Beacon Financial Strategies Financial Planning NC

All Star Portfolio?

In Asset Allocation, Investments, Personal Finance by Chip Hymiller

A recent USA Today article titled “Finding the All Stars:  How we whittle down the funds” scanned the universe of mutual funds in an attempt to identify a number of “all star” mutual funds.  The list of funds that were selected for the article all have impressive track records and are certainly worthy of consideration in any portfolio.

However, the second part of the article actually uses the all star funds to build investment objective based model portfolios including a “Conservative,” “Moderate,” and “Aggressive” portfolio.  As an advisor, I cringe when I see this type of article – one that offers very generalized investment advice to the masses.  I actually envision someone who considers himself or herself a “conservative” investor heeding the journalist’s advice and investing in the model portfolio.

As an exercise, I thought it would be interesting to scrutinize the conservative model portfolio that was recommended in the article.  Here is the conservative model portfolio that the article recommends:

  • 35% “Average” bond fund
  • 30% T. Rowe Price Equity Income
  • 20% FMI Large Cap Value
  • 15% Fairholme Fund

Definition of “Conservative”

Academic research has consistently proven that the asset allocation of a portfolio, the ratio of stocks, bonds and cash, is the primary driver of both investment performance and portfolio risk.  In this case, a portfolio with a 65% allocation to stocks does not fit my definition of conservative.

While the individual stock funds recommended all have stellar “risk adjusted” returns, the fact is that stocks can be very volatile – especially over shorter time periods.  Consider the following return information (using the Vanguard Total Bond index as the “average” bond fund):

  • 3 mos. Return (Sept. 2008 to Nov. 2008):       -19.2%
  • 1 year Return (March 2008 to Feb. 2008):      -29.2%
  • 3 year Return (March 2006 to Feb. 2009):        -6.9%

While these returns are respectable relative returns, I believe that the average conservative investor, focusing on absolute performance, would consider these losses extreme.  In addition, I believe that when experiencing losses of this magnitude, a conservative investor would likely bail out on the investment strategy at the worst possible time – turning these paper losses into real losses.

The Danger of a Focused/Non-Diversified Investment Approach

Each of the funds recommended in the conservative model portfolio employ a non-diversified investment approach.  That is, they invest in very few stocks and/or they invest in several stocks in the same sector or industry.  For example, the Fairholme fund currently has about a 13% weighting in Pfizer and about a 10% weighting in several health insurers including Humana, WellPoint, United Healthcare and WellCare.  While this approach can produce great long-term performance, there can be extended periods of poor performance.   These periods of underperformance can create uncertainty for some investors causing them to question the approach and ultimately “bail” on the fund – again usually at the worst time.

The use of non-diversified mutual funds can be a very effective way to create “market beating” returns, however, investors need to realize and understand the risks that are inherent to this approach.  More importantly in my opinion, people seeking a conservative investment approach are generally not return focused, but rather preservation focused.

The use of highly correlated investments

The recommended funds all have similar investment approaches and investment philosophies.  Here is the correlation matrix of the three funds that were recommended:

36 Month Correlation (2/1/2007 to 1/31/2010)

1 2 3
1. Fairholme 90% 91%
2. FMI Large Cap 90% 98%
3. T. Rowe Price Equity Income 91% 98%

From the results of the matrix, the Fairholme fund is about 90% correlated to the other two funds – a generally high correlation but honestly not too bad.  More alarmingly, the FMI Large Cap and the T. Rowe Price Equity Income funds are 98% correlated!  These funds essentially move in tandem with one another.

While all stock funds tend to be somewhat correlated with one another, the high degree of correlation of the recommended funds seem excessive for a portfolio with a conservative investment objective.   Isn’t the point of using multiple mutual funds to create a portfolio of low correlation, high quality investments?  This requires investing in mutual funds that allocate capital to various market segments and also utilizing portfolio managers who have varying investment philosophies.

Conclusions

The USA Today article does a great job at alerting investors to high-quality mutual funds that are relatively obscure to most non-investment professionals.  However, I believe that creating model portfolios utilizing those funds is irresponsible and may be doing a disservice to many USA Today readers.

In their effort to attract readers, these types of articles are all too common and can have the effect of damaging their readers’ financial standing.  There is more to creating a portfolio, that will meet investors’ long term objectives, than compiling a portfolio of mutual funds with solid past performance.

Of course, those investors who actually heed the journalists’ advice should realize that most journalists and pundits are ultimately not responsible for the results and the following disclaimers are generally implied:

  • These recommendations are only good for today.  The markets, the economy and the mutual funds themselves change with time.  Journalists and pundits will only tell you why they were wrong after the fact, because they have no responsibility to their readers – only to the publications.
  • Investors have the responsibility to “do their own homework.”  It is your responsibility to understand the risks involved in the investment strategy.

I have seen firsthand the damage that articles like these have imposed on well-intentioned investors and their families.  I really wish that journalists would simply state the facts, but stop short of providing investment advice to people that they do not know.