The Little Book of Safe Money
Jason Zweig

“The keys to investing are simple: diversify, keep costs low, buy and hold.”

“Like dieting, investing is simple but not easy.”

“It is absolutely mandatory for you to keep a reservoir of liquidity in your portfolio at all times.”

“No matter how valuable an investment may be or appear to be, it’s of no practical value to you unless it’s liquid when you need to cash out.”

“The biggest single holding in your portfolio is you: the income that your career will generate over the rest of your life.”

“Anyone whose human capital is vulnerable to the escalating cost of living should consider investing heavily in TIPS.”

“Wall Street is forever inventing another newfangled way to promise higher yield at low risk.”

“In Japan at the end of 1989, the leading Nikkei 225 stock index was at 38,915.87; two decades later, it languishes below 10,000.”

“Invest as if stocks are likely-but not certain-to beat all other assets. Keep some money in bonds, cash, and real estate just in case they do better.”

“Stocks are not certain to outperform bonds and cash no matter how long you hold on.”

“Men should make a special point of having their wives review any choices the husbands regard as a sure thing.”

“It is irresponsible for a husband to keep such tight control of the family’s investments that his wife will find them completely unfamiliar after he is gone.”

“In the stock market, much of what seems to be patterns is, in fact, just random noise.”

“You should never act on an investing idea the same day you get it.”

“Never invest in anything on the recommendation of a friend or family member alone.”

“Commit to a dollar-cost averaging or automatic investment plan that require you to add a little bit of money every month.”

“If you are investing for retirement 30 years away, buy a total stock-market index fund and hold it continuously for the next three decades.”

The Millionaire in You
Michael LeBoeuf

“Money should be invested passively. Passive investing means buying and holding no-load, low-cost index mutual fund with performances reflecting that of entire markets.”

“Don’t waste your time playing the market. Own the Market, live your life and enjoy the journey.”

“Taylor Larimore–summarized the index advantage best: “Index funds offer much more than superior returns. They also provide maximum diversification, no overlap, no style drift, no manager changes, lower turnover, lower expenses, lower taxes, greater simplicity and peace of mind.”

“The master key to wealth can be summed up in just one word: Simplicity.”

“The main reason index investing is so successful is because fewer people have their hands in your pocket.”

“Timing the market is for losers. Time IN the market will get you to the winner’s circle, and you’ll sleep a lot better at night.”

The Only Guide to Alternative Investments
Larry Swedroe and Jared Kizer

“Some investment products are so complex in design that it is very difficult, if not impossible, for the average investor to fully understand the risks entailed and the costs incurred.”

“When considering an asset class for inclusion in a portfolio, — investors need to consider the diversification benefit of the investment.”

“Recency is the tendency to give too much weight to recent experience, while ignoring the lessons of long-term historical evidence.”

“The evidence from academic studies demonstrates that equity REITs, both domestic and international, offer an attractive risk/return trade-off” and provide meaningful diversification benefits to portfolios.”

 ”The bottom line is that investors should consider devoting at least some significant portion of their fixed-income allocation to inflation-protected securities.”

” “Only informed and disciplined investors should consider including commodities in their portfolio.” 

“Unless they are highly risk-averse, investors should probably not buy an immediate fixed annuity until approaching age eighty.”

“Despite its low correlation with other portfolio assets, high-yield debt provides almost no unique benefit in terms of portfolio diversification.”

“In times of crisis, the markets for illiquid assets can virtually dry up.”

“For most investors the only way to obtain sufficient diversification of the risks of investing in speculative securities is through a mutual fund.”

“After ten years the survival rate of private firms was only about 34%.” (2002 study)

“Private equity investors forgo the benefits of liquidity, transparency, broad diversification, and the access to daily pricing that mutual fund investors enjoy.”

“Understanding the difficulty of identifying superior hedge-fund, venture-capital, and leveraged-buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high.”

“While preferred stocks offer relatively high yields, in general, they possess enough negative attributes to make them inappropriate choices for individual investors.” 

“One of the rules of prudent investing is to avoid complex securities because the complexity is likely to favor the issuer.”

