In recent years, the so-called Yale Model has been extremely popular with investors. The model is an attempt to mimic the investment strategy used by Ivy League endowment funds, which have an outstanding track record of beating the market indexes. David Swensen, the superstar manager of the Yale endowment fund, delivered returns of 10.1% annually from 2002 to 2011, a decade when stocks returned 3.9%. The Harvard endowment returned 9.4% over the same period and has grown 12.9% over the last 20 years.

The Ivy Portfolio, by Mebane Faber and Eric Richardson, describes how Yale and Harvard use an asset allocation model that is broadly similar the Couch Potato strategy. The key difference, however, is that the endowments include a number of asset classes that are not available to retail investors, including private equity, hedge funds, and direct ownership of timber resources and commercial real estate.

The first half of Faber and Richardson’s book is a fascinating look at how individual investors can mimic the Yale Model. The authors quote both Swensen and Jack Meyer (Harvard’s former endowment fund manager), both of whom recommend building diversified portfolios with low-cost index funds. Then they offer three possible “Ivy Portfolios” that anyone can assemble with ETFs: the simplest one allocates 20% each to US stocks, foreign stocks, government bonds, real estate and commodities. Two other chapters explain that private equity and hedge funds can be profitable for institutional investors, but are best ignored by the great unwashed.

It’s all in the timing

So far, so good—but the latter half of The Ivy Portfolio goes a giant step further. Rather than simply encouraging investors to diversify widely and rebalance, Faber explains his strategy for protecting oneself from dramatic drawdowns, or “winning by not losing.” He points out that four of the five asset classes in the Ivy Portfolio have experienced declines of about 50% or more since 1973. (Government bonds were the only exception.) “So, is there a way to avoid these long bear markets and losses?” he asks.

The suggestion Faber offers in the book is based on his paper A Quantitative Approach to Tactical Asset Allocation, first published in 2007 and updated in 2009. It’s still the most downloaded paper on the Social Sciences Research Network, which testifies to its extraordinary popularity.

Faber’s strategy is actually very simple. You just check the price of each asset class on the last day of each month, and if it is greater than its 10-month simple moving average (SMA), you buy (or continue to hold). If the price is less than the 10-month SMA, you sell and move to cash. In other words, it’s straightforward market timing.

If one had employed this timing strategy with U.S. stocks from 1900 through 2008, Faber reports, it would have delivered returns of 10.45%, compared with 9.21% for the S&P 500. More remarkable, it would have protected you from almost all the worst drawdowns: it even earned slightly positive returns in 1931 and 2008, when the market lost 44% and 37%, respectively. Faber’s analysis shows similar results when applied to international stocks, real estate, commodities and even 10-year government bonds. In all cases, the timing strategy produced higher returns with much lower volatility, while avoiding the largest drawdowns.

Backtested from 1973 through 2008, the the Ivy Portfolio with the market timing strategy trounced a buy-and-hold approach and delivered returns that would have made Swensen and Meyer smile:

These are very impressive results, especially when you consider that they came about with an average of just three to four round-trip trades per year.

The Ivy Portfolio is an excellent book that I would highly recommend to index investors (though I would discourage them from building a portfolio that is 40% real estate and commodities). But how about Faber’s timing strategy? Is it a recipe for lowering the volatility and improving the long-term returns on a Couch Potato portfolio? I’ll consider that question later this week.

If your portfolio loses 1% today and gains 1% tomorrow, are you back to even? Not quite, but you’re awfully close. You actually need a gain of 1.01% to get back to where you started.

While that difference seems trivial, it gets magnified when the ups and down of your portfolio get larger. A loss of 5% requires a 5.26% gain to recover, while a 20% loss needs 25%. As for a 50% drawdown like we saw in 2008–09, well, that’s even worse than it appears. Your portfolio needs to double (a 100% gain) to return to its starting value. Stocks do recover from devastating declines like this, but it can take many years: the Canadian and US markets are still well below their 2007–08 highs.

