Simple Plans to Beat the Market

published 31 March 2009

As you view the damage to your investments, consider this: You can beat the great majority of professionals by using simple strategies that take advantage of low-cost index funds. Index funds track a broad swath of the market, such as big-company stocks, small-company stocks, emerging-markets stocks and so on.

Some of the sharpest minds in the world of finance -— from Nobel Prize–winning professors to Warren Buffett, who is arguably the greatest money manager of our time -- advocate a passive style of investing best accomplished with index funds. The evidence seems to back them up. For example, over the past 15 years through December 31, Standard & Poor's 500-stock index performed better than 66% of mutual fund managers who specialize in stocks of large U.S. companies.

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We went to three experts with a straightforward request: Construct a balanced, low-cost portfolio, with no more than eight components, for people who are investing for the long term. We weren't rigid about the guidelines; our experts were allowed to use actively managed funds, if they wished, as well as index funds. The experts submitted their portfolios in December 2008, and we began tracking performance on January 1. We will rebalance the portfolios twice a year: on the last day of June and the last day of December.

In Burton Malkiel's view, managers in developed markets will be hard-pressed to beat their indexes over time. So he invests the bulk of his assets in index funds. And Malkiel, whose latest book (with three coauthors) is From Wall Street to the Great Wall: How Investors Can Profit From China's Booming Economy, keeps the majority of those assets in foreign stocks. He thinks foreign markets offer better growth opportunities than the U.S. does.

Although for the most part Malkiel recommends passively managed open-end and exchange-traded funds, he also holds stakes in some actively managed funds. (His sample portfolio represents his actual investments.) For instance, he owns Vanguard Capital Opportunity because of his "enormous" respect for the managers at Primecap Management Co., which runs the fund for Vanguard. Malkiel, a former director of the Vanguard Group, says he thinks he can make a small bet on Primecap's expertise because the core of his portfolio is in index funds.

More interesting are his picks of Templeton Dragon and Matthews India, both actively managed. "I believe that of all the places in the world, China and India are the two that will have the highest growth rates," says Malkiel. Templeton Dragon, a closed-end fund that buys stocks of companies based in China and nearby places, is managed by longtime emerging-markets maven Mark Mobius. Although Malkiel isn't sure that Mobius can beat the relevant index, he nonetheless considers him an excellent manager. “If I can buy Mark Mobius at 85 cents on the dollar, I'm happy to do it.” At its February 6 closing price of $17, Templeton Dragon sold for 6% less than the value of its underlying assets.

Larry Swedroe doesn't mince words. Believing in the effectiveness of active management is "absurd" and "the triumph of hope over experience and wisdom," says Swedroe, director of research for St. Louis–based Buckingham Asset Management and author of several useful books, including The Successful Investor Today and The Only Guide to a Winning Investment Strategy You'll Ever Need. Some managers will beat the indexes occasionally, says Swedroe, but when they do, it's "purely out of luck."

Given the interest in fixed-income investing (and the fear and loathing surrounding the stock market these days), we also sought a stock-free portfolio. William Larkin, fixed-income portfolio manager at Cabot Money Management, in Salem, Mass., says his portfolio gives investors exposure to all parts of the fixed-income market at the lowest possible cost; the average annual expense ratio of his picks is 0.33% (for our own take on investing sans stocks, see Stock-Free Portfolio). The portfolio, which includes a healthy dose of inflation protection, yielded 5.3% in early February. All but one of Larkin's picks (Fidelity Floating Rate High Income fund being the exception) are index-tracking, exchange-traded funds.

In the Kiplinger's portfolio, we use only Vanguard index funds because their costs are low and it's easier for investors to buy funds from a single family. Small-company stocks tend to outpace big-company stocks over time, so we overweight them a bit—but not so much as to add more volatility. Similarly, we include a couple of bond funds to reduce the portfolio's ups and downs. But we don't overdo the bonds because we want the bulk of the package to benefit from the long-term growth potential of stocks. And although property markets look dicey and real estate investment trusts have been battered, we add some REITs because they have delivered good long-term returns and can help tone down the portfolio's overall volatility.

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