May 2, 2016: Low Cost Index Fund Investing

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Low Cost Index Fund Investing

This weekend, in Berkshire Hathaway’s annual meeting, Warren Buffett renewed his attack to hedge fund industry and suggested that individual investors (and many institutional investors too) stick to low cost index fund such as S&P 500 index fund (Vanguard’s 500 ETF VOO, for example). While we believe that in addition to cost, there are other important factors to consider, we agree that investing in low cost index funds is the way to go.

Fees matter

Though readers can find plenty of articles to discuss this, it is still worthwhile to point out the following:

First of all, even after many years’ campaign by people like John Bogle and Warren Buffett, investors still carry their inertia to continue to invest in expensive funds. For example, when it comes to S&P 500 ETFs, one can find several ETFs and no load mutual funds such as the following:

S&P 500 ETFs & mutual funds (as of 5/2/2016)

Fund	Expense Ratio	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR
IVV (iShares Core S&P 500)	0.07%	2.1%	0.3%	11.6%	11.1%	6.9%
SPY (SPDR S&P 500 ETF)	0.09%	1.7%	0.1%	11.2%	10.9%	6.8%
VOO (Vanguard S&P 500 ETF)	0.05%	1.8%	0.1%	11.1%	10.8%
PREIX (T. Rowe Price Equity Index 500)	0.27%	1.7%	-0.1%	11.1%	10.7%	6.6%
SWPPX (Schwab S&P 500 Index)	0.09%	1.7%	0.1%	11.2%	10.9%	6.9%
VFINX (Vanguard 500 Index Investor)	0.16%	2.5%	0.8%	11.7%	11.1%	6.9%

When we tried to construct mutual fund portfolios for our Brokerage Investors, we were frequently frustrated with the lack of no transaction fee index funds in various brokerages. For example, PREIX (T. Rowe Price Equity Index 500) is the only low fee S&P 500 index fund available transaction fee free in Etrade and Merrill Edge. This fund is 0.09% to 0.15% more expensive than the others. The above table only shows the funds for the most popular index S&P 500 stock index. For other index funds such as various stock style indexes (for example, mid cap value index fund), you’ll be surprised to find out that there are still many alternatives whose fees can vary to 0.5% or so!

We can only attribute this to investors’ inertia or reluctance to deal with the trouble to move to a better brokerage. Maybe the following discussion can further help you to look at this issue more seriously.

0.5% is a big deal. To put things under perspective, 0.5% of $100,000 is $500, or the cost of an iPhone. When it comes to purchase an iPhone, people would go extra miles to find a cheaper price, but for investing, these become some intangible numbers and people respond differently. Remember this is the recurring annual extra cost. Furthermore, when your asset grows, this number can become much bigger.

Because of the recurring cost, this extra cost can affect your long term growth dramatically. For example, at an annual 8% growth rate, a $10,000 initial investment would become $46,610 after 20 years. But with the extra 0.5% fee bite, the value after 20 years would be $42,479, a $4,131 difference.

In a realistic 6% to 8% per annum portfolio return world, 0.5%, let alone 1%, is a big deal. Most active funds have a hard time to outperform an index fund even before fee. Investors tend to be confused by the short term performance phenomenon: yes, it is very common to see funds that outperform (or underperform) a benchmark index by a large margin in a particular year. But over time, in the long term, it has been shown that it’s incredibly hard for a fund to outperform. At best, you might end up getting the index fund return while your fund managers or advisors getting their fees, i.e. the managers derive their fees by ‘beating’ the index with just the fee amount. Odds are, however, that investors might get an even lower return.

Paying a manager to manage a simple strategic portfolio or a fund of funds with anything above 0.1% is questionable, in our opinion. Vanguard’s 60/40 index fund VBINX charges 0.22% expense while VFINX (the stock portion) and VBMFX (Vanguard total bond market index) charge 0.16% annually. With lower cost ETF alternatives, one can get VOO that only charges 0.05% and BND that charges 0.06%, thus, saving about 0.15% to construct a 60/40 balance portfolio, compared with VBINX. Another glaring example is PRPFX (Permanent Portfolio) that charges 0.8% while one could construct a Harry Brown type permanent portfolio with as little as 0.2% or lower expense, a saving of 0.6%! We will discuss permanent portfolio performance shortly.

Similarly, we believe that low cost indexing is also applicable to portfolio management. This is especially true for strategic asset allocation portfolios that only require simple rebalances a few times per year. Recently, there have been a new crop of on line investment advisors (the so called robo advisors) that offer low cost strategic portfolio management services. It’s debatable whether such ‘low’ cost (as low as 0.25%) is justifiable or not. Regardless, investors just need to do the math and be extremely cost conscious to understand the value added by these services.