Some investors simply don’t have the ability or the stomach to endure drawdowns of 20% or more. As index investors all know, the most straightforward way to protect your portfolio from catastrophic loss is to adjust its asset allocation: a 50-50 mix of Canadian stocks and government bonds lost just 12% in 2008.

But as I wrote about last week, markets are filled with uncertainty. We simply don’t know how far stocks can fall, nor can we be certain that bonds will be there to catch them. That’s why some index investors look for ways to build a floor under their portfolio.

Exploring your options

One way to set a limit on your portfolio’s losses is to buy put options. A put gives you the right to sell an asset—such as a popular ETF—at a certain price within a specified period. Here’s an example that was kindly provided by Alan Fustey of Index Wealth Management, the author of Risk, Financial Markets & You. (These prices were accurate as of May 1, but they will change with market conditions.)

• You purchase the iShares S&P/TSX 60 Index Fund (XIU) at $17.60.
• You also purchase put options with a strike price of $17.00, expiring in six months.
• These puts cost you $0.62 per share.

With this strategy, no matter how far markets may fall in the next six months, you can’t lose more than 6.9%. Here’s why:

• If XIU has declined below the strike price when the options expire, you have the right to sell your shares for $17. Since they were originally trading at $17.60, that works out to a maximum loss of 3.4%.
• You also need to account for the premium you paid for the puts. At $0.62 per share, that’s an additional loss of 3.5%.

As you’ve probably figured out, this protection is not free. Remember that the cost of the options will reduce your return by 3.5% no matter what happens. The value of XIU needs to increase by 3.5% for you to break even, and if markets go up by 10% you’d get only 6.5%. (Note that we’ve ignored dividends here to keep things simple. With XIU you can add about a 1% dividend every six months.)

Calls for help

Clearly protective puts, as they’re called, are an expensive insurance policy. One way to lower the cost is to also sell call options on your ETF. A call gives the holder the right to buy an asset at a certain price within a specified period. You sell (or “write”) calls in order to earn income from the premiums. Here’s another example from Fustey to illustrate this strategy, which is called a collar. Again, prices were accurate as of May 1.

• You buy the iShares S&P/TSX 60 Index Fund (XIU) at $17.60.
• You purchase put options with a strike price of $17.00, expiring in six months, at a cost of $0.62 per share.
• You also sell call options with a strike price of $18.50, collecting a premium of $0.30 per share.
• Your net cost for the options works out to just $0.32 per share, or 1.7% of original value of XIU, about half what you paid for the puts alone.

Now the maximum loss you can suffer is just –5.2%. But with this strategy you limit your upside even further. If the price of XIU rises above $18.50 (about a 5% gain), the holder of the call options will buy the ETF shares from you at the strike price. You’d get the 5% gain, but no more. And once you factor in the 1.7% cost of the options, you’re guaranteeing that your maximum return over the six months will be 3.3% (plus any dividends).

Weighing the costs

There are a number of other ways to combine options strategies with index investing in order to limit catastrophic drawdowns and to generate additional income. When properly managed, they may be appropriate for investors who understand the trade-off. But while that trade-off may seem small when markets are trending down or sputtering along with single-digit returns, it won’t always seem so comforting. Investors will feel pangs of regret when they get left behind by a market surge like the one that began last October (US markets are up about 25% since then). As Fustey explains: “There is no free lunch that allows an investor to receive complete protection against loss without either an outlay of cash or capping upside return potential.”

For investors who are still in the accumulation stage—who have lots of time to recover from losses and no need to generate income—a traditional asset allocation strategy is likely to be far more efficient.

When we consider the risk in investing, we’re often thinking about volatility: that is, the sometimes dramatic movements in equity prices. But as Alan Fustey explains in his book, Risk, Financial Markets & You, there’s a big problem with equating volatility with risk.

