User:BeBH65/Selecting funds for the portfolio

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After having settled on your asset allocation you can turn to selecting the funds for your portfolio. The funds should flesh out your desired asset allocation and should be placed in the most tax efficient manner. "Selecting funds" is best guided by the principles of the Bogleheads® investment philosophy. The best and lowest cost way to buy in a widely-diversified and simple way is with total market index funds.

It is usually best to consider all of your investments together. If you are married, you should usually blend accounts held by both spouses into one unified portfolio.

In summary, the process to "select funds" is:

  1. The first step is to make a list of all your current investment accounts and the funds available in each account.
  2. Next, start with selecting funds in the accounts that offer the most limited investment choices. 401k and 403b type plans regularly offer limited fund choices, so starting here and building around that plan's best fund choices is often the best idea. Look at all the funds available in your 401k and list the ones with the lowest expense ratio from each category (US equity, international equity, bonds, etc), then validate that they satisfy the Bogleheads® principles of simplicity, diversity and low-cost. Repeat this step for all accounts.
  3. Finally, you must consider the tax consequences of investing, especially in taxable accounts. Generally, the most tax efficient way to use your different accounts is:
    1. Invest as much as possible in your tax-deferred and tax-free accounts.
    2. Put the most tax-inefficient funds in your tax-deferred and tax-free accounts.
    3. Use only tax-efficient funds in taxable accounts.
    4. If all else is equal, put funds with higher expected returns in tax-free (Roth) accounts in preference to tax-deferred (traditional 401(k), 403(b), traditional IRA) accounts.

Introduction

Implementing your portfolio comes after you have established a sound financial footing. Investing should only commence after you have initiated a good saving practice and have created an emergency fund.

The first step when starting an investment program is to choose your asset allocation, basically your allocation to stocks, bonds, and cash. The asset allocations should reflect your need for portfolio return balanced against your tolerance for risk. Risk tolerance is an investor’s emotional and psychological ability to endure investment losses during large market declines without selling or undue worry, such as losing sleep. Risk and return are directly related, a higher expected return will necessitate a higher level of risk. The asset allocation should reflect one’s unique ability, willingness and need to take risk. Assessing risk tolerance is a critical step in determining the appropriate trade off between the risk and expected return of a portfolio. Selecting the mix of risky and less-risk-free assets is one of the most important decisions in designing a portfolio. This balance is a key factor in creating a portfolio that will allow investors to stay the course during the inevitable market downturns.

Document your chosen asset allocation in your investment policy statement, if you would not yet have completed it.

After settling on your asset allocation you can turn to selecting funds that flesh out your desired asset allocation and decide on the most tax efficient placement.

Bogleheads® principles for selecting funds

The Bogleheads® investment philosophy includes a few principles directly focused on selecting funds for portfolio construction. These principles lead to a preference for simple, low-cost, tax-efficient total-market index funds. Each such fund contains thousands of securities and as such limits the number of funds needed. These index funds achieves maximum diversification in a simple and low-cost way.

Diversify

When choosing the funds for a portfolio, Bogleheads® prefer funds which are maximally diversified; a maximum number of assets, covering the most sub-asset-classes, or even approximate the whole market[1]. This diversification lowers risk, because the failure of any one securities does not have a big effect.

Simplicity

Selecting funds for a portfolio can be simple, resulting in a simple portfolio. A simple portfolio has many advantages. It almost always lowers costs (including taxes), makes analysis easier, simplifies rebalancing, simplifies tax-preparation, reduces paper-work and record-keeping, and enables caregivers and heirs to easily take-over the portfolio when necessary. It is not necessary to own many funds to achieve effective diversification. Following the above principles will also allow the investor to limit the need for transactions for rebalancing.

Keep costs low

Figure 2. Reducing Expenses by 1% Per Year [note 1]

It is critical to keep the costs related to investing low. The effect of the compounding costs over an investing lifetime is enormous. [note 2] Figure 2. is an example showing that 1% of additional costs will reduce available retirement funds by 10 years.