At any rate, lowering your fees is the only true ‘free’ lunch that can immediately boost your returns without risk.

Indexing and mechanical investing

We would also like to draw readers’ attention to indexing. Although indexing almost becomes a misnomer for ‘dumb down’ investing, if one looks at what’s under the hood in an index, you’ll find that things are far more sophisticated. For example, the popular S&P 500 index is constructed based on a non-trivial, rigorous addition/deletion and rebalance policy. To us, indexing is a just loose term for a mechanical/rule based investing.

Mechanical/rule based investing has several advantages over human driven investing. First, mechanical investing eliminates the costly human labor. More importantly, it eliminates human errors which can occur frequently due to emotions and other human factors (such as manager change). Precisely because of the pre-selected rules or strategies in mechanical investing, investors are forced to vet the strategy or ‘index’ thoroughly beforehand, unlike those funds or portfolios managed by human managers that can ‘improve’ or change as time goes, making it hard to predict, hard to understand and prone to mistakes in the long investing process.

It’s also because of the requirement to fully understand the method or strategy behind an index, indexing or mechanical investing entails a simple and intuitive explanation for its method or rules. All of the traditional capitalization based indexes have very basic intuitive rules and they have been vetted for many years. Again, it all comes down to our belief that simpler is better. Just like Buffett said, no investment consultant would like such business because there just isn’t one on their end. No wonder you see so many sophisticated and super secretive hedge (or mutual) funds popping up. Without such ‘sophistication’, how can they charge such a high fee?

Finally, with the above said, we would like to point out that we do believe there are some outstanding investment managers or strategies out there that can beat the market consistently. However, it’s just not for an average investor. In fact, for any individual investor, overly relying on finding these managers is a fool’s game: this is because individual investors can not withstand the consequence of committing to a bad investment (which has a very high probability) in their limited lifetime. After all, there aren’t many 10 years in one’s life. So go for a safer route instead of chasing a home run.

Permanent portfolios

Though Buffett’s portfolio consists of only S&P 500 and a short term bond index fund, the low cost indexing investing can be extended to other alternative portfolios. The following table shows examples permanent portfolios:

Portfolio Performance Comparison (as of 5/2/2016):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	10Yr Sharpe
Harry Browne Permanent Portfolio	7.6%	4.1%	3.5%	4.6%	6.3%	0.78
Permanent Income Portfolio	4.5%	3.8%	3.7%	6.2%	6.4%	0.96
PRPFX (Permanent Portfolio)	10.9%	1.4%	0.8%	0.3%	5.2%	0.42
VFINX (Vanguard 500 Index Investor)	2.5%	0.8%	11.7%	11.1%	6.9%	0.29
VBINX (Vanguard Balanced Index Inv)	2.9%	0.9%	7.4%	7.9%	6.4%	0.47

One can see that the Harry Browne Portfolio and Permanent Income Portfolio have done well recently. These are attributed to the recent strength in gold and long term bonds. PRPFX (Permanent Portfolio), a mutual fund, recovered a bit recently. However, its long term performance has been damaged. Furthermore, as we discussed above, one can construct a very low cost Harry Browne permanent portfolio using the following

Ticker/Portfolio Name	Percent	Expense
IAU (iShares Gold Trust)	25%	0.25%
VGLT (Vanguard Long-Term Government Bond ETF)	25%	0.1%
VOO (Vanguard S&P 500 ETF)	25%	0.05%
CASH (CASH)	25%	0%
Total	100%	0.1%

So, instead of 0.8% charged by PRPFX, you can have a permanent portfolio with 0.1% expense. If you tweak this portfolio further, it might cost a bit more, but for sure no more than 0.25% (permanent income portfolio has 0.22% overall expense), still a big saving here.

For the above portfolio, you just rebalance once a year. You are paying yourself 0.7% of the portfolio by doing the buying and selling two or three funds at most once a year!

Market Overview

Stocks underwent some correction last week. This was caused by several major earning misses (Apple, Microsoft and Google). However, overall, S&P 500 earnings actually improved over the expectation on March 31, 2016: from Factset, so far for Q1, the reported and estimated S&P earnings combined till the end of last week declined -7.6%, better than the previously expected -8.7%. Markets are making guesses by fluctuating up and down. What we need to do is to ignore the noise and stay with the strategies we have chosen.

For more detailed asset trend scores, please refer to 360° Market Overview.

We would like to remind our readers that markets are more precarious now than other times in the last 6 years. Since the financial crisis in 2008-2009, we have not seen substantial structural change in the U.S., European and emerging market economies. Even though U.S. stocks have had a recent correction, their valuation is still at a historical high level. It is thus not a good time to take excessive risk.

We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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