One of the biggest shortcomings in financial models is the reliance on standard deviation (SD) as a measure of risk. SD is a measure of volatility—or more specifically, how much returns vary around the average. About two thirds of all returns will fall within one standard deviation of the average, and 95% will fall within two standard deviations. In theory, annual returns that vary by three standard deviations should happen only once in a century, while a six-SD event would occur about once in a billion years.

This idea makes more sense when you use some real-world numbers. According to Credit Suisse, from 1900 to 2011 the average annual return on equities was 8.5%, with an SD of 17.7%. That means two years out of three should see returns between –9.2% and 26.2% (the average +/- one SD). In only one year out of 20 would returns be lower than –26.9% or higher than 43.9% (the average +/- two SDs). Looking back to 1970, you would expect two such years in Canada, and that’s what we experienced: a 44.8% gain in 1979, and a –33% loss in 2008.

One in a billion?

Although SD is a backward-looking measure, it seems a reasonably reliable measure of annual market volatility. Yet as Fustey explains in his book, the probabilities don’t hold up when we look at daily returns. If the average daily return on stocks is 0.03% and the SD is 1% (a close enough estimate), then two-thirds of daily returns should be between –0.97% and 1.03%. In about 19 days out of 20, the returns should be between –1.97.% and 2.03%. A daily return that is five SDs from the average (a gain or loss of about 6%) should happen only once in 3.5 million trading days, and a six-SD event is a one-in-a-billion proposition.

But that isn’t borne out by history. Fustey presents data going back to 1927 that shows the S&P 500 has seen 19 days with losses greater than –7%, three of which came in 2008 alone. Black Monday in 1987 was a 22-standard-deviation event, which should have been as likely as throwing a dime off a tall building and having it land on its edge.

With this in mind, Fustey makes a distinction between risk and uncertainty. “Risk is what you have when you’re playing poker,” he told me in our interview. “There are a known number of outcomes with 52 cards, and the probabilities can be mathematically calculated. You can’t do that with markets. There is an infinite set of possibilities, so it is a completely different animal. Risk has the connotation that there is some kind of control there. But even with indexing, there isn’t that control. You get whatever the market gives you.”

Fustey’s takeaway message is that standard deviation can’t model uncertainty. “Anything can happen in financial markets,” he says. “So you’ve got to somehow assess the likelihood of these bizarre, extreme events, both positive and negative.” In practical terms, this means that investors may want to consider some kind of safety net to protect them against sudden, unexpected drawdowns. Next week, I’ll look at a couple of methods that index investors might use to protect their portfolios from crippling losses.

Book winners

Congratulations to readers Anthony and Cam, who were chosen as the winners of the draw for copies of Fustey’s book. Many thanks to everyone who entered.

If you’ve researched the theoretical foundations of index investing, you’ve no doubt come across Modern Portfolio Theory and the Efficient Markets Hypothesis. And if you read the commentaries of active money managers and the financial media, you’ve probably seen countless articles that dismiss both as obsolete. Modern Portfolio Theory is declared dead after every market crash, and all stock pickers, almost by definition, believe markets are not really efficient. Many of these critics think passive investing is folly—only the warm embrace of active management can protect you and your portfolio.

In his provocative book, Risk, Financial Markets & You, the Winnipeg-based financial advisor Alan Fustey adds his own criticisms of these two decades-old models. But his conclusion is surprising. When I interviewed him recently, I asked what investors should do if these models were broken. “Well, the first thing you do,” Fustey replied, “is you index.”

The background

Before going further, let’s review these two landmark financial theories, both of which revolutionized investing. Modern portfolio theory was devised in 1952 by Harry Markowitz, who later shared a Nobel Prize for his contribution. Markowitz showed that by combining risky assets that have less than perfect correlation, you can create a portfolio that has lower risk and a higher expected return than its individual components. Index investors understand this as the “free lunch” offered by diversification.

