US Videos

Create a Portfolio You Don't Have to Babysit

Christine Benz
Michael Rawson, CFA

Note to viewers: Filmed in late April 2012, this Morningstar presentation was part of Money Smart Week, a series of free classes and activities organized by the Federal Reserve Bank of Chicago and designed to help consumers better manage their personal finances. Morningstar is a Money Smart Week partner.

Moderator: Welcome to Morningstar. Thank you for attending today's Money Smart Week event. Today's presentation is one of hundreds around the country, free education events that are going on in connection with Money Smart Week.

We have financial institutions, government agencies, nonprofits, libraries, and schools that are all joining forces with Money Smart Week to raise awareness about financial education and provide resources to the public.

Morningstar investing experts Christine Benz and Mike Rawson will lead today's session about how to create a portfolio that you don't have to babysit. They'll share some advice on constructing a hands-free portfolio and also some sample portfolios for investors at different life stages.

Christine is Morningstar's director of personal finance and author of the book 30-Minute Money Solutions. Mike is an ETF analyst with Morningstar and holds the Charted Financial Analyst designation.

Thank you for coming today, and enjoy the presentation.

Christine Benz: Thank you all for coming in today on this rainy April afternoon. I really love these events, because I do get a chance to talk to some of our readers and subscribers and investors just about what's on their minds.

So, Mike and I will leave room for questions at the end of the presentation. We are recording or webcasting this event, so if you could hold your questions until the end that would be really helpful.

Again I thank you all for coming.

If you read my stuff on Morningstar, you know that this concept of helping investors find ways to reach their financial goals in the most simple and straightforward possible ways is a big focus for me here at Morningstar, and that was really the impetus for this presentation. Investors frequently tell me that they don't have time to create and oversee portfolios on an ongoing basis. They are willing to invest the time at the outset, but in terms of ongoing maintenance, picking individual stocks, or overseeing individual fund managers, they just don't have time to do that babysitting. So that's what we're going to focus on tonight.

We're also, I hope, going to serve up some ideas for even those of you who are active, hands-on investors, who do have the time and the inclination to babysit your portfolios. You may recognize that there might be a point in your life when you are not going to be able to keep doing that, and maybe your spouse has no inclination to manage the investments. So, at some point, you may want to create a portfolio that is more or less hands-free. So, we will share some ideas for doing that.

I'm happy to say that my colleague Mike Rawson is here. He is an exchange-traded fund specialist, and I think in a lot of ways, ETFs and index funds are really ideal building blocks for hands-free sorts of portfolios. So, I'm glad Mike is here to share his expertise, and he will also share some specific ideas for what "no babysitter required" portfolios might look like.

So, I'm just going to start by giving you a quick roadmap of what we'll cover in this presentation. I'm going to start by sharing what I think are essential ingredients for hands-free portfolios. I'll also talk about how you can break down the process of creating a hands-free portfolio into a few simple steps, and I'll share what those steps are.

And then, as I said, Mike will share some sample portfolios for investors at various life stages--both for investors who are currently retired as well as those for whom retirement is further off into the future.

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All securities mentioned in this video

Vanguard Balanced Index VBINX
SPDR Gold Shares GLD
PowerShares QQQ QQQ
Vanguard Total Stock Market ETF VTI
iShares Barclays Aggregate Bond AGG
SPDR Barclays Capital International Treasury Bond BWX
iShares Gold Trust IAU
iShares Barclays TIPS Bond TIP
Vanguard Total International Stock Index ETF VXUS
Procter & Gamble PG
PIMCO Total Return PTTRX
Harbor Bond HABDX
Metropolitan West Total Return Bond MWTRX
Dodge & Cox Income DODIX
Templeton Global Bond TPINX

Read Full Transcript

So, in terms of successful or essential ingredients for successful hands-free portfolios, what would I put on my shortlist?

Well, the starting point would be creating that blueprint for the overall portfolio. What does the stock/bond/cash mix look like, and how does that gradually get more conservative as you get closer to your goal? So that's the starting point.

In addition, you'd also want to think about looking at broadly diversified investment types. As I said, ETFs, index funds are great building blocks from that standpoint. They do not require a lot in terms of ongoing oversight.

Another issue that I feel passionately about is taking control of whatever aspects of portfolio management that you possibly can, and one that falls squarely within our sphere of control as investors is managing the overall cost of that portfolio--managing the drag of transaction costs, managing the drag of expense ratios on an ongoing basis, also managing tax costs. So a portfolio that is mindful of reducing all of those costs is going to be effective over the long haul.

Finally, the best portfolios do help investors resist the urge to buy and sell at inopportune times. So I think that that's another key ingredient--a portfolio that is set up maybe to avoid some of the more specialized investment types and focus on those that are more broadly diversified and help investors resist their own worst impulses.

