Some great questions and (hopefully) some good answers

A few days ago, a visitor VJ posted a some good questions and points in a comment in this thread. Here is his post again:

Great blog, and very impressive and logical thoughts given your relative newness to the topic!

I work in finance, but in institutional research, so my knowledge of personal finance issues is slightly limited, but my grounding is pretty good. A couple of ideas/thoughts:

1) My company has its 401ks with Fidelity. Fidelity has “asset allocation” funds which are indexed blends of stock and bond which have various “maturities.” That is, if you plan to retire in 2010, you have mostly a bond mix, and if you plan to retire in 2050, you have mostly a stock mix, and by 2045 the 2050-fund will look kind of like the 2010-fund looks today; they become more conservative over time. Sounds like an intriguing product and I would love to hear your thoughts on it.

2) The academic and practitioner evidence suggests that, although indexing is better than most active investing strategies, there are a handful of “investment anomalies” that over the long haul produce above-market returns. Most importantly:
a) small stocks beat large stocks
b) cheap (high E/P) stocks beat expensive (low E/P) stocks
and less importantly
c) stocks with improving earnings estimates win
d) stocks with strong balance sheets and high quality earnings win
e) stocks with low levels of insider selling and short interest win
f) stocks which have won over the last year, and lost over the last month, win

(c) through (f) are hard to capture without incurring transaction costs. But (a) and (b) can be captured by overweighting small cap and value stocks even at the index fund level. One idea is to overweight (relative to most asset allocations) small and value stocks to take advantage of these established anomalies.

3) Because I actively manage my equity portfolio to capture shorter-term effects like (c) through (f), I do more trading than a strategy like yours would do. As such I’ve used a service called folioFN (www.foliofn.com) which lets you do loads of trades per month at a flat annual fee. I really like it as a trading account for a small amount (a few K) of “play money” and recommend it for those who want to trade a bit.

4) I agree with your thoughts on financial advisors. I’d also suggest that with a few hours’ commitment, many individuals and small businesses can come up with an asset allocation that makes sense and will beat what an FA will provide. The exceptions are FAs who provide more comprehensive services on tax management, real estate, insurance, and so on. I’m less qualified to judge those skills, though.

VJ

And here is my reply:

1) My company has it’s 401k in Fidelity as well, and I used to have my money in their Freedom 2040 (FFFFX) mutual fund. Then I did some research and realized that their “fund of funds” actually has another layer of expenses (about 0.10%) on top of the underlying funds! I suppose it is warranted as there are a good number of funds and they probably have to do a bit of juggling. But I don’t believe active management is good enough to overcome the expenses associated with it anymore. The overall expense ratio is about 1%, but this is after some “temporary” fee reductions, which “may be terminated at anytime”.

I also found more insight in this Morningstar.com article – “Three Steps Needed to Bolster Fidelity’s Freedom Lineup”.

I have instead moved much of my funds into their Spartan Index series of funds, and kept my chose asset allocation of 80% stocks/20% bonds. Roughly, my 401k looks like this:

40% U.S. Equity Index Commingled Pool (Similar to S&P 500 Index Fund, expense ratio (ER) unknown, read elsewhere as 0.10%)
20% Spartan International Index Fund (FSIIX, ER=0.10%)
20% Extended Market Index Fund (FSEMX, ER=0.10%)
20% PIMCO Total Return Fund (PTRAX, ER=0.68%)

I like it because it is simple, I can custom rebalance easily, and has a lower expense ratio than the Freedom Fund, even without the temporary 0.10% cap. I am really considering dumping the PIMCO Fund due to it’s high expense ratio, but that is the only real bond indexing fund available to me. I’m open to suggestions!

2) I agree with you on (a) and (b). As you can see, I am overweighting myself on small- and mid-cap stocks in my 401k. I intend to diversify into smaller-cap and value funds in the future, as my portfolio grows. Right now I would incur low-balance fees by slicing and dicing.

As for (c)-(f), I am more hesitant to do to much with it, except for perhaps through my FreeTrade account below.

3) I looked at FOLIOfn, which is neat because you are almost making your own mutual fund. But I went with FreeTrade Brokerage instead, due to the 20 completely free trades per month, no minimum trades. In addition, FreeTrade does real-time trades, while FOLIOfn only does orders twice a day. I am also starting with $5,000 of “play money” to experiment, and $199/year for FOLIOfn is a bit steep (4% of assets). Hopefully we can compare year-end results!

4) I agree that certain financial advisors/tax professionals/attorneys will be worth the money they charge, especially in your mentioned areas of tax management, real estate, and insurance. I just wish there was full disclosure of commissions!