The efficient markets hypothesis was formulated by Eugene Fama in a 1970 paper. It suggests that security prices reflect all public information, and therefore analysis of individual companies does not allow investors to identify “mispriced” stocks. (Occasional mispricings probably exist, but they cannot be reliably exploited.) In an efficient market, buying an index fund is the best way to get market exposure at the lowest possible cost.

‘You’ve got to have a better alternative’

These two ideas are among the pillars of the Couch Potato strategy. But as Fustey explains in Chapter 4 of his book, both have some shortcomings. For example, he says, MPT presumes that asset class correlations remain constant, and that market returns follow a normal distribution (represented by a bell curve). We know neither of these assumptions is valid. He also points out that it is possible for some  participants to have an informational advantage, so capital markets are not truly efficient.

But if you think Fustey is building a case against passive investing, think again: he argues that indexing still offers investors their best chance of success. “It comes down to this,” he told me. “If you’re going to throw out these ideas, then you’ve got to have a better alternative. If you reject the efficient markets hypothesis, you’re saying that you have the ability to get superior information, and that you can make money from that knowledge. But that flies in the face of reality. Someone is always going to have better information than someone else, but are you going to be able to profit from that on an after-fee basis? I don’t think so—and the history of active management proves that.”

Book giveaway

Alan Fustey is a CFA and a portfolio manager at Index Wealth Management, a Winnipeg firm that also has offices in Calgary and Vancouver. I recently added the firm’s three offices to my Find an Advisor directory.

Alan sent along two copies Risk, Financial Markets & You to offer to readers who are interested in learning more. Leave a comment below to be entered in the draw for the books. Contest closes at midnight EST on Wednesday, May 2. I will announce the winners in Thursday’s post.

Speaking of contests, a big thanks to everyone who requested a ticket to PWL Capital’s event featuring Carl Richards, author of The Behaviour Gap. The answer to the skill testing question was Buckingham Asset Management (BAM Advisor Services was also acceptable). Winners will be notified by email.

I once went to an investment seminar at my local library. It was attended by a handful of folks who had little or no experience with investing and were looking for someone to put them on the right track. The guy leading the session held up a copy of the Globe and Mail business section and encouraged us all to read it every day so we could learn what was happening in the economy and apply it to our investments.

That is some of the worst financial advice I’ve ever heard, and if Carl Richards had been there I imagine he would have thrown a few rotten eggs and tomatoes. Richards’ new book, The Behaviour Gap: Simple Ways to Stop Doing Dumb Things With Your Money, spends most of its 178 pages encouraging investors to ignore the headlines and focus on the real determinant of financial success or failure: ourselves.

“Forget about what’s going on in China or global demand for the dollar or the price of gold,” Richards writes. “While we’re worrying about those things, we could be doing things that actually make a difference in our financial lives—like working or trying to figure out how to save or earn a little more.”

Richards is a financial planner and a New York Times blogger who has a remarkable talent for distilling his insights into napkin sketches. His book sets out to discover why Dalbar studies demonstrate that equity investors have underperformed the market by over 4% annually over the last 20 years. The primary reason isn’t high fees:  if that’s all it were, the difference would be much smaller. Rather, it’s a behavior gap: Richards’ term for the difference between what investors should do and what they actually do.

Stop smoking, start saving

One of the anecdotes Richards shares comes from a former doctor who changed careers to become a financial adviser. The adviser regularly hears from clients who are desperately seeking higher returns while ignoring far more important parts of their financial lives, which reminds him of a former patient. This patient loved to debate about which medication was the best treatment for his high blood pressure—but he refused to stop smoking.

I encourage investors to remember this story the next time they want to make adjustments to their portfolios Even the Global Couch Potato is more than adequate to help you reach your financial goals if you’re a disciplined investor. I would estimate that will outperform 90% of individuals (on a risk-adjusted basis) over any period longer than 10 years. It’s not perfect, and you might be able squeeze out as much as a percentage point with more diversification or cheaper products. But chances are your behavior has a bigger influence on your returns than the specific funds in your portfolio.