So, let's get into what I see as the most important step of portfolio construction. Apart from how much you are able to save and what your time horizon is, the most impactful decision that you'll make as an investor is how you apportion that portfolio among stocks, bonds, and cash.

And really there are two key ways to go about this. There is the strategic, long-term, buy-hold-and-rebalance approach, and then there is the more tactical approach. And these tactical strategies have really gained traction, particularly in the wake of the bear market. A lot of investors and financial advisors have said, "You know, if we can be a little more active and avoid those big downturns, maybe we can generate a portfolio result that's better than one that is sort of 'buy, hold and rebalance,' a kind of a 'set it and forget it' approach."

So we have started to see a lot more tactical strategies out there. I've talked to investors who tell me that they are being more tactical in terms of how they manage their portfolios. But I still strongly favor the long-term strategic approach, mainly because the experience of active fund managers does not bode well for the ability for us as individual investors or other professional money managers to successfully carry off those tactical strategies.

So my next slide ... illustrates the potential pitfalls of tactical strategies. One of my colleagues here at Morningstar, Jeff Ptak, has been attempting to quantify how tactical fund managers have done over time. So he has been keeping tabs on the universe of tactical fund managers, dating back to 1992--so a 20-year time horizon--looking at all those funds that have actively jockeyed among asset classes. And he's looked at their performance versus ... a very plain-vanilla benchmark, which is Vanguard Balanced Index. Some of you may know it; it's a very vanilla portfolio: 60% equity, 40% bond, regularly rebalanced back to those targets. It's really hard to think of a more vanilla product out there on the market today. So he's used that as the benchmark for these tactical funds, and what you see here on this pie chart is not an encouraging picture. So just 4% of this universe of tactical fund managers has managed to be better overall in terms of a risk-reward profile than Vanguard Balanced Index.

You can see that fully a fourth of these funds have gone belly-up, or obsolete. They've either been merged, or liquidated, or something, which usually doesn't happen if you've had good performance. So fully a fourth of these funds have gone away over time, and 13% of ... the tactical universe had neither better upside nor better downside protection than the simple index.

Where the tactical funds have distinguished themselves, in some respect, is in terms of providing better downside protection. So they've done a good job of getting out when the markets were sliding, which as we all know, is really the easy part of it. So if you're in October 2008, for example, during the financial crisis, it was easy to feel that it was probably time to pare back on stocks. So it's not surprising to see that that is where these active tactical managers have distinguished themselves. But in terms of overall performance relative to a very vanilla benchmark, they really haven't made a great case for themselves. And I think one of the reasons why goes hand-in-hand with the fact that at least some of them have had better downside protection, and that's illustrated on my next slide.

You can see, and many of you have seen, slides like this before. The risk of missing the market's good days, very good days, can be very impactful, because we all know when the market rebounds, in an early-2009 type of environment for example, it does so in a hurry; it does so in a matter of days, where you see 400 [point] swings to the upside. That's where investors can really hurt themselves with more tactical strategies, because they are not there on those good days. They've maybe done all right in terms of protecting on the downside, but they haven't managed to get back in and get more fully invested when the market begins to surge.

So you can see that for someone who even missed the 10 best market days, their return would be a little more than half of the person who just had a fully invested portfolio during that whole 20-year period from 1991 through 2010. The poor soul who missed the 15 best days of market performance actually had a loss over that 20-year period.

So, the takeaway here is that tactical strategies, though they might seem very intuitively appealing, are simply very difficult to pull off with any degree of consistency, which is the reason that I favor the strategic approach for my own portfolio and for the portfolios that I talk about in my work on Morningstar.com.

So, what is the starting point for that asset allocation? Well, there are certainly lots of different tools out there on the web that you can use for getting yourself in the right ballpark in terms of your asset allocation. What I have provided here are some asset allocation frameworks based on some indexes provided by Ibbotson Associates. Ibbotson is part of Morningstar, and arguably the leader in the field of asset allocation, and these are strategic asset allocation mixes geared toward investors with varying time horizons.

So you can see that they gradually become more conservative as retirement draws near, but even the 2010 portfolio here, geared toward investors who are already retired, does have a healthy component of stocks. So, it's not fully half stocks, but it is a sizable share in stocks, simply because today's retirees may easily be retired 25 or 30 years, and they need that growth engine that stocks can provide.

And you can see that all of these portfolios--and I will just switch out to the longer-dated portfolios--all of these portfolios portrayed here have a small stake in commodities, and the idea there is that inflation protection is important for all of our portfolios, and that becomes particularly important as we are getting close to retirement or in retirement, and we're no longer able to count on that cost of living increase that our paychecks might give us. So, it's important to have inflation protection all the way through your life, but especially important in retirement when your income isn't necessarily delivering that inflation protection for you.

