If designed well, a diversified, multi-asset portfolio can provide growth during pre-retirement accumulation years and stable income flows during post-retirement distribution years.There should be 12 required asset classes: large-cap, mid-cap and small-cap U.S. stocks; foreign stocks (developed and emerging markets); real estate; natural resources; other commodities; U.S. bonds; inflation-protected bonds; foreign bonds; and cash.
LARGE-CAP EQUITY BASE
The base asset in many portfolios is large-cap U.S. equities. There were 754 large-cap U.S. equity funds as of Oct. 31, according to Morningstar Principia. To be included, each fund had to have less than 5% of its portfolio in bonds, non-U.S. equity or cash. Only distinct funds were counted, meaning only one share class was included.
The biggest share of all large-cap fund assets is held by a small percentage of funds. The median market capitalization of all 754 large-cap funds was $33.6 billion as of Oct. 31, with a maximum value of $149 billion and a minimum value of $10.2 billion. The largest 25 funds represent only 3.3% of all 754 large-cap U.S. equity funds, but hold nearly 60% of the $1.2 trillion in total assets, or about $717 billion.
Index funds hold a disproportionately large share of the assets of U.S. large-cap equity funds (by a factor of 2 to 1). Of the 25 biggest large-cap funds, 19 are index funds. Those 19 hold $648 billion in assets, about 90% of the assets held by the top 25 large-cap U.S. equity funds.
Index-based mutual funds are still the dominant vehicle used by investors to achieve passive exposure to the large-cap U.S. equity market. Of all 754 large-cap U.S. equity funds, 271 (36%) are index funds. Within that group, 155 are ETFs (57%) and 116 (43%) are mutual funds. Despite representing more than half of the index funds, the ETFs hold just 36% of the index fund assets.
Of particular note are the seven funds in the table that explicitly track the S&P 500. Of those seven funds, five are mutual funds and two are ETFs (see the "Send in the Clones" chart on page 90).
There is no material difference between the average performance of the five mutual funds and the average performance of the two ETFs over the last three, five and 10 years. The five-year tax-cost ratio is identical (as per Morningstar's calculation of tax efficiency). Similar to an expense ratio, the lower the tax-cost ratio, the better.
The average expense ratio is slightly lower for the mutual funds, due in large part to the minuscule expense ratio of four basis points for Vanguard Institutional Index Fund. However, lower cost comes at a price - admission. Whereas ETFs have no required initial investment, this fund requires $5 million to open an account.
ARE FUNDS INTERCHANGEABLE?
Here's how each of the 25 largest U.S. large-cap equity funds contributed to a diversified portfolio over the past 10 years (2001 to 2010). The 12-asset portfolio consisted of equally weighted allocations (8.3%). The performance of each of the asset classes was represented by an established index.
The annual returns of the 25 largest U.S. equity funds were inserted into the 12-asset model - one fund at a time - and the 10-year performance of the entire portfolio was calculated (see the "Single File" chart, at right). Despite the performance differences among the individual large-cap funds, the 10-year annualized return of the overall portfolio was largely unaffected by which large-cap U.S. stock was utilized.
The most dramatic difference was found between using Energy Select Sector SPDR (XLE), which had a 10-year return of 11.8%, versus Technology Select Sector SPDR (XLK), which had a 10-year return of 3.1%. The 12-asset portfolio return was 8.7% using XLK in the large-cap slot compared with 9.5% for XLE.
Understandably, these are sector funds that do not necessarily represent a diversified swath of the large-cap U.S. equity market. When examining more diverse large-cap equity funds - index or actively managed - the performance differences at the portfolio level were so small as to be immaterial.
ASSET ALLOCATION IS VITAL
The statistics in the "Single File" chart at left illustrate a vitally important point - the asset allocation model is more important than the individual fund being used in the model. As shown, there are a number of perfectly adequate large-cap U.S. equity funds - just pick one. The important issue is to incorporate that large-cap U.S. equity fund into a diversified portfolio.
Craig L. Israelsen, Ph.D., is an associate professor at Brigham Young University and the author of 7Twelve: A Diversified Investment Portfolio With a Plan.