“The bottom line on hedge funds is this: They are ’sinkholes’ for investors.”

“Variable annuities are products that are sold, not bought.”

“Variable annuities (VA) convert what would otherwise be long-term capital gains into ordinary income.”

“Education, or a good fee-only advisor who is not influenced by commission-based compensation, can be the armor that protects investors.”

To be continued …

The Investor’s Manifesto
William Bernstein

 ”Wall Street is littered with the bones of those who know just what to do, but could not bring themselves to do it.”

“Very high returns are almost always made by those brave enough to invest when the sky is blackest.”

“Many investors lean heavily on past returns to gauge future ones. This is a mistake.”

“No risk matters more to investors than that of running out of assets before they die.”

“The most spectacular example of luck masquerading as skill was the recent case of William Miller, skipper of the Legg Mason Value Trust.”

“Mr. Buffett is not so much a money manager as a businessman.”

“The Morningstar database suffers from so-called ’survivorship bias,’ meaning that hundreds of poorly performing funds have disappeared from their fund universe, all of which would have underperformed the index funds.”

“Over the long haul, the differences in the amount of wealth provided by different stock asset classes can vary enormously, and owning all of them helps minimize your chance of dying poor.”

“The investor should forget trying to pick stocks and mutual funds or to time the market. The best the investor can do is to maximize returns by minimizing expenses.”

“Age is the first factor determining the overall stock/bond allocation. Investor risk tolerance is the second.”

“The most important asset allocation decision is the overall stock/bond mix. Start with the “age=bond allocation’ rule of thumb.”

“Be highly skeptical of sophisticated ‘black box’ methods of asset allocation.”

“China as had one of the world’s highest economic growth rates, yet between 1993 and 2008 its stock market has lost 3.31 percent per year.”

“Nations with the most rapidly growing economics quite often have the lowest stock returns.”

“Nothing last forever: more often than not, recent extraordinary economic and financial events tend to reverse.”

“The sooner you turn off CNBDC, get out into the bright sunshine, and take a walk, the sooner you’ll feel better about your investments.”

“You’re not going to impress the crowd at your country club by telling them you own shares of an index fund. Let them laugh; the joke’s on them.”

“If you’ve never been tested before, I strongly urge that you encounter your first bear market conservatively invested.”

“The most important investment ability of all is emotional discipline.”

“Do not invest with any mutual fund family that is owned by a publicly traded parent company.”

“Most retirees should purchase ‘longevity insurance’ by postponing Social Security until age 70, and perhaps by adding a commercial immediate fixed annuity as well.”

“In general, variable annuities come wrapped in enormous fees and are offered by insurance companies, that as a group constitute some of the worst players in the financial business.”

“Rebalance your portfolio approximately once every few years.”

The Lazy Person’s Guide to Investing
Paul Farrell

Investing really is very simple stuff. You can do it yourself.”

“Lazy portfolios are keep-it-simple, no-hassel, low-stress, time-saving, low-maintenance portfolios–so you can get on with the business of everyday life.”

“The only solution is to be in the market all the time and stop jumping in and out.”

“In a study of 66,400 Merrill Lynch investors, professors Odean and Barber discovered that buy and hold investors actually beat the more active investors by a fairly sizeable margin, 18.5% to ll.4% over a six-year period.”

“You don’t need to complicate your life–just stick to the basic Scott Burns Couch Potato Portfolio (50% S&P/50% Total Bond Market) with no stress, except your little ten-minute annual rebalancing efforts.”

“Taxes, Time, and Psychology favor the laziest portfolios.”

“A penny saved is a dollar earned, thanks to compounding.”

“Charles Schwab says that for every five years you wait to start saving for retirement, you’ll have to double your annual savings.”

“Kahneman was asked by a CNBC anchorman the day afer his Nobel was announced what investment tips he had for viewers. He responded, ‘Buy and hold.’”

“Experience has taught me that the relentless noise from breaking news sources, like CNN and CNBC, easily distracts most investors from what really works in the long run.”

“Where does Fama invest his retirement money? In index funds. Mostly the Wilshire 5000–.”