So, I should've mentioned at the outset, Mike and I are happy to provide these slides for you. I think we're going to provide a link where people can download them, so you probably don't need to take notes unless you really want to. If you want to refer back to the slides later, we're happy to send them your way.

So, those are just very rough benchmarks in terms of setting asset allocations, but it's really quite a personal decision in terms of what your portfolio's stock/bond/cash mix looks like, and here are a couple of swing factors I have provided on this slide that I think are important to think about to customize that asset allocation based on what you have going on in your own life.

One concept that Ibbotson talks about and they pioneered, and I think it can be very powerful when trying to customize your asset allocation, is thinking about your own human capital. One way Ibbotson often expresses this is thinking in terms of career path: The person who is a tenured college professor has very bond-like human capital. He or she could rely on this steady stream of income throughout his or her life, probably a pension, too, and so that person has very bond-like human capital, and could keep relatively more in his or her equity holdings, because they can rely on that stable stream of income throughout their lifetime.

The opposite extreme would be maybe a commissioned broker--a person whose income will be very dependent on market performance, will be very dependent on commissions. For that person, they probably would want to think about having more in bonds because their income could be prone to shortfalls or periodic interruptions. They have more equity-like human capital.

So I think it's a powerful concept. It can also translate to life stage, and one of the key things Ibbotson talks about is that folks who are just starting out in their careers and have maybe done a lot of work on the education front, they have very bond-like human capital at that point, because they have many years of income ahead of them, and so they can afford to have relatively more in stocks.

By contrast, as you get close to retirement, your human capital is most decidedly equity-like. It's prone to interruption perhaps, and you plan to hang it up altogether someday, and so you need bonds, you need stable sources of income to help supplant the income you had during your working years. So, I think that's one concept that can be helpful in terms of customizing your asset allocation.

Another thing that you'd certainly want to think about would be longevity. And the extent to which you have 95 year olds running around in your family, that would call for a higher-than-average equity weighting than someone else who does not have that great longevity on their side.

Think about other sources of income that you might be able to draw on during retirement. Certainly folks who have a pension, a steady pension, and one that they believe they can count on--those people would be able to have larger equity holdings than folks who do not have a pension in retirement, largely because the pensioner's income would be replaced in part by that pension, rather than their portfolio, so they could afford to have a more equity-heavy portfolio.

Another thing would be how much you feel that you've saved, and how close you are to hitting your financial goals. I don't think you want to go completely overboard in equities, but certainly if you're playing catch-up and feel that you haven't done a very good job saving to-date, you'd want to think about having relatively more in equities because you need their growth potential.

You also want to think somewhat about risk capacity. I didn't put this on the top of my list mainly because I think investors tend not to be great judges of their own risk capacity, but I think it definitely should be in the mix. And if you know that you're a person inclined to panic during periods of market volatility, that would possibly call for having a lower equity weighting than someone who is rather Spock-like during periods of market turbulence.

Finally--and certainly this is not an inclusive list of all the swing factors--but another key variable that you'd want to keep in mind when setting your own asset allocation would be the desire to leave a legacy for children or grandchildren. For people for whom that is a big priority, that would argue for having more equities in the portfolio than someone who is using a "last breath, last dollar" approach to managing their portfolios and isn't so concerned about leaving money to children and grandchildren.

So, these are just some of the key swing factors to keep in mind when setting your own asset allocation.

The next step, once you've created that true north for your portfolio and thought a little bit about how you will make your assets more conservative as you get closer to retirement, is thinking about what are the broadly diversified building blocks that I can use to populate this asset allocation mix.

One thing that often bugs me is that I feel like Wall Street really sends the message, sells the message, that this is hopelessly complicated stuff, and you need really complicated strategies to help achieve your goals. You need that merger-arbitrage fund, you need that managed-futures investment, you need that inverse fund as part of your portfolio, and I strongly believe that a simple vanilla stocks and bonds [combination] can be just as effective and certainly more cost effective than more complicated strategies.

So the beauty of more simple investments, as well, is that you would just have fewer investments to monitor on an ongoing basis. I do like for a "no baby sitter required" portfolio certainly broad market index funds, also exchange-traded funds can certainly be very powerful components, and Mike is going to talk a little bit more about them in the next part of the presentation. I think that they can be truly great ways to obtain very low-cost diversification, but I also like very plain vanilla balanced funds, as well as the whole universe of target-date funds that has come out over the past decade. Not all of them are good. A lot of advisors like to say they're "one size fits none," but I like them in that they help investors with two of the most difficult parts of the portfolio management process. First, getting in the right ballpark in terms of what is a right asset allocation, and second, making that asset allocation mix more conservative as you get closer to needing your money. I think target date funds can be very powerful from that perspective.

