At a major ETF industry conference, Vanguard CIO Tim Buckley shared a preview of an upcoming report from by Vanguard Research. The general idea is that a good financial advisor should be able to affect the performance of client’s portfolio by three full percentage points. That’s a really big number, and I’m sure it has many advisors excited. Here’s how that 3% breaks down:

• 1.5% – Controlling client behavior. Avoid market timing. Don’t chase performance. Stick with asset allocation. Stay the course and keep investing during market downturns.
• 0.60% – Efficient tax management. Maintain optimal asset location (not allocation) to minimize tax costs. When money is needed, determine which assets and when to sell.
• 0.50% – Keeping costs low. You have the ability to choose investments with low expenses.
• 0.40% – Rebalancing. Rebalance regularly back to target asset allocation.

Buckley used the terms “controlling alpha”. Alpha is defined as excess risk-adjusted return above a benchmark, usually involving things like timing asset class movements and careful stock selection to make the difference. In contrast, the four factors listed above are less about being smarter than everyone else and more about avoiding simple mistakes.

This is still helpful advice, as these are the areas in which you should realistically expect assistance when looking for a financial advisor. It’s quite unlikely that the friendly person in the office building downtown is the next Warren Buffett. However, he or she may be the calming voice that you need to stay the course. I don’t know about 3%, but I do think a good advisor can invest better than many people on their own. As long as the advisor costs less than their “advisor alpha” benefit, you’ll come out ahead. The hard part, as always, is to find one of these “good” advisors.

Of course, being a DIY investor I feel I can do all these things myself. I also can’t help but notice again that many of these aspects are already rolled up into a nice balanced fund like the Vanguard Target Retirement 20XX Funds. By being all-in-one, the fund discourages trading and encourages doing nothing. The funds rebalance back to their target asset allocations automatically. The costs are extremely low. The only area where they come up short is tax-efficiency. However, for many individual investors the vast majority of their retirement assets are located in tax-advantaged accounts like IRAs and 401ks. In those cases, the benefits of tax-management are minimal.

It will be interesting to read the methodology behind the full report when it is published.

Sources: InvestmentNews (registration req’d), ETF.com

P2P lender Prosper.com was sued because the defendants “allegedly violated securities laws due to Prosper’s selling securities without qualifying or registering them and acting as an unlicensed broker-dealer” (they later registered with the SEC). I was just notified that the case was settled without admission of wrongdoing for $10 million (1/3rd will go to lawyers of course). Details at ProsperClassAction.com.

You are eligible for a portion of this settlement if you purchased notes from Prosper between January 1, 2006 and October 14, 2008. This period is sometimes referred to as “Prosper 1.0”. You used to be able to bid on loans, and many early investors lost money while this new model was being tested out (their loan collection methods back then were horrendous). Accordingly, settlement payouts will be made “in proportion to the aggregate amount of losses”.

It appears that you don’t have to file a claim to get your share of the settlement. However, if you have changed e-mails since buying since investing in a Prosper loan, you may not have gotten this notice. Also, if you moved you should update your address on record to make sure you get that check.

It is very tempting to invest in an actively-managed mutual fund that advertises above-average historical returns. Why would you bother investing in the ones with below-average returns? However, there’s something behind the whole “past performance does not guarantee future results” fine print. While there will always be funds that outperform looking backwards, that fact just doesn’t reveal very much about the future.

Index provider Standard & Poor’s publishes something called the S&P Persistence Scorecard twice a year, which examines the persistence of mutual fund performance over consecutive and overlapping time periods. By using quartiles, relative performance is compared, not absolute performance. Do the funds that had top returns in the past continue to have top returns?

The most recent December 2013 study [pdf] reaffirms the general conclusions of many other similar studies on persistence of actively-managed mutual fund performance, namely that it is often nowhere to be found when compared with random chance.

Very few funds can consistently stay at the top. Our studies show that as time horizons widen,the performance persistence of top quartile managers declines. Of the 692 funds that were in the top quartile as of September 2011, only 7.23% managed to stay in the top quartile at the end of September 2013. Similarly, 5.28% of the large-cap funds, 10.31% of the mid-cap funds and 8.15% of the small-cap funds remain in the top quartile.

For the three years ended September 2013, 19.25% of large-cap funds, 20.1% of mid-cap funds and 26.8% of small-cap funds maintained a top-half ranking over three consecutive 12-month periods. It should be noted that random expectations would suggest a rate of 25% and small-cap funds was the only category to exceed the repeat rate.

A good analogy I’ve read is that you don’t drive by only looking at your rearview mirror.

More: Barron’s, Rick Ferri/Forbes

2013 was a great year for US stocks, and that also means that many mutual funds distributed (taxable) capital gains to their shareholders. ETFs are hot right now and there are many articles like this one which tout the tax-efficiency aspect of ETFs as to why they are superior to mutual funds.

Yes, it is true that ETFs have an inherent structural advantage over mutual funds in avoiding the production of capital gains. (I won’t explain it here, but here is one explanation.) However, the primary reason that mutual funds tend to distribute more capital gains is that most ETFs are passive and thus trade sparingly, while actively-managed funds by definition buy and sell much more frequently (what else are you paying them to do?).

But if you hold a good index fund, it will have very low turnover and thus you’ll rarely have to deal with capital gains either way. For example, both the Vanguard S&P 500 Index Fund (VFINX) and the Fidelity Spartan 500 Index Fund (FUSEX) had zero capital gains distributions in 2013 despite being up over 30% for the year.

