If we could design the mutual fund landscape from the ground up...

Our previous post discussed the poor results of mutual funds in 2011 at least partly due to the prevalence of closet indexing.  So it was refreshing to see that one company is doing something really different.  This article in the Christian Science Monitor talks about a new fund from Gamco Investors called "Focus Five."  A full 50% of the fund will be invested in only 5 stocks — what the company calls its best ideas.  The remaining 50% of the fund will still be focused relative to the rest of the market, investing in between 10 and 20 stocks.

Now, it remains to be seen whether Gamco will be any good at stock picking.  But whether they fly high or crash and burn, you'll at least know why.  Their disclosures will be crystal clear, leaving no mysteries, so that it will be easy to hold them accountable for their picks.

It makes one think about a different way mutual funds could be built if one had the opportunity to rebuild the ecosystem from scratch.  One could imagine that investors desiring active management would split each asset class exposure between two funds - a passively managed index fund and a small, highly focused fund with few holdings.  Investors would then get their market exposure cheaply, as they should, in a fund that is an index fund and says so.  That wouldn't be muddied together with active picks — bringing transparency and accountability to those picks.

It will probably never happen — investors may not like the complexity of using lots of funds, and they could hurt their returns badly if they overload on a single, badly-chosen focused fund – but it's an interesting idea, and one we may hear more about if Gamco has success.

A reasonable portfolio

A lot of effort in the investment space has gone into giving people advice about their proper asset allocation. There’s a good reason for that – academic studies have shown that over 90% of variation in returns is determined by asset allocation. As a result, there’s a lot of advice out there. Academics talk about efficient frontiers and Monte Carlo simulations. Companies such as Financial Engines and Betterment have come along to help people.

Me? I’m more in the William Bernstein camp. The problem is that the inputs to the models are unknown. Things like the risk premium accorded to equities and correlations between asset classes are not very stable over time. Plugging historical data seems unlikely to work – times change, there are different periods, and the future almost certainly won’t look like an average of the past. Having written a Monte Carlo simulator for these types of things, I can tell you that it’s mostly junk. The answers you get heavily depend on whether you think the risk premium for equities will be 4%, 4.5%, or 5%, or other such wonky inputs. I wouldn’t believe anyone who says they know which it will be.

So what do you do, then? I’d start with simply being diversified and rebalancing your portfolio yearly. Also, no matter what you decide, stick to it. You don’t want to introduce unnecessary churn, and you don’t want to chase performance.

Beyond that, here is a reasonable portfolio. It probably won’t be the optimal portfolio over any time horizon, but, hey – it’s worth what you paid for it, and it’s probably just as good as anything else you’ll see.

30% US Large Cap (iShares IWB)
15% US Small Cap (Vanguard’s VB)
20% International (Vanguard’s VXUS)
10% Emerging Markets (Vanguard’s VWO)
5% REITs (Vanguard’s VNQ)
10% Treasuries (iShares IEF)
10% TIPS (SPDR IPE)