To keep cost low, select funds with the lowest expense ratio and the lowest turnover. Choosing a limited number of maximally diversified funds is a way of limiting cost related to transactions as the events that would necessitates an asset to be added or removed from the fund are limited.

Minimize taxes

Careful consideration should be given to tax efficiency when selecting funds for your portfolio. Minimizing the effects of taxes on your portfolio should be considered directly after you established your asset allocation. No-one controls how markets might perform; rather than obsessing over the unknowable, you should focus on areas where your decisions can save money: by preserving money for retirement what would otherwise go to taxes.

  • Tax-advantaged accounts such as 401(k)s and IRAs allow your money to grow, using the magic of compound interest, without a portion being removed every year to pay taxes.
  • Those investors who have taxable accounts, look carefully at the tax efficiency of each fund; produce very low interest and dividends (total return is the metric to watch) and low capital gains due to low amount of transactions. If there's not enough room for bonds in tax-advantaged accounts, and you are in a higher tax bracket, holding tax-exempt municipal bond funds in a taxable account may be a good choice.
  • Tax-efficient fund placement matters; Bogleheads put tax-inefficient funds (like high yielding bond funds, REITs, small value funds, and actively managed funds that frequently churn their holdings) into tax-advantaged accounts.

Use index funds when possible

Low-cost, tax-efficiency, and simplicity are recognized as advantages of index funds (either traditional mutual funds or ETFs).

  • Low-cost: Index funds typically have the lower expense ratios in their category.
  • Tax efficiency: Due to lower fund turnover and longer holding periods stock market index funds tend to exhibit greater tax efficiency.
  • Simplicity: The low cost, high tax efficiency, and long term consistency of performance advantages of indexing greatly simplify the task of fund selection and fund monitoring in an investment plan.

Index funds based on broad indexes, like total-market indexes, provide a large diversification because each contains thousands of securities.

Lazy portfolios

Asset allocation strategies range from simple to complex. Lazy portfolios design their asset allocation to perform well in most market conditions. Most contain a small number of low-cost index funds that are easy to rebalance. They are "lazy" in that the investor can maintain the same asset allocation for an extended period of time, suitable for most pre-retirement investors.

The selection of the funds for these lazy portfolio's should follow the guidelines of this page. The three fund portfolio page provides suggestions on choosing the three funds from several popular fund providers.

Tools and calculators

One can use various utilities to design and manage portfolios. Investors should look at all of their accounts as a unified portfolio to construct a portfolio that is low cost, well diversified, and tax efficient. Most tools cannot automatically compose your ideal portfolio, but you can use the tools to enter two or three models that you composed, and then you can compare and contrast the results, looking in particular at the blended expense ratios and the totals of each asset class.

Alternatively one can use a spreadsheet to maintain your portfolio.

Guidelines for selecting the funds

The fund selection process starts by reviewing the available funds, and then selecting the appropriate funds to create the portfolio[note 3] For the chosen asset allocation one then needs to view the available funds and select the appropriate ones. The following checklist can help you find the offerings that can help fill your desired asset allocations.

For portfolios following the Bogleheads Investment Philosophy, you would be looking for low-cost diversified index funds matching your targeted asset classes.

Special challenges when selecting funds from a 'plan'

In constructing a portfolio one often does not have a full freedom in selecting the funds.

  • Often a plan (like 401(k)) or account (like IRA) has a limited choice of good funds while still presenting investors with a long list of unfamiliar names. Apply the rules mentioned below.
  • Some plans may have a self directed brokerage account that provides access to a wider selection of indexed investment options, but be sure to calculate the expected cost of utilizing this service.
  • Plans may only contain actively managed funds. In this circumstance one should select the lowest cost stock funds and highest grade bond funds that approximate the targeted assets classes.
Costs. CITs are only offered to large institutional accounts, do not deal with retail investors, and have lower regulatory costs than do mutual funds. As a result, CITS generally have lower costs.
Reporting requirements. The CIT spells out the terms and guidelines under which the investments of the trust are managed in a Declaration of Trust (a mutual fund uses a prospectus). There are no annual or semiannual reports. Unlike a mutual fund, a CIT has no ticker designation. The company contributory plan will usually provide the plan holder with factsheet disclosure and performance information.
Dividend reinvestment. A CIT does not make dividend distributions. Dividends are added and accumulate in the net asset value of a CIT share.

