“Enhanced” Index Funds?

Over at Fidelity, where I have my IRA and Roth accounts, I received an e-mail touting their new “enhanced” index funds. Hmmmm, “enhanced.” I understand the concept of an index fund, which is managed to track a particular benchmark or index. The benefit of an index fund is that management is minimized; all the fund manager has to do is follow the index. This has the benefit of reducing fund expenses, and the majority of index funds often outperform actively managed funds. However, the fund’s return is often slightly below the return of the index, due to the expenses.

So, what’s up with this “enhanced” index fund? Fidelity says:

The funds’ managers use computer models to sift through the universe of stocks and rank them based on predicted performance. The results are then optimized to construct a portfolio that is comprised of the highest ranking stocks, but resembles the benchmark index in terms of sector/industry weights and other risk-related factors. What you are left with is a fund that seeks to out-perform the index while matching the risk, yield and other characteristics of a comparable index fund.

Uh…isn’t that an actively managed fund?  Am I missing something? Sure they use the index as a foundation, but then they apply subjective criteria to the stocks that comprise the index. The criteria may be based on objective factors, but choosing which criteria to apply and their application itself is subjective. Fidelity says that their range of return is greater when compared to the index. For example, a standard index fund, according to Fidelity, will return between -0.2% to -1.2% when compared to the index benchmark, while the enhanced index fund will return between +3.2% to -1.5%.  Fidelity does acknowledge that the enhanced fund has more risk than a plain vanilla index fund, but that the expected excess return more than offsets the risk.  I guess the expectation is that the return of the enhanced fund will generally beat the index due to the active management “enhanced indexing.”

I’m a fan of indexing, but will wait and see how these funds perform.  In any case, like most other Fidelity index funds, the minimum investment is $10,000, and I don’t have that much in my IRA and Roth accounts yet, so I cant invest anyway.  But that doesn’t mean I won’t keep my eyes on them…

Trolling the Blogoverse: 5/23/07 Edition

The latest Carnival of Personal Finance is up at FIRE Finance. I just wanted to comment on a few posts…

Investment Choices…

So, what to do with my money? Here’s the breakdown for my 401(k): 35% international, 35% small-cap, 15% mid-cap, 15% large-cap. Like I said before, I have 30+ years until retirement, so I can afford a little risk right now, which is why I’m overweighted in international and small-cap. However, I’m limited to the options in the plan.

My IRA and Roth accounts at Fidelity are heavily weighted towards large-cap (~70%), with the rest in international. About 40% of this is in Fidelity’s US Equity Index, a nice S&P 500 index. But the rest…

I’m a fan of index funds, although I have only a small portion of my total investments in them (it’s not my fault my 401(k) doesn’t offer them). Warren Buffet is a fan of index funds. Free Money Finance is all over index funds. What’s so great about index funds? Two thing: 1) low costs, and 2) more importantly, most actively managed funds do worse compared to their index benchmarks. And they offer instant, broad diversification (as long as the underlying index is broad and diversified). Ok, so that’s three good things.

The problem I have is that the index fund choice is limited at Fidelity, where I currently have my money. Although the choices are pretty good, the minimum investment amount for most of the index funds is $10,000, which I do not have yet. So, either I wait and build up my balances, taking advantage of actively managed funds, or go to Vanguard, where the minimum balance amounts are much lower ($3000), although this would mean having different accounts in different financial institutions. Since my actively managed, large-cap fund is doing pretty well, I think I’ll stick with that, although I will still research to keep my options open.

My asset allocation

So, after thinking about all the stuff I wrote on asset allocation, I plugged my numbers into the X-ray overview at Morningstar to get an idea of my asset allocation.  Here’s what I got…

Asset Allocation: Putting it all together

OK, we’ve got stocks and bonds, and different categories of each. The initial question is why should we invest in these different asset classes? We like a stock, say General Electric, so just buy that stock, collect the dividend, and watch the stock grow, or, since generally stocks have a higher return than bonds, so just buy a stock fund, sit back, and watch your portfolio shoot through the roof, right?

The answer, as is most of the answers concerning investing (and nearly everything else) is “it depends…”

Invest in Yourself

I was looking over at Free Money Finance this morning and saw a couple of posts that, although it seems that he did not intend to be related, kind of tied in together nicely. The first was M.B.A.s Don’t Prepare Managers for Real-Life Challenges, which I think you could apply to college or advanced degrees in many different areas. The first quoted sentence says it all:

An M.B.A. provides the strong general education that an executive needs but it doesn’t teach the skills needed in the day-to-day operation of a business, according to a survey of international executives.

I have an advanced degree, not an MBA, but I would definitely agree that my degree provided me a good general education, but did not provide the specific skills to do what I do. This does not mean that the degree was unnecessary. Rather, I was able to go in the right direction because of what I learned, so that when I didn’t know what to do, at least I could stumble in the right direction. Second, I interned while getting my degree and was able to see how things worked and to look at different areas in my field, which in turn helped me focus on what I should learn at school.

However, what really matters about a degree is #5, which reads in part:

The most valuable part (employment-wise) of a [degree] to me has been that it opened doors for me that would have never been opened otherwise.