“Perhaps the most amazing insight I got out of this review of the investment habits of Nobel laureates is the simplicity of their investing strategies.”

The Little Book of Common Sense Investing
John C. Bogle

“Index funds eliminate the risks of individual stocks, market sectors, and manager selection. Only stock market risk remains.”

“Common sense tells us–and history confirms-that the simplest and most efficient investment strategy is to buy and hold all of the nation’s publicly held businesses at very low cost.”

“The brokers, the investment bankers, the money managers, the marketers, the lawyers, the accountants, the operations departments of our financial system are the only sure winners in the game of investing.”

“The lower the costs that investors as a group incur, the higher rewards that they reap.”

“Common sense tells us the obvious; while owning the stock market over the long term is a winner’s game, beating the stock market is a loser’s game.”

“We investors as a group get precisely what we don’t pay for. So if we pay nothing, we get everything.”

“It’s amazing how difficult it is for a man to understand something if he’s paid a small fortune not to understand it.”

“Investment of $10,000, 1980-2005:

Index Fund….Managed Fund
$179,200…….$179,200…….Gross Return
$170,800………$98,200…….Pre-Tax Return
$149,000………$61,700…….After-Tax Return
$65,000………..$23,100…….After Inflation Return”

“Don’t look for the needle–buy the haystack”

“The average fund portfolio manager lasts just five years.”

“Of the 355 equity funds in 1970, fully 233 of those funds–almost two thirds–have gone out of business. Only 24 outpaced the market by more than one percentage point a year–one out of every 14. Let’s face it: These are terrible odds!.”

“A mutual fund portfolio continuously adjusted to hold only Morningstar’s five-star funds earned an annual return of just 6.9% between 1994 and 2004, nearly 40 percent below the 11.0% return of the Total Stock Market Index.”

“Of the 35 newsletters (tracked by Hulbert) that existed in 1980, only 13 are still in business today. Only 3 outperformed the market.”

“Index funds endure, while most advisers and funds do not.”

To be continued …. here.

The Intelligent Investor (Rev Ed)
Benjamin Graham and Jason Zweig

“It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits.”

“Allocating at least 10% of your retirement assets to TIPS is intelligent.”

“The worse the future looks, the better it usually turns out to be.”

“The primary cause of failure is that investors pay too much attention to what the stock market is doing currently.”

“The key to rebalancing is having a predictable schedule”

“For most investors, intermediate bonds are the simplest choice, since they enable you to get out of the game of guessing what interest rates will do.”

“For most investors, bond funds beat individual bonds hands down.”

“If you had invested $1 in U.S. stocks in 1900 and spent all your dividends, your portfolio would have grown to $198 by 2000. But if you had reinvested all your dividends, your portfolio would have been worth $16,797.” (Stock indexes do not include dividends.)

“It is essential that (the intelligent investor) entrust himself only to firms of the highest reputation.”

If you find yourself trading more than twice a year–or spending more than an hour or two per month on your investments–then something has gone badly wrong.”

“If you started investing $100/month in September 1929, your money would have grown to $15,571 by August 1939. That’s the power of disciplined buying–even in the worst bear market of all time.”

“The knowledge of how little you can know about the future, coupled with the acceptance of your ignorance, is an investor’s most powerful weapon.”

“Alan Greenspan said on January 7, 1973: “It’s very rare that you can be as unqualifiedly bullish as you can now.” (1973 and 1974 turned out to be the worst years for the stock market since the Great Depression.)”

“A great company is not a great investment if you pay too much for the stock.”

The Intelligent Portfolio
Christopher Jones

“Sadly, our educational system has been woefully behind the curve in preparing people for the heavy new financial responsibilities of a self-directed investment world.”

“Be careful of how your advisor gets paid. Conflicts of interest can yield advice that is not in your best interest.”

“There are many ways to measure risk other than looking at just the volatility of returns.”

“A study of investor behavior by the research firm DALBAR found that market timers in stock mutual funds lost -3.29% per year on average relative to investors who pursued a consistent strategy.”

“Unlike a mutual fund, it is quite possible for a single stock to lose all its value by going bankrupt.”