Shortlisting funds

For each entry in the fund list, look for the following information, which can be found in the fund's "fact sheet" or summary sheet.

  • Determine the fund's expense ratios as applicable in your situation. [note 4]
  • Look for the asset class categories that are part of your asset allocation, such as US stock, international stock, small cap stocks, value stocks and US bonds. Funds marked "fixed income" or "guaranteed income" counts as bonds; company stock funds count as stock. Some bond funds may be listed as "inflation protected."
  • Identify the index funds.
    • Look for the word index in the name.
    • In most cases, the lowest-expense funds will be index funds.
    • For international stocks, which sometimes have an alphabet soup of acronyms like MSCI EAFE.

Generic rule

For each of the asset classes of your asset allocation, select in the shortlisted funds, the most-diversified, lowest-cost index fund that covers the asset class.

See below for specific info on the most common asset classes.

Selecting suitable US-domestic stock funds

Within the shortlisted US-domestic stock fund look for an S&P 500 index fund and/or a Total US Stock Index fund.

  • Note that the actual name of the fund might not actually be S&P 500 Index Fund. It might be called 500 Index, Equity Index, Large Cap Index or some other name. You may need to read your plan information carefully determine the fund’s composition.
  • If the expense ratio of the Total US Stock Index fund is not much higher than the S&P 500 Index fund, then use it (you get a higher diversification)
  • If you don't have a Total US Stock Market Index Fund, but you have a 500-index fund then you may want to approximate the total market by using funds that "complete" the S&P 500 index with for instance an extended market index fund, or a combination of small- and mid-cap index funds.

Selecting suitable International stock funds

Within the shortlisted International stock funds look for a fund with a name like International Index, Total International Index, International Equity, Global, World, MSCI All-World ex US, or other fund names that suggest a total market international fund.

  • Generally, if there is an index fund, it will be the least expensive international fund in the plan. You may need to study your funds carefully to find the right fund.
  • Plans often provide international exposure with a developed market index fund, which lacks the emerging market stocks and small cap international stocks. One can approximate total international funds by adding these subclasses individually.

Selecting suitable US-domestic bond funds

Within the shortlisted US-domestic bond funds, look for a bond fund with "index" and/or "total" in its name.

  • Look for a bond fund with "index" (or total) in its name. You will likely need to study your funds more closely to see if there is an index fund in your plan. Many Bogleheads like the Bloomberg Barclays US Aggregate Bond Index, which is a very broad index of quality bonds with intermediate duration bonds.
  • Select the fund that matches your desired duration and quality
  • If there's not enough room for bonds in tax-advantaged accounts, and you are in a higher tax bracket, holding tax-managed bonds funds or tax-exempt municipal bond funds in a taxable account may be a good choice.

Funds that implement target asset allocations

If one desires, and especially early in the investing one could select an "all-in-one" fund to cover the full asset allocation.

Balanced funds offer the investor the possibility to achieve the target asset allocation in a simple way using only one fund. Each of these "all-in-one" funds combines several underlying index funds into a single fund with a specified stock/bond ratio, so you can select a fund with the appropriate amount of risk. This makes it even easier for you beginners to get started with a simple, low-cost, highly diversified indexed portfolio. Many of these funds maintain a fixed asset allocation; some pursue a variable allocation policy, changing asset weightings according to market conditions.

Target date funds have the additional benefit that they automatically move to a more conservative asset allocation over time. Avoiding the need to personally need to decide on changes of the asset allocation over time. As such, they attempt to provide investors with portfolio structures that address an investor's age, risk appetite and investment objectives with an appropriate apportionment of asset classes. However, critics of this approach point out that arriving at a standardized solution for allocating portfolio assets is problematic because individual investors require individual solutions.

