Jason Stipp: I am Jason Stipp for Morningstar. With the markets bouncing around quite a bit in 2010, investors might feel compelled to take some actions with their portfolios, but Morningstar's Christine Benz, director of financial planning, says sometimes the best action is no action at all. She is here to tell us why. Christine, thanks for joining me.
Christine Benz: Jason, nice to be here.
Stipp: So the markets in 2010 have jumped around a bit. There has been some activity. A lot of concerns have cropped up in 2010. Investors might be looking at their portfolio and thinking they need to do something here, because the market seem to be doing something.
Stipp: Is that a good idea?
Benz: Well, not necessarily. In fact, Jason, I think back to a few of my favorite fund managers and one of their favorite sayings is, don't just do something; stand there. And I think for investors that can often be the right choice. So you want to go through the analysis of whether it makes sense to do something, but ultimately standing still may be your best bet.
Stipp: So one of the things that investors will do on their portfolios and may feel compelled to do at certain times is to rebalance, and certainly there are good reasons to rebalance. But how should I have known whether the rebalancing was right for me, given all this volatility?
Benz: Right. It's felt like we've been through a lot and you may think, well, I probably have big changes in my asset allocation. But really when you look at broad asset class performance, what you see is that maybe stock funds are modestly up or modestly down, bonds probably up a little bit.
But this year, even though it's felt very active, has not seen big swings in terms of asset class exposure in most portfolios, is my guess. And you typically want to see big swings before you are making changes or rebalancing because you will incur tax and transaction costs some of the time. So you want to make sure that it's worth your while.
Stipp: And you were mentioning to me, obviously, one of the things that you look at is to see if certain asset classes have gotten outside of your target range when you are looking to rebalance, and if you sort of rebalanced too often or too soon, you might actually be hindering some of your performance. So tell me a little bit about what triggers I should look at to see if now really is a good time to rebalance for me?
Benz: Right. I usually say you want to rebalance when you see your asset class exposure veering 5 or 10 percentage points from your targets. So if you want to be more hands-off, 10 percentage points is fine; if you want to be a little more hands-on, 5 percentage points.
But if you're making changes with swings smaller than that, again, you do risk racking up your total costs.
Stipp: So doing that rebalancing when you get 5% to 10%, it's actually kind of a way of having a little bit of active management in your passive portfolio or in your allocation because again you would be selling some of those higher-performing securities and putting some money back into the lower performing ones.
Benz: That's right. So it bakes in a little bit of a valuation bias into your portfolio. But the reason that you don't want to be too active in terms of rebalancing is that there are also these momentum effects in the market. So trends that we might see, might persist for a period of time, maybe several years. So by being too proactive, you shut off your portfolio's exposure and its opportunity to benefit from those momentum effects.
Stipp: Very interesting point. Another thing that investors might be thinking about – investors who are currently holding index funds, and we know a lot of our readers do hold those: ETFs have over the last several years made a big splash in this area, and their fees in some cases are much lower than index funds or mildly lower than index funds, depending on the provider.
Should I be thinking about being hands-on and moving out of my mutual index fund and moving into an ETF for those cost savings?
Benz: Well, it's a case-by-case basis, and certainly a lot of ETF providers have made the decision a little simpler by waiving some of the commissions. So you do want to do the analysis, though, and one of the key swing factors about whether this decision is right for you is your own tax position in the thing that you hold.
So if you have a gain in a traditional index fund, so selling it would trigger a taxable capital gain. Any money that you might save by opting for the index fund even though it has lower expenses may not offset the taxes you'll paid it to make that switch.
So it's case-by-case. Certainly if you have a capital loss in an index fund. It's a good opportunity to potentially swap into that lower-cost ETF instead.
Stipp: But certainly not as easy as just comparing the expense ratios of two funds and making a decision.
Benz: No. And the other point, too, is that, we are watching this tax efficiency question closely. So, ETF certainly have some levers to pull, and I won't get into the specifics, but that should make them more tax efficient than traditional index funds. When we look at the data, that's not necessarily the case.
And Gus Sauter had an interesting interview this week, where he feels that this issue has been pretty much overstated. It's really kind of a wash in his view from the tax efficiency standpoint.
Stipp: Last question for you, Christine. We've noticed when we looked at fund flows is that a lot of money has gone away from active-managed funds and into passive investments. And I think part of that might have been that investors saw that they were paying an active manager a certain fee, and the active manager didn't perform well in the downturn and maybe didn't perform as well in the upturn as an index or as the peers.
So people in actively managed funds might be thinking, I need to get out of this, and I should really move into a passive investment. When is a good time to make that decision, and when is it a good time to stay put?
Benz: Well, it's an important question. I tend to be sort of agnostic on the active versus passive debate. Our data certainly points to a very mixed picture, even though partisans on either side of the debate have very strong views.
But one thing I would say is, before firing an underperforming active manager, really get in there and do your homework about what's going on with the fund. And I usually say, you don't want to fire a manager based on performance alone, you want to see some fundamental factors that argue in favor of that fund being an ongoing underperformer.
So you're looking for strategic changes, manager changes, fund company upheaval, expense ratio increases. You want that fundamental factor in addition to the underperformance before you give a fund the heave-ho.
Stipp: Well, Christine thanks for your insights today on when it's best sometimes to just stay put.
Benz: Thanks Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.