“Never make the critical mistake of being too concentrated in your employer’s stock.”

“Fund expenses are like termites. They can quietly eat away at the returns of your investment without you even realizing there is a problem.”

“From the analysis of 22,472 mutual funds–only about one quarter of mutual funds were able to demonstrate performance that exceeded what you could achieve with a low-cost index fund.”

“Evaluate diversification at the household level, not at the individual account level.”

“If you own a home already, you probably have enough real estate in your household portfolio.”

“Asset allocation explains more than 90% of the variation in returns for most mutual funds.”

“You are virtually guaranteed to outperform more than two-thirds of the actively managed funds with low-cost index funds.”

“It is very expensive to guarantee that you will have a certain amount of money in the future, but if you can tolerate some uncertainty, you can likely fund your future goal with significantly less savings.”

“The only way to be more confident of reaching a financial goal is to invest more conservatively and save more.”

“All other things held equal, it will cost a woman more to fund her retirement than a man of the same age due to her longer expected lifespan.”

“As an investor, you want to be cautious about investing in a fund just prior to it making a distribution to shareholders.”

The Individual Guide to the Top Mutual Funds
American Association of Individual Investors

“The most important factor when diversifying a portfolio is selecting investments whose returns are not highly correlated.”

“Bond mutual funds are attractive to investors because they provide diversification and liquidity, which is not as readily attainable in direct bond investments.”

“The higher the turnover, the greater the brokerage costs incurred by the fund.”

“The market risk measure used for common stocks is beta; for bond funds, average maturity is used.”

“Dollar-cost averaging works especially well with more volatile portfolios.”

“Top Performance lists are dangerous.”

“The classic response of funds that focus on small stocks is to migrate investments to mid-cap and large stocks when they start to achieve a large asset base.”

“Don’t forget that almost all fund performance data is reported without adjusting for front-end or back-end loads.”

“One reason beyond low expense ratios that make index funds are tough to beat is that they are always 100% invested in the market.”

To be continued …. here.

The Great Mutual Fund Trap
Greg Baer & Gary Gensler

“You cannot improve your returns by spending more time or money trying to pick funds or stocks. You can, however, significantly improve your returns by choosing vehicles that offer the lowest possible costs and the greatest tax efficiency.”

“With returns corrected for survivorship bias, the average actively managed funds trail the market by about 3 percentage points a year.”

“In October 2001, less than two months before Enron declared bankruptcy, 19 of the 22 analysts who covered the stock rated it a “buy.”

“Every study we have ever seen on the subject shows that the more frequently individual investors trade, the worse they perform.”

“The only way for an investor to earn predictably higher returns over time is by taking on more risk.”

“The basic thrust of efficient market theory, is relatively simple and extremely important: Information currently known about a company is reflected in the prices for its bonds and stock.”

“Accept the fact that you are unlikely to beat a market where prices are set by the consensus of thousands of professionals and where you have to pay a steep price for every attempt.”

“The most likely way for a fund manager to generate a high ranking is to take on additional risk.”

“If you simply buy and hold — you don’t need to read investing magazines, watch financial news networks, subscribe to newsletters, or pay a broker to execute new trades.”

“Hulbert’s data show more than 84% of newsletters underperform the market over 5-years. Over 10-years, that number rises to 90%.”

Kahneman/Tversy Study: “A loss of $1 is approximately twice as painful to investors as a gain of $1 is pleasant.”

“The financial services industry spends billions in advertising to keep investors excited about the prospect of better returns around the corner.”

Daniel Kahneman, winner of the 2001 Nobel Prize in Economic Science: “Asked how he invested his money, he said that he favors index funds.”

How a Second Grader Beats Wall Street
Allan Roth

“Investing isn’t rocket science. Wall Street experts want you to believe that it is.”

“Kevin’s magic portfolio: Vanguard Total Stock Market Index Fund; Vanguard Total International Stock Index Fund; Vanguard Total Bond Market Index Fund.”

“We strongly resist thinking of ourselves as average.”