For example, if you’re not saving enough, or if you’re carrying credit card debt, it makes no sense to worry about giving your investment returns a boost. Your precise allocation to US stocks, Vanguard versus iShares, or whether you use currency hedging—all of that is meaningless by comparison. Saving more and paying down debt will always swamp these decisions.

See Carl Richards live

If you’d like to hear more of Richards’ insights on the behavior gap, here’s your chance. PWL Capital Inc. is bringing Richards to Canada for a series of presentations in Toronto, Ottawa and Montreal. I have accepted an initiation to attend the Toronto event, and PWL is offering a limited number of invitations to Canadian Couch Potato readers in each of the three cities.

The Toronto presentation will take place on Tuesday, May 22, at 6 pm. The Ottawa and Montreal events will be held on Wednesday May 23 at 11:45 am and 6 pm, respectively.

If you would like to be entered into the draw for free tickets, email me with the answer to the following skill-testing question: What is the name of the firm that employs Richards as its director of investor education?

Please include your full name and indicate which of three events you would like to attend. Entries must be received by midnight on Sunday, April 29. I’ll announce the winners in next Monday’s post.

As loyal readers will know, I’ve been critical of the zeal with which some investors approach dividends. Based on countless blog posts, emails and conversations, I feel that many investors’ preference for dividends is often irrational. And that’s not simply my opinion—the dividend puzzle has been a popular topic in financial theory for decades.

There are some situations where dividends are clearly preferable to price appreciation. The most clear-cut is the tax advantage enjoyed by investors (especially those in a low tax bracket) who hold Canadian dividend stocks in a non-registered account. But there are other situations where investors should actively avoid dividends—and yet they flock to them anyway. The latest example of misplaced enthusiasm comes from Apple.

As everyone knows, Apple announced in March that it will pay a quarterly dividend starting later this year. Predictably, the news was met with widespread approval—the dividend was called “payback,” and a “reward.” As The Globe and Mail reported, “It will raise demand for the stock, since dividend-focused investors, mutual funds and exchange-traded funds will now put Apple on their radar screens.”

Therein lies the puzzle. Because whether you hold Apple stock directly or in an index fund (as the largest company in the world, it’s a significant 4.5% of the S&P 500), it’s hard to see this dividend announcement as anything other than bad news.

Taking a bite out of Apple

Several American commentators have argued against Apple paying a dividend, because US investors will face a 15% tax on the distribution. For Canadians, it’s much worse. If you hold the stock in a taxable account, your annual dividend of US$10.60 is subject to a 15% withholding tax (which may be recoverable), and the remainder will be fully taxable as income. You could easily lose half of it. By contrast, when the stock was paying no yield, you would only have incurred a taxable event if you sold shares at a profit—and these capital gains would have been taxed at only half your marginal rate.

It’s also interesting that the dividend hoopla overshadowed the announcement that Apple is also planning to repurchase USD$10 billion of its shares in 2013. Unlike the dividend, this move is likely to be a boon to investors, since it will raise the value of remaining shares by a corresponding amount. The pre-tax impact of a dividend and a share repurchase is the same (either a $1 cash distribution or a $1 increase in share price), but the buyback is likely to deliver a higher after-tax return. So where are the cheers from investors?

Finally, even if you hold Apple in a tax-sheltered account where you’ll keep all of the dividend, it’s difficult to understand why you would want the company to fork over its cash. The Financial Post quoted an analyst who said “it’s probably better to have the cash in the shareholders’ pockets then in Apple’s pockets.” Really? Apple’s return on equity is over 36%, which blows most other companies out of the sky. The company’s share price has increased 574% over the last five years. Do you think you’ll be able to do better with the $10.60 that will go into your pocket next year? And if you do, why not sell a few shares today and deploy the proceeds somewhere else?

