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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35357  
Subject: Selecting Benchmarks for Investing Date: 1/26/2006 7:52 PM
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The following is yet another investigation of the role that mutual funds might play in the portfolios of “average investors” such as Ken Fisher touched on for the Jan 30, 2006 issue of “Forbes” and that Robert Kiyosaki pursues in his book, WHO TOOK MY MONEY? In both cases, the authors are very careful to point out that their comments on mutual funds are not meant as universal prescriptions. In fact, they suggest just the opposite is more likely to be true. If you want be to “average”, then doing the “average thing” (which is buying into the mantra of “mutual funds held for the long term”) will most assuredly achieve your goal of being “average”. But whether that “average” will build sufficient assets for retirement is a separate problem. They think not, and so do I. But that's a matter each investor must decide for her or himself. So, if you can tell already tell where this post is headed and you don't like it, then click on elsewhere.
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Inspired by reading Kiyosaki's WHO TOOK MY MONEY? I've decided (once again) to re-organize my financial activities. Roughly speaking, I'm running my own two mutual funds: a junk bond fund and an investment-grade bond fund. (Collectively, it might be argued that I'm running a single, multi-sector/spectrum-income fund, but that's an issue I've dealt with in a separate post.) But whatever I'm doing, it is merely responsible that I have benchmarks against which to measure my performance, both in terms of whether I'm meeting my own financial objectives, and whether, in the wide world of money management, I am pursuing a productive investment path, or whether I'm wasting my time doing something that others could be doing for me, and possibly better.

That's the essential question that faces every investor:

Do I do my own investing/financial planning, or do I sub it out to the ”experts”?

Frankly, I have no idea how each person might begin to answer that question for her or himself, especially since a bad choice can be so devastating. It's a tough, tough problem. I've opted to be a do-it-yourselfer out of necessity. For too long, I was too small of an account for an “expert” to want to fuss with. And by the time I grew an account big enough to consider worth their time, I also knew more about managing money than they typically did. So, I'm very hostile to the financial industry and its middlemen, way beyond “once bitten, twice shy”, and everything I say needs to be understood in that light.

Conventional, open-ended mutual funds are an obvious choice for benchmarking one's own investing efforts. If I can't beat the fundies, then I should own their products and let them do the work. But I know I can beat them (if I can access the same underlying securities), and I despise their sleazy business practices. So I don't really want to own them, not when there are [in most cases] CEF/ETF knockoffs (index or otherwise) that facilitate better risk control (due to the restrictions/penalties funds impose on “trading”). But conventional mutual funds can be useful benchmarks. The problem is selecting which fund(s) to use, because there are so many of them, and because they slice and dice the investing world so many dozens of ways.

E.g., Morningstar considers the category of “Taxable Bond” mutual funds to include the following:

Governments, Short/Medium/Long Term
Corporates, UltraShort/Short/Medium/Long Term
Bank Loan
High Yield
Multi-sector
World
Emerging Market

Such a list could be quibbled with for its failure to include “asset classes” such as “preferreds”, “converts”, “tax liens”, “royalty trusts”, and all of the other means by which “fixed-income investors” attempt to secure for themselves “fixed-income”. But I'm going to let the list stand as it is for being sufficiently representative of the common choices.

If I consider myself to be a fixed-income investor, with which of those sub-categories does it makes the most sense to compete by buying individual securities instead of a mutual fund? With which does it make the most sense to buy the off-the-shelf, pre-packaged product? Furthermore, what might it mean to “compete fairly”?

Let's consider the last question.

If I buy a sufficient number of individual securities within the same “asset class” so that I have created a meaningful and coherent portfolio (and not merely a “financial sampler” that I might pretend is “diversified”), then I have built my own mutual fund. I can then benchmark my fund against any other fund which purports to have the same investment objective provided that both are taking comparable risks. That is the crucial point. For fair comparisons to be made, our holdings have to be similar and our management of those holdings have to be similar, for reasons of risk.

Any higher-risk fund has the potential to beat any lower-risk fund over any given time period and over the long haul. Therefore, if they (or I) are not taking the same risks, then we are not measuring ourselves by the same benchmark and comparing total returns (which is the usual, one-number benchmark) is meaningless. (There are lots a fancy ways to get around the problem of disparate strategies so that “risk-equivalent” comparisons can be made. If you know what they are, then you also know how to use them and you aren't my audience.)

Consider a further problem in making comparisons or in selecting where to compete. As a small investor, I simply do not have access to the same markets the fundies do. Most especially, I do not have comparable access to emerging market debt. (E.g., they can buy Egyptian or Sri Lankan bonds. I can't except with the most extreme of difficulties.) Therefore, there are some fixed-income “asset classes” which can only be accessed by the “average small investor” through the use of mutual funds. (Whether accessing those otherwise hard-to-access asset classes is a beneficial necessity will be for each investor to determine for herself. I would guess that no financial instrument is inherently useless. But I'd also wager that there are lots of financial instruments or opportunities that are impracticable for the “average, small investor” who is always my intended audience and who I consider myself to be.

Also, I ask why the common fixed-income asset classes are partitioned as they conventionally are except for reasons dictated by Modern Portfolio Theory and its search for “asset classes” by which to achieve “diversifications”. What, really, is the meaningful difference in the portfolio of the “average” fixed-income investor of making a clear-cut distinction between “short-term bonds” and “medium-term bonds” other than for reasons of “definitional purity'? If you're trying to put a couple billion dollars to work in bonds, then sophistications like “maturity”, ”duration”, “convexity” become very practical tools. But the average FI investor, working with a lot less money and opportunity, is more likely to be asking herself: “Is this particular bond likely to be the best opportunity I have to put this $5,000 to work?”

There can be no doubt that “diversification” can be a useful risk-management tool. But diversification can't be spent at the grocery store the way that achieved returns can be. Therefore, what really matters most to a small investor isn't diversification, but capturing as much of the opportunities available to him as there are, any where, at a given time, for a given effort and risk. And the biggest “any where” will always be using mutual funds and what they seem to promise, rather than doing one's own active, self-directed, self-managed investing. So funds become a DIYer's bogie, wherein “If you can't beat 'em, you might as well join 'em.”

For lots of years now, I've been going toe-to-toe with the fundies on junk bonds. For lots of very idiosyncratic reasons, it's a gig I like, have done well at, and will continue. (“To each his own, right?”) But it's nothing I'd ever recommend anyone else pursue. The obstacles are so horrendous and the rewards might be so unfavorable that the conventional wisdom (that I've heard personally from Dave Gardener himself in response to a question I put to him when he did his usual rant against bonds generally at a West-coast talk some years back) is that the asset class should be avoided in favor of stocks.

That might be sound advice, or at least advice that should be carefully considered. That, also, will be for each person to decide. But the result is this: I am running my own junk bond, and how I benchmark myself and what asset classes I fail to pursue is my own concern, as must be the benchmarks each investor chooses for her or himself, which might be a particular mutual fund, or a customized composite index you create for yourself, or yet some other standard.

If you want to win the ”investing game”, you play to win, as I argued in another post. But what “Win” means, as defined by the benchmarks you choose, can be only be for yourself to choose. But you do have to choose.

"If you don't know where you're going, you probably won't get there."

(attributed to Yogi Berra)
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