First Portfolio

[Jeff W]

I have a lot of money sitting around earning 0% interest right now because I've been lazy about investing my money. I want to put together a simple portfolio(taxable account) of passive and active funds with low expense ratios.

A few questions:

1. I should use ETFs, yes? I'm investing a substantial amount of money.

2. Should I go light on actively managed funds or should I gamble that the top low expense ratio active funds will outperform the index funds in the future?

It seems to me that if you take X funds, then some percentage of them will outperform the index funds just because of variance.

Some Active funds that look attractive to me are the Dodge and Cox International DODFX and the Loomis Sayles Bond Funds (ER .75 or 1.0 depending on size of investment) LSBRX and LSBDX. I'm also looking at the Bridgeway Ultra Small fund BRSIX but it has a high ER .7% for a quasi-index fund.

3. As a beginning investor with a long investment horizon, should I incorporate bonds into my portfolio? If I'm going to have funds in an ING 4.5% interest account, should I just put most of that in bonds instead? I'm leaning towards including 20% bonds, but could go anywhere from 0-40%.

5. How does this portfolio look:

Dodge and Cox Funds:

DODFX - International Large Value (ER 0.7%)

Loomis Sayles Funds:

LSBRX - Bonds (ER 1.0% or .74% if I put in $100,000)

Vanguard ETFs:

VB - Small Cap Blend (ER .10%)
VO - Mid Cap Blend (ER .13%)
VV - Large Cap Blend (ER .07%)

I'm not sure of my allocation %s yet.

I think I need an international small cap fund with low ER in here. I'll have to look into that.

Do I need to chop my funds up further(small value, small growth, etc)?

[Tupacia]

If you're a young investor and don't need the money you invest for any specific goal (besides capital appreciation and retirement), I would recommend a heavy proportion of equities (dependent on your risk tolerance). If you could handle the bumps associated with stocks, then you will achieve a higher rate of return over the long term with equities over any other asset class. Couple of general things to keep in mind:

1. Actively managed mutual funds are a loser's game - the vast majority of them fail to beat the S&P 500, and academic research has shown that picking funds that have performed better than others has no measurable impact on future performance (i.e. it's nearly impossible to pick the funds that may consistently beat the market). It's pretty easy to understand why this is: mutual funds must invest in a large amount of stocks because of SEC requirements preventing them from investing over a certain percentage in a particular stock (meaning they mimic the larger indexes to a large degree) coupled with the expense ratios (the proverbial rake). If you want to invest in funds, a passive approach is always better in my opinion (with the exception of international investing which lacks a clear benchmark).

2. Over the long-term, value stocks have outperformed growth stocks.

3. Over the long haul, small stocks have outperformed big ones.

You can't really go wrong if you invest in an S&P Index Fund, a Small-Cap Index Fund, and some International Fund with a low Expense Ratio.

[Jeff W]

I did some more research on LSDBX/LSBRX and I think I'm going to skip them as they're not tax-efficient. I'm not 100% clear on tax efficiency(yet), but according to Morningstar LSDBX has a tax cost ratio of 2.81% which I think would really kill its returns for a taxable account.

DODFX has a TC ratio of .35%, so it should maintain a prominent place in my portfolio.

[BeL0wMe]

Jeff W, congrats on finally taking the plunge, don't pay any heed to Tupacia by the way. DODFX is my largest holding fwiw, and I've been extremely happy with it. Very tax efficient, (I'd assume this is for a taxable account), outstanding firm, great track record. It's pretty much THE fund to own. Depending on how young you are, I'd say leave out the bonds, and stick to 100% equities, unless you are really afraid of losing money. Also, NEVER keep bonds in taxable accounts, they are taxed as ordinary income, and taxes will destroy you, as opposed to equity funds which are taxed with LTCG, assuming you've held them for 1+ years. Other funds I'd consider right now, for creating a core of your portfolio
Fairholme (FAIRX)
Third Avenue Value (TAVFX)
T. Rowe Price Cap Appreciation (PRWCX)
but be careful of the last because it does contain some bonds. It's a balanced fund. Good luck [img]/images/graemlins/wink.gif[/img]

[Evan]

[ QUOTE ]
It's pretty much THE fund to own

[/ QUOTE ]
Do you not see the inherent problem with this? Actually problems.

1) The better your historical performance has been the more likely it is your current holdings are overvalued.

2) The better your historical performance is the more money you're going to have under management. Managing larger amounts of money is an undeniable structural advantage. If you gave the best money manager in the world $10M and had him manage it forever, and you could do this on enough trials to get meaningful results, his return would decline over time.