“There is one way, and only one way, to build a stock portfolio that is guaranteed to beat the average dollar invested. For the U.S stock market, that one way is to buy the entire market in proportion to the value of each company.”

“With only three index mutual funds, we can own many thousands of securities that own the whole world.”

“Cramer is a human cartoon character who rants about buying and selling and encourages others to engage in foolishness.”

“Lehman Brothers was the most admired securities firm in 2007 according to Fortune magazine. In 2008 it filed for bankruptcy.”

“A recent study found that funds sold by advisors underperformed those that were bought directly by the consumer.”

“We all know that most mutual funds greatly underperform the appropriate index, but did you know that the average investor underperforms the average mutual fund by another 1.5% percent per year?”

“The beauty of a 3-fund portfolio is that it automatically builds the global portfolio without having to worry about standard deviations, correlatons, Sharpe ratios, and the like.”

“Never buy an instrument that has a fancy name like Enhanced collateralized debt obligation investment unit trust.”

“Investing is much more than maximizing our wealth. It also involves minimizing the chances we will run out of money.”

“Our willingness to take risk isn’t easy to quantify because it is difficult to measure and very unstable.”

“Remember that staying with your asset allocation is every bit as important as choosing the right one in the first place.”

“Make it a rule never to buy a financial investment you couldn’t describe to an average second grader.”

“If the Wall Street brokerage firms were really so good at giving investment advice and managing risk, why did it take taxpayers to bail them out?

Index Your Way to Investment Success
Walter R. Good and Roy W. Hermansen

For most individual investors, the benefits of indexing remain a well-kept secret because brokers, mutual funds, and other familiar sources of investment information routinely focus on products that offer substantially higher commissions or fees.”

“Expenses and other deductions from returns are extremely important, but other considerations, such as services and access to other funds provided by the same fund family, may also influence your choices.”

“This time is different is a message that resurfaces in every bear market.”

“The index fund advantage consists of lower costs, deferral of capital gain taxes, and control of risk through more complete diversification.”

“Index funds save on management and marketing expenses, reduce transaction costs, defer capital gain, and control risk–and, in the process, beat the vast majority of actively managed mutual funds!”

The Informed Investor
Frank Armstrong

“Each brokerage house or investment manager wants the public to believe that somewhere in the back office is a genius who can make you rich.”

“If we don’t establish the discipline to live on less than we make — no amount of investment advice will help.”

“Market risk means that sometimes your equities will go down. It is only a function of when, and we can’t know that. — If you can’t get used to the idea, don’t go into the market.”

“Risk and returns will be driven far more by asset allocation than stock selection or market timing.”

“Investors must understand that a superior portfolio will underperform from time to time. If they are prepared for this disconcerting reality, they are less likely to find themselves abandoning their superior portfolio in favor of Wall Street’s deal of the day.”

“My view is that, properly practiced, investing should be reasonably boring.”

“Rating services such as Morningstar’s star awards or the ‘Forbes’ honor roll attest to the futility of applying past performance to tomorrow. If these two organizations can’t make useful predictions with all their resources, how can the rest of us hope to?”

“Do the right thing: In every asset class where they are available, index!”

“Mutual fund independent directors lack any discernible backbone and appear to be born with rubber stamps attached to their hands.”

“Discipline is the key to success for the long-term investor. He or she must not fall into the trap of managing holdings by newspaper headline, sound bites, mindless prediction, gut feelings, or the last time period’s results.”

“The primary cause of investor failure is the behavior of the investors themselves.”

“The ‘buy and hold’ strategy outperforms the average investor by more than three to one after ten years.”

To be continued ….

The Bogleheads’ Guide to Retirement Planning
Taylor Larimore, Mel Lindauer, Rick Ferri & Laura Dogu

“Early retirement planning should begin when you have your first full-time job.”

“No matter what your risk tolerance is, your asset allocation should become more conservative as you approach retirement age.”

“Joint accounts are a great option for ensuring that assets are immediately available to a surviving spouse, child, or partner.”

“Count yourself lucky if you still have a defined benefit plan, but also keep in mind that it may go away in the future.”

“Variable annuities or equity-indexed annuities are products to be avoided.”