“Why is Apple initiating quarterly payouts?” asked Forbes columnist William Baldwin, one of the more vocal critics of the decision. “Because the mob wants it.”

Tracking error—the difference between the performance of a fund and that of its benchmark—is the best way to measure an index fund’s true cost. While many investors focus on MERs, a low fee means little if an ETF lags its index by an additional 30 or 40 basis points.

A couple of weeks ago, I reported on the tracking errors of iShares ETFs in 2011, which were mostly very low. Today let’s look at the 2011 performance of the most popular ETFs that formerly bore the Claymore name, all of which were recently rebranded as iShares.

Let’s start with the positive results: the three core equity funds tracking the RAFI fundamental indexes had very low tracking errors. The Canadian Fundamental (CRQ) and the non-hedged version of the US Fundamental (CLU.C) both lagged by less than their MERs, which is always impressive. The International Fundamental (CIE) didn’t fare quite as well, but the higher costs of trading international equities makes this unsurprising.

Once again, currency hedging proved to be a major drag on performance: the hedged version of the US Fundamental (CLU) had a tracking error 60 basis points higher than that of CLU.C. Remember that this added friction will be there whether the Canadian dollar rises or falls during the year.

The performance of both CLU.C and CIE are very encouraging, given that both funds have experienced terrible tracking errors in the past. I currently recommend the US-listed PowerShares fundamental ETFs in my Über-Tuber portfolio because of this poor track record. But now that these funds hold all of the stocks in their indexes (as opposed to a representative sample, as in years past) they seem to be doing an excellent job of mirroring their benchmarks. Next time I update the model portfolios I will have to consider including CLU.C and CIE.

Not such an advantage

The Claymore/iShares Advantaged ETFs, which hold either bonds or foreign dividend paying stocks, are designed to be as tax-efficient as possible. I include three of them in my Yield-Hungry Couch Potato, which is designed for non-registered accounts.

The performance of these funds was mixed. The Global Monthly Advantaged Dividend (CYH) actually had a higher return than its benchmark, which is a pleasant surprise. But the Advantaged Canadian Bond (CAB) and the Advantaged U.S. High Yield Bond (CHB) lagged their indexes by 2.1% and 1.8%, respectively.

The Advantaged funds have higher expenses and should be expected to have bigger tracking errors than their plain-vanilla counterparts—even then the tax advantages might still put them ahead. But for investors who are not in the highest tax bracket, the “advantage” is likely to be slim to zero when tracking errors are this high. The comparable iShares DEX Universe Bond (XBB) returned 9.36% in 2011, while the iShares U.S. High Yield Bond (XHY) returned 6.83%. It’s quite possible the after-tax returns on these traditional ETFs may have been higher for investors who were not in the highest tax brackets.

I consider these Advantaged bond funds to be on probation: if they continue to lag like this, I will remove them from my model portfolio.

I haven’t watched Saturday Night Live for a long time, but I’ve been thinking about a classic line from the show’s Weekend Update sketch. Back in 1988, during the Winter Olympics, Dennis Miller opened his sportscast like this: “In Calgary tonight, Katarina Witt won the gold medal in figure skating, prompting Yankees owner George Steinbrenner to fire manager Billy Martin.”

If you’re not a baseball fan, the joke needs an explanation. Billy Martin was the manager of the New York Yankees during five separate stints beginning in 1975. The mercurial Steinbrenner fired Martin in 1978, rehired him in 1979, fired him again after 95 games, then hired and fired him three more times in 1983, 1985 and 1988. No one knows exactly what reasons Steinbrenner used to justify all those firings, but Katarina Witt’s gold medal performance in Calgary seems as good as any.

I remembered the joke this morning when I read the Financial Post’s daily market commentary: “The S&P 500 added more than 2% in the two previous sessions as immediate concerns over rising yields in Spain and Italy ebbed and on bets the Chinese GDP data would surprise on the upside.”