There are some arguments against using a balanced fund .

  • Balanced funds are not tax-efficient and do not allow a tax-efficient fund placement, as such they are best placed in a tax-advantaged account. Outside of the tax-advantaged accounts it is better to select individual funds.
  • Many balanced funds are active funds. When investing in balanced funds, please ensure the fund adheres to the Bogleheads principles of simplicity, low-cost and diversification.

Target date funds and, more generally, balanced funds can be approximated with general index funds.

Portfolio construction across multiple accounts

If you hold multiple accounts, you do not need to select a fund for each of your portfolio's asset classes in each account. The allocations can be spread across accounts (as an example: holding the bond allocations in an employer plan; the US stock investments in a personal IRA, and holding international investments in a taxable account.)

Assuming you are already prioritizing investments, then follow the principles below in selecting funds, listed in general order of priority:

  1. Choose the best and most appropriate fund choices for each asset category across your entire portfolio to achieve your target asset allocation
  2. Follow principles of tax-efficient fund placement
  3. Minimize the blended expense ratio across entire portfolio
  4. Provide ability to maintain asset allocation as ongoing contributions accumulate, without needing frequent rebalancing or exchanges (see Rebalancing considerations below for details)

Maintaining your portfolio; rebalancing and new contributions

Once you have your portfolio, it's important to keep your portfolio close to your target allocation. This will control the risk at the level desired by the investor. Due to their different risk-return, asset classes will deviate away from the target asset allocation and need to be brought back into line.

Rebalancing is the action of bringing a portfolio that has deviated away from one's target asset allocation back into line This is accomplished by transferring from over-allocated funds (sell) to under-allocated funds (buy).

One can use the new contribution to the portfolio to maintain the portfolio close to the target allocation, by adding to the lowest funds. This approach minimizes transaction costs, effort, and taxes. Withdrawals can also be used to a similar effect. To further limit the rebalancing costs, one can elect to not re-invest the dividends automatically, and to use those amount to also invest in the underperforming asset classes.

As prioritizing investments across accounts is important, the new contribution might not be in the account that holds the underperforming funds. This might necessitate to exchange with (rebalance) other funds in other accounts.

Target date retirement funds automatically rebalance for you.

Notes

  1. Results are simulated. The saving phase simulates a participant with a salary of $45,000 at age 25, linearly increasing to $85,000 by age 65, making yearly contributions of 6% of salary at age 25, increasing by 0.5% per year to a maximum of 10% and with a 50% company matching contribution up to the first 6% of salary. In retirement, $63,750 (75% of final salary) is deducted at the beginning of each year. The blue-shaded area shows ending savings with an after cost investment return of 9% assumed at age 25, linearly decreasing to 6% at age 80 and remaining constant thereafter. Inflation is assumed to be a constant 3%. The tan-shaded area assumes 1% greater return each year due to reducing the costs of investment by 1%. All amounts are in present-day dollars. Source: AllianceBernstein, as presented to the DOL/SEC Hearing On Target Date Funds And Similar Investment Options.
  2. The difference between an expense ratio of 0.15% and 1.5% might not seem like much, but the effect of the compounding over an investing lifetime is enormous. After 30 years, a fund with a 1.5% expense ratio will provide an investor with several hundred thousand dollars less for retirement than a 0.15% index fund with the same growth.Bogle John (January/February 2014). The Arithmetic of “All-In” Investment Expenses (PDF). Financial Analysts Journal Volume 70 (1): CFA Institute. Check date values in: |date= (help)CS1 maint: location (link)
  3. Hint: Put everything in a spreadsheet. It's easier to make updates and will help when calculating percentages and fund amounts later on.
  4. 401(k) plans can impose administrative costs on employees in addition to fund expense ratios. Many 401(k) and 403(b) plans are funded with variable annuity contracts which can impose fees in addition to the funds' expense ratios. Make sure you are aware of the total costs.

References

See also