“Rather than rebalancing by the calendar, many people make changes only when their portfolio allocations are off by a certain percentage.”

“Each time you need to withdraw money from your investments, simply look at your asset percentages and take the money out of the one that is overweight.”

“Reverse mortgages should be a last resort for providing income.”

Your greatest asset is your ability to earn a living for yourself and your family.”

For younger breadwinners, term insurance is the only practical way to provide needed protection at affordable costs.”

“The more complex the product, the worse it is for you, and the better it is for the adviser.”

“Certain assets, such as life insurance … pass to designated beneficiaries if you die. A divorce decree will not change the designations.”

“In the real world, people lose jobs, good health turns bad, more than half of marriages end in divorce, and other setbacks occur that can ruin a good retirement plan.”

The Coffeehouse Investor
Bill Schultheis

“The investor who starts saving and investing $300 monthly at 8% in a retirement account at age 25 instead of age 35–ends up with an additional $604,195 in her portfolio at age 65.”

“When fear and greed aren’t controlled, buying and selling individual stocks can quickly become a miserable experience.”

“As long as Wall Street has a vested interest in lots of transactions and busy portfolios, investors will continue to latch on to the hype and hysteria of Wall Street, perpetuating the misconception that by carefully reviewing market trends, diligently studying mutual fund tables, religiously researching global economies and closely watching interest rates, anyone and everyone can own a successful portfolio.”

“Let go of the mistaken belief that the secret to a successful portfolio is to accurately forecast bull and bear markets.”

“The simplest approach to diversifying your stock market investments is to invest in one index fund that represents the entire stock market.”

“The top 35 mutual funds from 1978 to 1987 cumulatively under-performed the stock market average by 7% annually during the next ten years.”

“The most important factor when diversifying is to adhere to your asset allocation strategy, because when you stick to your strategy and rebalance your asset at year-end, buy and sell decisions are no longer arbitrary.”

Common Sense on Mutual Funds
John C Bogle

“To invest with success, you must be a long term investor.”

“Suppress the temptation to add redundant layers of diversification.”

“After nearly 50 years in this business, I do not know of anybody who as done it (market timing) successfully and consistently.”

“When stock prices are high, investors want to jump on the bandwagon; when stocks are on the bargain counter, it is difficult to give them away.”

“The key to fund selection is to focus, not on future return–which the investor cannot control–but on risk, cost, and time–which the investor can control.”

“Backtesting, of course, should always be viewed with skepticism.”

“Choose a balance of stocks and bonds according to your unique circumstances–your investment objectives, your time horizon, your level of comfort with risk, and your financial resources.”

“Asset allocation is critically important; but cost is critically important, too. — All other factors pale into insignificance.”

“Most of all, beware of wrap accounts–packages of mutual funds assembled within a ‘wrapper’ for which an additional fee is paid.”

“The ‘Equity Risk Premium’ is the extra return required by investors to compensate them for taking the extra risk of owning common stocks rather than risk-free U.S. Treasury bonds. The average since 1802 has been 3.5%”

“The simplest of all approaches is to invest solely in a single balanced market index fund–just one fund. And it works.”

To be continued …. here.

• much shorter and more to the point than Four Pillars
• readers of Bogle, Swedroe, Swenson, etc. may not find too much new
• one reader called it 4 Pillars for Dummies
• more emphasis on simpler index portfolios
• e.g. portfolios based on three broad-market funds
• tilt toward small cap/value indexing not as prominent
• seems more concerned about implementation risk and burden
• “More complex portfolios, particularly those with value and small stock emphasis, may have higher returns, but come at the cost of time and effort.”
• if young with less than $250k, recommends All World, Total Stock and Total Bond ETF; once older and richer, then slice and dice
• less emphasis on short-term bonds, more open to total bond market 
• “A perfectly simple and serviceable portfolio [for U.S. investors] might be: 42% US Total Stock Market; 18% Total Foreign Market, 40% Total Bond Market. That’s it.“
• Bernstein’s distaste for financial services industry as strong as ever: “If rigorous precautions are not taken, the financial services industry will strip investors of their wealth faster than they can say ‘Bernie Madoff …The average stock broker services his clients in the same way that Baby Face Nelson serviced banks … Unlike your doctor, lawyer, or accountant, your broker is not a ‘fiduciary’: that is, he is under no legal obligation to place your interest above his … Don’t come anywhere near a stock broker or brokerage firm; sooner rather than later you will get fleeced … Do not invest with any mutual fund family that is owned by a publicly traded parent company.”