On top of all that, at Vanguard their mutual funds and ETFs of the same name are structured as different share classes of the same basket of securities. That means the mutual funds and ETFs have exactly the same level of tax-efficiency. From the Vanguard website:

Are there tax advantages to owning Vanguard ETFs?
Because Vanguard ETFs are shares of conventional Vanguard index funds, they can take full advantage of tax-management strategies available to conventional funds and to ETFs. Conventional index funds can manage tax liabilities by selling high-cost securities to realize losses to offset realized gains. Vanguard ETFs can also limit a fund’s potential capital gains exposure by using in-kind redemptions to eliminate stocks with high built-in capital gains from the portfolio. This advantage gives our Vanguard ETFs management team more flexibility in implementing tax-management strategies.

For example in 2013, both the Vanguard Total Bond Market Index mutual fund (VBMFX) and ETF version Vanguard Total Bond Market ETF (BND) distributed a small long-term capital gain 0.076% of NAV.

Bottom line: If you hold passively-managed index funds, it really won’t matter much tax-wise if you pick ETF or mutual fund. If you hold Vanguard funds, it won’t matter at all. There are other factors like expense ratio differences or intra-day pricing availability that may sway you to either mutual fund or ETFs.

If you hold actively-managed funds, you will be less tax-efficient and that will be an additional drag on performance unless you hold them in tax-advantaged accounts.

While dividend size is not the primary driver of my investment decisions, I still love seeing dividend distributions arrive in my brokerage account and consider them a critical part of my portfolio’s total return.

Eddy Elfenbein of Crossing Wall Street created the chart below, plotting both the S&P 500 index value (blue) and its dividends (red). The vertical axes are scaled 50:1, so that when they cross the dividend yield is 2%. We see that while dividends don’t always go up in the short term, they have been bouncing back and growing along with stock prices today (unlike during the dot-com boom).

If you take a step back and look at the bigger picture, Multpl.com has a chart showing the dividend growth for the S&P 500 on a real (inflation-adjusted) basis since 1870. While the dividend yield remains at historical lows, the total amount of dividends still appear to grow faster than inflation over longer (10+ year) periods. Note the vertical axis is on a log-scale.

The blog Short Side of Long has a nice post discussing the relative performance of several different asset classes over the last few years. The charts especially caught my eye, and I went over to Stockcharts.com to make my own with the asset classes that I prefer to follow.

Here are 2013 year-to-date price charts for selected major asset classes (using representative ETFs): total US stock market (ticker VTI), total international stock market (ticker VXUS), total US bond market (ticker BND), inflation-protected US bonds (ticker TIP), and gold (ticker GLD). Dividends are not included. As mentioned earlier, 2013 was year where assets didn’t move in sync (lower correlations).

(click to enlarge)

The chart below shows the same ETFs over all of 2012. Looking back, it felt like every asset class ended positively and everything was recovering in 2012.

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Due to a lack of tax-deferred space, my current tax bracket, and the current interest rate spread over US Treasury bonds, I started investing part of my portfolio in Vanguard’s tax-exempt municipal bond funds. As a result, I try to read every single muni bond article that Vanguard puts out. In this month’s blog post Municipal debt, Detroit, and diversification, one of the topics covered was the importance of minimizing fund fees.

Research shows that lower-cost mutual funds have tended to perform better than higher-cost funds over time. So instead of worrying about things we can’t control (e.g., how a judge in a municipal bankruptcy is going to decide a case), we should focus on controlling the one variable that we can, which is cost.

The article included the chart below, which plots the net fund expense ratios of municipal bond funds against their 5-year annualized returns.

Source: Vanguard Blog, Morningstar

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More charts! The Atlantic has a big collection of 41 economic charts for 2013. Some are neat, some I don’t understand, and some I don’t think anyone really understands. 😉 Here are two investing-related graphs that caught my eye. The first one shows that correlations between multiple asset classes have dropped significantly recently. Submitted by Joe Weisenthal of Business Insider, who states that “one of the characteristics of a crisis is extreme correlation between multiple asset classes: everything trades up or down together.”

The second one shows the cumulative investment inflows into stock and bonds funds over the last year. Submitted by Joshua Brown of The Reformed Broker, who suggests that this shows “America is regaining confidence in the institution of investing again”.

When I see low correlations, it feels like a good time to rebalance your asset allocation. At the same time, it certainly looks like stocks have some momentum right now. Perhaps it’s best just to take a long nap until 2014.

In the post Foreign Stocks For The Long Run, author Rick Ferri recently revisited the topic of how much international stock exposure you should add to your portfolio’s asset allocation. I also have an older post about this – Choosing An Asset Allocation: Deciding On The Domestic/International Ratio – as part of my Rough Guide to Investing series.

One of the reasons to invest in international stocks is for the diversification benefit. While both have historical average returns of 8-10% annually before inflation, they don’t always move in sync (not perfectly correlated). As a result, Markowitz showed us you can attain a higher risk-adjusted return by holding some of both as opposed to just one or the other. So how much of each should you hold?

In my 2007 post, I posted this chart taken from the then-current edition of the bestseller A Random Walk Down Wall Street by Burton Malkiel. It maps the risk/return for portfolios that range from 100% US stocks to 100% EAFA (Non-US Developed countries) for the period January 1970 to June 2006:

From 1970-2006, foreign stocks outperformed US stocks, while the point of optimal risk-adjusted returns was a split of 76% US and 24% Foreign (70% is a typo).

However, the updated data collected by Ferri shows a different yet similar story (see chart below). From 1970-2013, we see that now US stocks outperformed foreign stocks instead, with the point of optimal risk-adjusted returns at 70% US and 30% Foreign.

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