In many situations, an advanced degree is required to get a job. Sometimes, like engineering or law, you cannot even enter the field without the right degree. Other times, you will receive a promotion or advancement faster (or at all) with an advanced degree. Most entry level positions today require a college degree, even if it’s just a liberal arts degree (which I have and am not complaining about).

This ties in with the second post, Stats on Income, Commute Time, and Vacation Days, which shows the difference in hourly wages between a high school and a college graduate. Essentially, people earn nearly twice as much with a college degree. $28.06 vs. $15.65 for men, and $21.30 vs. $12.34 for women. (The difference in income based on gender is the subject for a different post)

The point of this post (yes, there is a point) is that an education is an investment in yourself, and it pays off big time. If you don’t have an undergraduate degree, get one. If you do have one, try and get a graduate degree. Yes, I know it takes times and money, and if you are already successful, then a college or advanced degree is not necessary (see: Bill Gates). But if you want to advance, a degree can make it easier by opening doors and giving you opportunities that you would not have had otherwise. If you are currently working, sometimes your company will pay for you to go to school, and even going to school can look good to your boss. And many universities offer classes at night or on weekends for those that are currently working.

FMF has written extensively on the value of an education here.

Update: I received a comment from Shadox (thanks for the international review) stating that b-school taught him how to fish, to use the old analogy, rather than giving him a fish, in addition to providing many skills directly applicable to work.  This is a much better way to phrase what I want to say.  My graduate education examined issues from a theoretical perspective, but gave me the tools that I would use later on, even though we never addressed specific situations that I would face.

Asset Allocation: Stocks and Bonds

OK, before I talk about diversification, I should probably talk about what we will diversify first, so here is the big stocks and bonds discussion. This is gonna be a long , so more after the break..

Trolling the Bolgoverse

I was looking at the latest Carnival of Personal Finance today, and a few of the “state of the economy” posts caught my eye.

The first post is “Subprime Bail Out? Hell No!” while the next two posts deal with the lack of American savings.

Asset Allocation: Risk

Last time, I talked a little about risk. I wanted to expand a little more on this because risk is a concept that underlies much of investing.  I think that people generally understand what risk is, but not how it affects different asset classes as well as the decisions an individual should make when investing.

There are different types of risk, but here I want to start off by talking about the basic risk-return issue, which, as I stated before, is that if a person invests in a risky asset, meaning that there is an increased chance they could lose part or all of their investment, that person would demand a higher return to compensate for that risk.  This is true for any asset class.  The basic “risk free” investment is U.S. federal government bonds, because there is almost no chance that the U.S. government will default on its obligations.  If the U.S government does default, the economic/social/political situation would probably be so bad that basic survival would probably be a little more important than the return on your investments.

Other types of bonds are generally at the lower end of the risk spectrum, although you would expect that bonds issued by financially challenged entities would demand a premium.   Stocks are generally more risky than bonds, although stocks also vary in risk, from large, established companies with relatively consistent earnings to small start-up companies that promise explosive growth but could also go under just as easily.  If a risky investment does not provide the necessary return to justify the risk, then the investor can either switch to an investment that would provide the return, or put their money in a lower risk investment that also provides a lower return.

Evaluating this type of risk, and how a specific investor would respond to risk, is the first step of developing a suitable portfolio.  Someone who does not like risk should not invest in highly speculative stocks, while someone who could tolerate large changes in stock prices in seeking a large return should not invest solely in government bonds.

Next up: diversification and modern portfolio theory…

Asset Allocation: An Introduction

So I put all my accounts through to Fidelity. Now what? It’s time to do the asset allocation dance…

When people talk about asset allocation, they usually just mean stocks and bonds. Stocks are ownership in a company. When you own a share of a company, you are own part of that company. If there are 100 shares in a company, and you buy one share, you own 1% of the company. When the company does well, the stock price goes up; when the company does…not so well, the stock price goes down. Investing in stocks can be very risky, because the company can go bankrupt, and all the money invested in the company (in stocks) will be lost. Generally, this doesn’t happen, but the risk is that you could lose your entire investment. However, a company could do extremely well, and the stock could shoot up in value (just as it could come crashing back down: see dot.com bubble).

Bonds are essentially an IOU. Governments (federal, state, local) and businesses issue bonds, you buy the bond, the bond pays interest during the life of the bond, and you get your initial money back at the end. The life of the bond could be anywhere from one month to thirty years. Bonds are generally safer than stocks, and as the risk is less, so is the growth potential. That is, the interest paid on bonds is usually less than the return on stocks. Less risk, less reward.

So the conventional thinking is that when people are younger (assuming that this money is for retirement), they can withstand the greater risk in stocks, and should hold more of their assets in stocks. As you get older, the tolerance for risk goes down, because the investment time frame is shorter, and you don’t have as long to allow a stock to recover if price if it falls. At this point, you want to preserve the money that you have, and you shift more money to bonds.

Of course, this is a vast simplification of stocks, bonds, and asset allocation, and leaves out many of the nuances and other asset classes, but we are just starting…