This commentary can sound so knowledgeable and wise. But to suggest that daily market movements can be explained in such simple cause-and-effect terms is laughable. If you want proof, all you need to do is read the commentary every day. You’ll just as often see statements like this: “The S&P 500 shed more than 2% in the two previous sessions despite immediate concerns over…”

It can’t work both ways: either these events affect daily stock prices, or they don’t. Once you accept this, you realize that commentary linking the S&P 500 to surprising Chinese GDP data sounds a lot like the joke about Katarina Witt and Billy Martin.

Here’s my own version of the daily market report: “The S&P 500 added more than 2% during the last two sessions because of an incredibly complex and largely random combination of factors that cannot possibly be distilled into one sentence. Analysts expect gains to continue during the second quarter, but since this already priced into the markets, no one should give a fiddler’s fart what they think. Meanwhile, money managers have released their forecasts for the year, which will be widely read and acted upon, despite the fact that their previous forecasts were dead wrong. Tune in tomorrow for more of the same. In the meantime, stick to your long-term plan.”

Critics of index investing often argue that the strategy is not sensitive to valuation. They feel that a simple strategy of buy, hold and rebalance is folly: there are times when the market is cheap or overvalued, and it makes sense to shift toward or away from equities accordingly.

It’s hard to argue with that principle. There are certainly periods when markets appear frothy and others that look like excellent buying opportunities. The problem is, whose valuation should you believe?

On April 2, Vanguard’s chief economist Joseph Davis went on BNN and said that valuations are right around their historical averages, so expected stock returns over the next several years should also be near their historical averages, which in the US is about 9% a year.

Three days later, The Globe and Mail ran an article about Prof. Robert Shiller’s method for valuing the market. According to Shiller, the earnings yield of the S&P 500 is currently 4.5%, compared with the historical median of 6.3%, which means the market is significantly overvalued. This translates to expected returns of 2.6% annually over the next 10 years.

What is the average investor to make of this? Of course, investment firms (even Vanguard) have a vested interest in being bullish on equities—I get that. But traditional valuation measures are easily quantified: the trailing P/E ratio of the S&P 500 today is about 16.2, compared with the historical average of about 15. So it’s indeed pretty close to average.

And while Shiller is an academic with fewer conflicts of interest, that doesn’t necessarily mean he’s right. While his predications have a good track record, his data were also saying equities were overvalued last fall, yet since October the US market is up about 25%. If you made a tactical shift away from stocks based on his valuation, you missed an enormous rally: 2012 saw the best first quarter for US stocks since 1998.

Diversify, rebalance and stop guessing

This is my concern about making tactical moves based on valuation, which is really just a form of market timing. First, you need to base your actions on data that can tell conflicting stories. I don’t know how you decide which criteria to use with any confidence, since all of them will be right during some periods and dead wrong during others. (Ken Fisher’s The Only Three Questions That Count includes a lengthy discussion about why P/E ratios don’t always have predictive value.) Then you need to execute your strategy consistently and unemotionally. I suggest that’s much easier said than done—especially after a couple of your moves backfire.

Simply owning a broadly diversified portfolio can go a long way toward making all of this less important. If you’re holding government bonds, corporate bonds, real-return bonds, stocks from around the world (with a mixture of value and growth, large and small), real estate and several currencies, chances are that there will always be both overvalued and undervalued assets in the mix, whatever yardstick you want to use. And a disciplined, rules-based rebalancing strategy is a self-correcting mechanism that ensures no asset class has too much or too little influence for very long. It’s not a valuation tool, but it does help you build in a measure of “buy low, sell high” without resorting to forecasts.

Update: Couch Potato returns

I have just uploaded the up-to-date returns data for the Couch Potato model portfolios with a new feature. Many readers asked me to include returns for the TD e-Series funds, and I’ve obliged. As it happens, this has the added benefit of allowing us to look at longer-term returns for the Global Couch Potato, since the e-Series has been around much longer than most of the ETFs on the list. As of March 31, the 10-year annualized return of the Global Couch Potato (using non-hedged funds for the US and international components) is 4.17%. The three-year return is 9.99%.