“Out of our 39 ETFs, only our REIT ETF paid a small capital gains (in 2004, 2005, and 2006), and our Consumer Staples ETF paid a small gain in 2004. Not one of our large, broadly diversified ETFs, like VTI or VWO, has ever paid a gain,” Vanguard notes.

Vanguard also says the share-class structure of Vanguard ETFs “gives Vanguard additional ways to maximize after-tax ETF returns relative to competitors.” All ETFs minimize capital gains by distributing their lowest-cost shares to meet redemption requests for creation units and Vanguard ETFs are no exception.  However, as cash flows into the funds’ conventional shares, they purchase stocks in various tax lots, and when investors redeem shares of the conventional funds (or when there are index changes that require sale of a security), “we sell the highest cost lots first, typically resulting in the realization of capital losses.”  These losses are then stored up in the fund to offset capital gains that could be realized in the future.

“Moreover, if there was a large enough transaction that might cause a capital gain, an open-ended fund could do an in-kind redemption of securities instead of cash. It’s rarely utilized … and in our case, rarely necessary. In fact, our index funds are so large, and take in such steady cash flow, that we can typically ‘cross’ incoming cash with outgoing redemptions, thereby avoiding the need to buy or sell stocks altogether.”

So the risk of capital-gains distributions is quite low in the case of Vanguard ETFs, especially for a fund with a large asset base that has steady cash flows and in-kind redemptions. For a fund with a small asset base without steady cash flows and the option of in-kind redemptions, the risks are somewhat higher.

Vanguard also says its ETFs have an edge in avoiding distributions when index changes occur. “Stand-alone ETFs may have to sell securities in order to purchase new index entrants and weight their portfolios appropriately because all of their cash flows are paid in kind, not with real cash.” Vanguard ETFs (i.e. their underlying index funds), on the other hand, will have cash flows that can be used to buy new additions to the index.

Lastly, as a special share class of the Vanguard index funds, the Vanguard ETFs have lower start-up costs and can leverage the economies of scale of an existing large pool of assets to minimize ongoing operating and trading costs – which means some of the lowest MERs around.

According to Preet, index funds face the risk of having to sell shares to meet redemption requests, which could trigger capital gains that are distributed to unitholders (and become taxable in their hands). ETFs don’t face this same risk because they “can simply redeem ETF units on an in-kind basis to fund the request.”

The table below, from Sigma Investing, might be interesting to consider in this context. It shows the capital gains distributed by the Vanguard 500 Index and SPDR S&P 500 (SPY) from 1993 to 2006. The bottom of the table shows that the Vanguard 500 distributions are, on average, higher than SPY. But this is due to the early years. For the seven most recent years of the period, there are no distributions.

The SPY has capital distributions because it has to update its holdings whenever its index changes. So do the Vanguard index funds, I believe. The latter have ways to offset capital gains, which Preet mentioned. ETFs also have ways to offset capital gains.

The Sigma Investing website has some tables containing “average tax drag” for a number of Vanguard index funds. The Vanguard Total Market Index Fund (VTI), for example, is reported to have an “average tax drag” of 0.33%. The site doesn’t say what period the data covers or provide the data source, etc. I sent them an email and hope to get this info.

Capital Gains Distributed by Vanguard 500 Index and SPY  

So far the decision to rebalance aggressively from 40%/60% to  60%/40%  stocks and bonds is paying off. But we shall see what ultimately unfolds as 2009 wears on.

The quarterly gain in the OMP reflects a 9% appreciation in the iShares S&P/TSX 60 Index Fund and a breakeven return on the iShares Canadian Bond Index Fund.

