Today, we have an anomaly, unfortunately the chosen Mutual fund cannot be defeated by any optimized combination of ETF’s. Now I understand the source of your earth-shattering surprise, nobody is more confident of my genius than I, but it actually brings up an interesting opportunity to explain why I developed this method in the first place.
I do not particularly like mutual funds, generally, because I think they are overpriced, underperforming, and are falsely advertised as diversified assets. The cost issue is well documented, but let me explain the underperformance and faux diversification.
Unbiasedness in Statistics
Think about a sample of 1,000 people, who have an average height of 6 feet tall. If you randomly select 50 people from that sample, you will likely get an average height of close to 6 feet. If you select 100 or more people, you will begin to get closer and closer to the average of 6 feet. This is a rough definition of what we call unbiasedness in statistics.
Let’s take this same simple example now and apply it to stocks. If we have a selection of 1,000 stocks, with an average return of 10%, and we randomly select 10 stocks, it isn’t that likely that we will get exactly 10%. But again, as we select more and more stocks, we get closer and closer to 10%. Well Mutual funds that invest in equities are similar to this example. Because of legal and investor relation reasons, most Mutual funds need to be ‘diversified’, the definition of which is that 75% of your portfolio cannot have any stocks making up more than 5% of the total portfolio, and you can never own more than 10% of the outstanding shares of a company. Now, combined with the fact that Mutual funds have billions of dollar in assets, you’ll see individual asset counts in the hundreds.
Really Beating the Index?
Mutual funds are also designed to beat an index, most traditionally the S&P 500. Beating the S&P requires one to deviate significantly from the average return of the S&P over a sustained amount of time. Think back now to our example of 1,000 stocks, is it easier to deviate from the average when selecting 10 stocks, or when selecting 500 stocks? The answer clearly is 10 stocks, and it illustrates the problem perfectly. Mutual funds have so many different stocks, that they effectively diversify themselves out of any possibility of outperforming the S&P 500. When you add the expenses they charge on top of this, Mutual fund managers are fighting an uphill battle than they cannot win. The amount of equity managers that outperform their index is roughly in line with a random walk.
This is how we can beat Mutual funds in performance and risk with a carefully optimized portfolio of ETFs. Diversification does not exist in holding a tremendous amount of assets, it exists in holding assets that act differently than each other. Mutual funds that own 500 stocks, usually own 500 stocks that are more or less identical. If the market drops, all 500 of their stocks are likely to drop, the opposite occurs during a rise. However, by selecting ETFs through our optimization process, we are purposely selecting stocks (or any other asset) that do not rise and fall with one another 100% of the time.
Rare, but Not Impossible
At this point you might be asking yourself how a Mutual fund, with all of its faults, could ever beat a portfolio of ETFs. Well Mutual funds have one area where they’ve developed a huge advantage over anyone else: fixed income.
This is actually true for a multitude of reasons. The first is the complexity of fixed income instruments. Even something as simple as U.S. Treasuries are incredibly difficult to price, and even harder to trade for profit. Unless you have advanced degrees in mathematics or quantitative finance, you will likely lose money trading fixed income. Buying and holding is a different story. Corporate bonds are even more difficult to deal with because they add an extra source of risk, default risk. U.S. Treasuries are considered to be risk free assets (your opinions on the U.S. or its budget scenario are unimportant here, people who make money do it by keeping their politics out of their wallet), but corporate bonds are subject to default on rare occasions. Forecasting default rates requires very advanced math and finance, and frankly isn’t done that well by even the most advanced practitioners.
This is where the tremendous asset base and diversification of Mutual funds play to the investors benefit, and more importantly offer a service that investors cannot create themselves. Since the default rates are so difficult to predict for corporate bonds, and treasuries are so difficult to deal with, holding a tremendous variety and amount of each effectively eliminates both of these concerns. In addition, the more complex the instrument, the larger the effect of active management. So since fixed income is so complicated, it gives mutual fund managers the opportunity to shine. Unless you have millions of dollars and tons of free time, which should contradict the millions of dollars, you’re better off investing in a Mutual fund for fixed income exposure.
The American High-Income Trust
Lets cover the Mutual fund in question briefly. AHITX, the American High-Income Trust, is a Mutual fund distributed by American Funds. It is predominantly corporate bonds that are almost junk level, and provides a high level of income with some appreciation. The expense ratio is .69% which translates to roughly $6.90 per $1,000.00 invested. It typically returns between 7% and 10%, with an average return of 7.42% over the last 10 years, and 10.80% over the past five.
The ETF’s used to, unsuccessfully, optimize a portfolio were mostly high yield corporate bond ETFs, passively managed and with a lower expense ratio than the Mutual fund. Some Treasury or non-US sovereign debt ETFs were also included in the calculations. The results of the optimization were as follows:
The y axis represents returns, while the x axis represents risk. Further up the y axis is desired, and further to the left on the x axis is desired. The blue line is the efficient frontier, it is the collection of portfolios with the maximum return and minimum risk that can be created. It beats the equally weighted portfolio handily, so optimization has clearly yielded results, however; it is absolutely blown away by the Mutual fund. You can see AHITX in the top of the chart towards the middle. The efficient frontier cannot come close to the return the Mutual fund offers, and doesn’t really beat it in risk either.
The Mutual fund here is clearly the superior investment, it offers significantly more return for less risk. Although you will pay slightly more in expenses on a year to year basis, the extra return you are likely to generate will more than make up for this.