Cents & Sensibility — Moving beyond core investments

Beth Peabody

“Tell me and I forget, teach me
and I remember, involve me and I learn.”

— Benjamin Franklin

Last month’s column focused on suggested strategies for readers who do not want to spend the significant amount of time necessary to select multiple investments for their retirement and personal savings. Target date funds are a solid choice for most investors as professional managers make the asset allocation and investment selections based upon the expected year of retirement. As a reminder, a target date 2040 fund assumes the investor will retire in 19 years.

For those who would like to expand beyond a “core” strategy of a target date fund and for those who are willing to really study investments — as more than a hobby — mutual funds and exchange traded funds (ETFs) can serve as a “non-core” complement to the core investment.

After reviewing if you have target date investments, the action item for last month was to determine which of your other investments are mutual and which of your investments might be ETFs. An additional action item included separating these into “passive” versus “active” managers.

Most index funds and ETFs are considered passive investments because of their allocations to securities that reflect a published index of holdings. The managers of these funds are trying to “match the market.” Because there is not an overlay of expertise in the selection of the fund’s investments, the expenses charged by the fund to investors of the fund are very small, generally 0.1% to 0.5% per year. This “annual expense ratio” is deducted from the fund’s performance and reflected in its reported percentage total returns.

Actively managed mutual funds and ETFs try to “beat the market” using portfolio management and research teams that specialize in the specific strategy of the fund.  Because of the added costs associated with the investment teams and maintaining their expertise, the annual expense ratio of these funds is generally much higher than those of passively managed funds. However, the higher expenses are also included in the annual expense ratio that is subtracted from the fund’s performance results.

Balancing your investments between active and passive managers is a complementary strategy that combines low-cost investing to earn market-like returns, while striving to outperform the market with a select group of managers.

When selecting an active manager for your investments, I suggest the following guidelines:

  • Avoid sector specific funds unless you have an expertise in this industry.
  • Determine the goal of the selection as it relates to your total portfolio. For example, if you would like access to technology stocks and communication services that have been favored by investors for many years, review “large capitalization growth” managers.
  • Do not use past performance as a guide for selection, unless comparing to similarly managed funds. For example, large capitalization value funds have been lagging the stock market for many years until a recent boost in performance from stocks they favor in sectors like financials and industrials. Their past performance would look terrible relative to growth managers, but that does not mean value managers should be shunned. The same is true for international managers whose performance during the past decade have generally lagged those of their U.S. counterparts. Relative underperformance is not a reason to avoid opportunity in stocks overseas.
  • Select all funds based upon tenured management teams.
  • Look for consistently good calendar year returns, as well as rolling period returns of three and five years.
  • Review annual expense ratios and make sure they are below category averages for similar funds.

Morningstar.com is an excellent tool for reviewing these guidelines using a fund’s ticker symbol. Each of your investments should have a “ticker symbol” which is like the fund’s social security number. The symbol associated with the investment is usually three, four or five letters. A popular ETF that tracks the S&P 500 Index, for example, is “SPY.”

ACTION ITEM: Review the investment strategy and performance of your investments and compare to similar peer group or index benchmarks. Make sure to review the performance results of the active managers to determine if the higher annual expenses paid to invest with them has produced higher percent total returns than the passive benchmarks.

Beth Stegner Peabody is CEO of Stegner Investment Associates, Inc., and a graduate of Sacred Heart Academy.

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