For more details on the OMP, check out the December 18 article on the last rebalancing. The OMP was created in early 2003 and has been rebalanced annually since. Based on just two exchange-traded funds, it follows the KISS principle when it comes to investing. The average annual gain since inception is close to 7.5%.

One way to get a smoother ride besides having a higher allocation to bonds (like the One-Minute Portfolio) may be to use sector indexes as building blocks instead of market indexes. With sector indexes, an investor can bring the risk-reduction process of rebalancing and lowering correlations down to a finer level of detail.

Consider a passive index investor just starting out. They can buy and hold the oldest and most liquid of exchange-traded funds (ETFs): the S&P 500 SPDR (SPY). Compared to other major indexes, the S&P 500 has better diversification and lower volatility. But it would have been even better to have owned an equal-weighted portfolio of ETFs tracking the nine sectors making up the S&P 500:

Materials SPDR (XLB)
Energy SPDR (XLE)
Financials SPDR (XLF)
Industrials SPDR (XLI)
Consumer Staples SPDR (XLP)
Utilities SPDR (XLU)
Technology SPDR (XLK)
Consumer Discretionary SPDR (XLY)
Health Care SPDR (XLV)

The investor would have enjoyed lower volatility/higher returns, as Tristan Yates illustrates in Enhanced Indexing Strategies (John Wiley & Sons, November 2008), a book reviewed in my last column. His table on page 49 shows SPY earned 3.9% annually with 14.1% annualized volatility from 1999 to 2006 while the portfolio of sector ETFs earned 7.2% annually with 13.5% annualized volatility (Yates’ figures are dividend adjusted). This result occurs because of rebalancing, i.e. keeping sector proportions equal over the years — as I understand Yates to say.

Yet, the nine-sector portfolio is not optimal in the sense the ETFs were selected so as to minimize volatility and correlations amongst each other. If only sector ETFs with low volatility/correlations are included, that leaves four: Consumer Staples SPDR, Energy SPDR, Financials SPDR and Utilities SPDR. This basket returned 8.8% per year with volatility of 12.7%, on average. “The results show that it’s better to build [your own indexed portfolio] than to buy [an off-the -shelf package],” writes Yates.

Taking Yates’ line of thought further, someone with a high aversion to volatility might conceivably index the equity component of their portfolio to a basket of non-cyclical ETFs, notably Consumer Staples, Healthcare, and Utilities. Over the five years to Jan. 9, they individually outperformed SPY. Two of them show a positive return for the period and the third a smaller loss than the S&P 500, which was down over 15%.

Notice how all of the above approaches put the emphasis on picking stocks? Yet, academics and a growing number of investors say stock picking plays a minor role in the variability of investment returns. More important factors are asset allocation, diversification, and cost minimization.

A better way to teach children investing, then, may be to set up a portfolio of index funds (say along the lines of the Couch Potato Portfolio). They can be purchased in small amounts at low cost. Dividends can be automatically reinvested, commission-free.

In Canada, they can also be held inside an RESP to collect government education grants and compound tax-free. The account will not only teach the value of saving, diversification, and asset allocation but also provide funds for university courses. A couple of stocks picked without regard for diversification, asset allocation, etc. has a greater risk of not compounding as well, and could end up discouraging saving and investing.

Blogger Canadian Capitalist took Mr. Mandelman to task on this point in his July 22 post; what CC said also seems applicable to Mr. West’s thesis. And as the creators of MoneySense’s Couch Potato Portfolio have said all along, buying and holding broadly based index funds and/or exchange-traded funds takes “only 15 minutes a year” and “will beat “about 80% of the money managed by professionals.”

How so? Markets are efficient. So financial managers and advisors are able to deliver no better than the market average over time. But after deducting their fees, they will underperform the market by 1.5% to 2.5% a year. Simply holding an index fund will yield the market average at a lower cost, between 0.3% and 0.6% a year. Over the long run, keeping fees low adds up big time.

Some of the best index funds in terms of cost, as CC has noted, are the TD eFund family. Blogger wheredoesallmymoneygo.com also recommends the DFA family of index funds. Providers of exchange-traded funds in Canada include iShares and Claymore Investments.