund. What’s up with that?

According to the advisor, Fund E is 100% foreign developed country bonds. Fund F, however is allocated 60% foreign developed country bonds, 40% emerging market bonds. By allocating 10% of the overall portfolio to this fund, he’s able to get 4% emerging market bonds (10% x 40%) and 6% foreign developed country bonds (10% x 60%) which, when added to Fund D’s weighting delivers the 16% foreign developed country bonds as illustrated in the allocation model.

That’s pretty clever, but perhaps not clever enough. First of all, where did the advisor learn Fund F was allocated 60/40 as described above? From the fund prospectus? From the most recent listing of fund holdings? Allocation targets in the prospectus are generally averages, not actual allocations. Managers try to make them as general as possible to retain the greatest degree of flexibility. The list of holdings are always stale. Funds are only required to publish them on a semi-annual basis. Some report more frequently, but even then the list is from the prior month and is always subject to change.

And that brings up the second problem: What assurance does the advisor have the fund manager didn’t decide to change the allocation? Maybe when the credit crisis hit a couple of years ago he decided to pull out of emerging market bonds and go 100% with debt from developed countries. Or maybe now with global rates so low, he sees greater opportunity in emerging market debt and has increased it to over 50% of the portfolio. Every time he strays from the 60/40 target mix, he changes the advisor’s asset allocation. Is that what the advisor really wants?

Then again, something else may be at play here. We’ve been assuming the advisor created the asset allocation model first and then populated it with funds, however we may have the process reversed. Maybe the advisor knew the funds he wanted to use and simply built the allocation model based on their current composition. While this may seem odd, it’s really not; many bottom-up equity managers build their portfolios in this manner.

Unless that’s the approach you’re using — and it probably isn’t — it’s best to avoid relying on a fund’s reported holdings or target mix. After going to such effort to create your asset allocation models, do you really want to leave their success up to the whims of distant fund managers? Hopefully you answered, “No.”

All or None

If you evaluate mutual funds, you’ll eventually be asked to analyze Socially Responsible funds. As you probably already know, these are funds that shun stocks of companies that produce sin products (alcohol, cigarettes, etc.), materials or products of war, or companies that have been polluters or are considered “not green”. These stocks may be easy to spot, but the appropriate benchmark for comparison isn’t.

When you choose to invest in a Socially Responsible fund, your decision is based on social beliefs rather than pure risk and return. For example, over the years, Philip Morris, General Dynamics, and Dow Chemical have all been market leaders, yet each would have been avoided by various Socially Responsible funds. As a consequence, these funds’ investors would have missed out on these stocks’ market-leading performance. The Dow Jones Industrials, the S&P Mid Cap 400, and the Russell 2000 don’t have these constraints; they simply consist of stocks with similar capitalizations and styles.

Aside from a few custom offerings created by S&P and other major index providers, there really aren’t any Socially Responsible indexes. One could argue a broad index such as the S&P 500 would be acceptable, not because it reflects Socially Responsible investing but simply because it’s a common yardstick to use against the category of Socially Responsible funds. In fact, using that logic, all broad indexes would be equally acceptable.

On the other hand, no broad index really fits the purpose. The whole concept of benchmarking revolves around comparing investments to indexes that most closely resemble their fundamental or style characteristics. That’s why you’d typically measure IBM against the S&P 500 rather than the Russell 2000 or the EAFE Emerging Market Index. But the problem with Socially Responsible funds is that there is no benchmark (aside from that handful of custom indexes) that truly reflects their characteristics. In that sense, no broad index is acceptable.

So, either you can either simply pick any index as a common yardstick or just compare Socially Responsible funds to one another or the group average. Unless you have access to one of those custom indexes, this is a case of all or none at all.