The humble Global Couch Potato portfolio, first recommended by MoneySense eight years ago, is an excellent way to get started with indexing. So when ING Direct launched its Streetwise Balanced Fund in 2008, I thought it would be perfect for new investors, since it’s a single fund with the same target allocation: 40% Canadian bonds and 60% equities, divided equally between Canadian, US and international.

The one problem with the Streetwise Funds was cost: with an original MER of 1% (now 1.07% with HST added) they were more expensive than I would have liked. After all, banks already offered index mutual funds with fees in that neighbourhood, and the TD e-Series Funds are dramatically cheaper: you can build the Global Couch Potato for a total cost of just 0.37%.

But four years after the launch of the Streetwise Balanced Fund, it’s worth taking a closer look at how it fared in comparison with the with TD e-Series. Here are the returns:

As you can see, the Streetwise Balanced Fund underperformed the TD e-Series by 70 basis points annually, which is exactly the difference in MER. But that’s not the whole story. Dig a little deeper and you’ll see that ING Direct’s simple index fund actually fared better than you would think at first blush.

It turns out that almost half of the performance lag can be explained not by cost, but by a subtle difference in asset allocation. The Canadian equity component of the Streetwise Balanced Fund is pegged to the S&P/TSX 60 Index, which includes large-cap stocks only. The TD Canadian Index Fund, on the other hand, tracks the S&P/TSX Composite Index, which includes mid and small caps as well. In each of the last three years, the latter index has outperformed—in both 2009 and 2010 the excess return was well over 3%.

To make a fairer comparison, I re-ran the performance numbers on the Global Couch Potato substituting the Altamira Canadian Index Fund, which tracks the S&P/TSX 60. This time the four-year annualized return fell to 0.81%, resulting in a lag of just 41 basis points for the Streetwise Balanced Fund. For every $1,000 invested, 41 basis points is $4.10 a year.

Notice that the Streetwise Balanced Fund slightly outperformed the Global Couch Potato in 2008: that’s because large caps did better in Canada that year—in fact, they trumped the overall market from 2004 through 2008. Had ING Direct launched its fund in 2004, it likely would have beat the Global Couch Potato over its first five years.

It’s also worth recognizing the Streetwise Balanced Fund’s relatively low tracking error. According to its Management Report of Fund Performance, since its inception four years ago, the fund’s 0.40% annualized return compares with a blended benchmark return of 1.13%. That’s a tracking error of 73 basis points, which is much lower than you would expect from a fund that has an MER of 1.07%, and it closes some of the gap between the Streetwise and TD e-Series funds.

An ideal first step

There’s no question that an experienced index investor can build an ETF portfolio that is far more diversified and much cheaper than the Streetwise Funds, and the TD e-Series are still my first choice for Couch Potatoes who want to use mutual funds. But there is a lot to be said for ING Direct’s simple solution. Unlike TD, which has actively discouraged investors from investing in their index funds, ING Direct makes it extremely easy to open an account, never charges account fees, and imposes no minimum balance, so you can start from zero. And because you’re dealing with one fund instead of four, you can make a single monthly contribution and ignore rebalancing, since that’s done automatically every quarter.

Based on the emails I receive, new index investors face two main obstacles. The first is philosophical: they need to move past the idea that successful investing is about picking the right securities and identifying the “right time” to get in or out of the markets. The second is practical: they need to build a diversified portfolio without incurring fees and transaction costs that will eat up their small account. The Streetwise Funds solve all of these problems. Would I recommend them to someone with investing experience and $50,000? Probably not. But they’re an ideal first step in a lifelong investing plan based on low cost, global diversification, and smart behaviour, and a reminder why MERs are not the whole story.

Disclosure: A member of my household has a small holding in the Streetwise Balanced Growth Fund.