February 24, 2017
For the main topic today, I want to follow up on one of the early newsletters of the year, in which we had discussed what an index fund is. (see here for a refresher). Once you understand how an index fund works, and why it exists, you are emerging from the mutual fund swamp, but you are not out of the woods. There are thousands of index funds, and many of those are not true index funds. Most of them have problems in one way or another, such as liquidity risk, trading volume problems, risk of shutdown, tax inefficiency, mediocre fee percentages, tracking errors, index construction errors, and more. I know, it's exciting.
In addition to all of the different fund choice dilemmas, keep in mind that index funds can swing wildly, like stocks. Some of the well constructed index funds dropped over 70% from peak to trough from 2007 to 2009. Psychologically, 70% down and 90% down feel similar - when confronted with that situation your reaction will not be "I just dropped 70% but I'm feeling good because it's not 90%."
What to do? That's where index portfolio construction comes into play. You need many indexes (but not too many), and they each serve a dedicated purpose. In the investment work that I see inbound from new clients, the "serve a purpose" function is almost always missing from their previous advisors or brokers. What I see is collections of funds or stocks that are often not well diversified and are not serving as either protection points, dividend generators, or areas of future possible capital gain. Without those purposes, capital is going to waste.
In a well-constructed portfolio, each position has a dedicated reason for being there. By reason I do not mean "Jim Cramer threw a rubber chicken across the stage he was so excited about this stock, so my advisor put it in my account." By reason I mean it is there to protect you, to generate current cash for you, or to generate capital gains. And importantly, the purposes work in tension with each other. Sometimes a world event will be detrimental to one index, but another will do well. Envision a matrix, where the index funds are spread out to cover the possible scenarios that the future may hold.
What could go wrong? Short of a mushroom cloud on the horizon, a lot. Probably the most insidious, because it is quiet and usually doesn't make the news, is inflation. Ask anyone who lived through the 1970's what inflation did to their savings. Moving on in this list of rosy scenarios, we have financial panics, currency risk, wars, corruption in corporate America, unfavorable tax changes, trade and tariff conflicts, regional risks (think real estate crashes and cost of living), and others.
If all this talk about matrixes and tension seems abstract, let me use a real example. In a severe crash like 2008, almost everyone's assumptions fell apart. This led to increased panic as things became unfamiliar. Almost all stock index funds, all real estate index funds, all foreign index funds, and almost all bond funds started to buckle under the pressure, and then moved to outright collapse. But U.S. Treasuries did not behave this way. Those boring treasuries that never made you much money now seemed so attractive you'd practically ask them to the prom. Unlike everything else, they were rising, and quickly, as the entire world rushed to their embrace.
They served their purpose: they protected you, and they gave you cash when it was most valuable: in a panic. Their purpose was not to make you a lot of money in capital gains, their purpose was protection.
Every index we buy for you has a dedicated reason to either offset risk or make you money long term. If we cannot make a succinct and clear argument as to the distinct attributes of each position, we should not own it.