3) Buying "THE [security of your choice] to own" is probably a pretty bad plan in general. This goes back to pretty basic supply/demand as well as the point in #2.

[DespotInExile]

I think as you get into it, you'll find international and small cap (whether value oriented or not), are the hardest areas to fill in an asset allocation strategy, b/c of their higher ERs, and the general problem of fund size of execution price (i.e., impact costs). Check out Ferri's All About Asset Allocation at a bookstore, which is a little dated, but at the end of each chapter he points you toward some of the better funds for passive indexing, other than DFA funds. Also, Ferri's book is just a wealth of empirical information if you're curious about correlations, covariances, etc.

[Jeff W]

Evan,

Is expectation of future price increases built into the price of mutual funds like it is for stocks? I know it is intrinsically because they track stocks, but if for example everyone thinks DODFX will do well in the future, will it be overpriced?

The other Dodge and Cox funds have outperformed their indexes over 10-year periods. Additionally, the fund's ER is only .3% higher than comparable index funds.

Do you really think my EV is higher going with an international index fund?

[Evan]

[ QUOTE ]
Evan,

Is expectation of future price increases built into the price of mutual funds like it is for stocks? I know it is intrinsically because they track stocks, but if for example everyone thinks DODFX will do well in the future, will it be overpriced?

The other Dodge and Cox funds have outperformed their indexes over 10-year periods. Additionally, the fund's ER is only .3% higher than comparable index funds.

Do you really think my EV is higher going with an international index fund?

[/ QUOTE ]
I'll start at the end. I have no idea what the EV of this fund is so I certainly have no idea if it's higher or lower than any one of many international index funds. Just want to make that clear.


Now, as far as the expected growth of a mutual fund being priced into it. Here's the easiest way to look at it imo. Let's say manager X has a curve denoting his expected return for every given portfolio size. A couple things should be obvious.

To make this a little clearer, we'll ignore things like transaction costs and minimum purchases. We will, however, take into account liquidity concerns (maximum purchases). Now this might seem like I'm kind of cheating to make my point. In a sense I am, but it really only ends up impacting the results in very unimportant ways. I'll get back to that.

So the manager's EV will be highest managing the smallest amount of money. Let's say 1 cent. He can never do any better than that because he can invest in any number of ideas he wants, from 1-whatever (we're pretending he can invest some fraction of a penny). So the logical thing that will happen is that smart people like you will come along and say "hey this guy kicks ass, let's give him some cash and make $$$$!" Now at first this probably isn't going to have much effect on his performance. There are thousands of public companies out there to invest in with huge market caps. So even if he's managing 7 or 8 figure portfolios his expectation is probably not terribly far off from when he was managing that 1 cent.

So now more people see that this guy is awesome. So they give him money. Now he's gone from 7 or 8 figures to 10 figures. All of the sudden there's just not a big enough market for some of his ideas. Let's say he made 20% one year by buying Apple right before Macworld. With the bigger portfolio he's not going to be able to pour as much money into that stock without running the cost up on his own (okay I lied, I am talking about transaction costs).

So the point I'm making is that as funds become "THE fund" and more money gets pumped into it it becomes increasingly hard for the managers to maintain their performance even if they previous performance was 100% a product of skill. It's not really the same supply/demand market as the stocks themselves, but logically the market is going to set the price for both in this fashion.

Now obvious the ideal size is not 1 cent, but the point on the high side still stands.

[Jeff W]

Thanks for the advice on bonds. I'll probably skip them. I do have the option to buy VCITX which is a tax-free bond fund.

[ QUOTE ]
Other funds I'd consider right now, for creating a core of your portfolio
Fairholme (FAIRX)
Third Avenue Value (TAVFX)
T. Rowe Price Cap Appreciation (PRWCX)
but be careful of the last because it does contain some bonds. It's a balanced fund. Good luck [img]/images/graemlins/wink.gif[/img]

[/ QUOTE ]

You feel strongly that these funds will overcome their ER premiums? I am still torn between the lowish ER active funds and passive funds. I understand the arguments in favor of both, but it's simply hard to evaluate the track records of mutual funds within the framework of variance and the index funds certainly have the fundamental edge of low ER.

[Jeff W]

That makes sense, but I've read that this problem is mitigated for international stocks. The largest holding for DODFX Sanofi-Synthelabo is only 3.3% of its total assets(next largest is 2.5) and in the past, D&C has closed their offerings when they felt they could not manage a larger amount of money efficiently.

http://quicktake.morningstar.com/FundNet...fdtab=portfolio