So at this point, I am going to turn it over to Mike, who is going to spend a little bit more time talking about index funds and ETFs, comparing the two, and also sharing some specific portfolios geared toward varying age dates.

Mike Rawson: Thank you, Christine.

Just to follow-up on that point that Christine was making about target-date funds: Even coming from the ETF side of the business, I feel that target-date funds can be great tools. Even if you are not using them, they are a good reference point. So you often want to look at your target-date fund when you get your statements in the mail, are you still invested according to your own target-date, or similar to how a target-date fund is invested. If not, you may want to ask your yourself, well, am I comfortable taking this much risk, or am I taking too little risk?

Before I get started talking about ETFs, I just want to survey the audience. How many among you, just by show of hands, how many among you are using ETFs actively in your portfolios? So I'd say that's about half. And I'm going to assume almost everyone here probably has mutual funds, so people here are probably comfortable with mutual funds.

I'm going to talk a little bit more about ETFs specifically, some of the advantages and disadvantages. Now ETFs are like a mutual fund. The F in ETF obviously stands for fund. It's regulated like a mutual fund, under the same securities laws. It has a manager. There is actually a board that oversees the ETF. And it's a structured package of assets just like a mutual fund.

However, there are a couple of differences. The E and the T stand for exchange-traded. It means that the ETF is going to trade on an exchange. Rather than going directly to your fund provider, whether it be Vanguard or Fidelity, you are going to go on the exchange and buy the ETF from the exchange. You don't go directly to the fund provider. And it's traded throughout the day. With your mutual fund, you put your order in the morning or the night before, and it doesn't get executed until the next day is closed, or actually after the close.

Not to say that's outdated technology, but ETFs couldn't have been done 100 years ago or 70 years ago when mutual funds first started taking off because we just didn't have the technology in place. Now, with ETFs, you can essentially trade your mutual fund throughout the day, at any point during the day when the market is open.

A genesis for exchange-traded funds was the crash of 1987. People saw the market declining, people wanted to get out of their funds, but you had to wait until the end of the day. By at that point, it was too late. Now, we found out during the "flash crash" that if you wanted to get out of your ETF, sometimes you can't get out either, but we'll talk more about that in a moment.

Now, this ability to trade an ETF during the day, it allows for stock-like trading strategies, such as using options, shorting, borrowing on margin, but this flexibility also entails a lot of complexity. The onus is now on you, the individual investor, to make that trade, to pull the trigger. Instead of relying on a mutual fund manager, you're now putting on that mutual fund manager hat and saying now is the right time to buy. So, it puts a little bit of added pressure and complexity onto the individual investor.

Let's dive into these advantages that I alluded to before. Let's take a look at some of these advantages that ETFs and index funds offer over traditional active mutual funds. First of all, there's a tax advantage. Both index funds and ETFs have a tax advantage over active funds in that they generate fewer trades, there's less turnover, so there are fewer capital gains and fewer capital gains distributions. So index funds and ETFs, even index mutual funds, are going to tend to be more tax efficient than active mutual funds.

ETFs take this tax efficiency a little bit further in that there is this in-kind creation and redemption process you may have heard about with ETFs. The ETF company itself doesn't have to do as much trading in the underlying stocks. The market kind of does that for them. So, when they create or redeem shares of the ETF, it's done in an in-kind fashion. There's no cash transaction, therefore no taxable event. So ETFs generally tend to be more tax efficient even than index mutual funds.

There is a cost advantage to ETFs. I'll show this in a few slides. ETFs tend to be lower cost than comparable mutual funds. They are able to pass on economies of scale.

And there can be a return advantage to ETFs, and to index funds in general. Now my first bullet point here, don't get confused by this. Obviously there is no guarantee when it comes to investing in the stock market. There is no guarantee at all. But when you're investing in an index fund, you're pretty much guaranteed to get the return of that index. Now that return may not be very good. Certainly, in 2008 the S&P 500 was down 37%, but at least you're guaranteed not to massively underperform. Some active managers did a lot worse than a negative 37% return in 2008. So, if you're not very active in your own personal investment philosophy, if you don't really know whether tech stocks or energy stocks are going to do well, you kind of take the average approach, and say, "I'm going to let the market decide my return for me; I'm going to take the average return," and that's what you're going to get with an index fund or an ETF.

So I talked about the cost advantage with ETFs. You can see that ETF expense ratios on average are about 55 basis points. Open-end index funds on average are about 81 basis points. Now, those are both much cheaper than actively managed mutual funds, which are about 1.23%.

Why are ETFs cheaper than open-end mutual funds and generally cheaper than index funds? It's that they have less overhead. As I mentioned before, an active mutual fund has to do the trading, so they have maintain a trading desk. They have to maintain a research staff. Whereas when you go with an index fund, and certainly when you go with an ETF, they're outsourcing a lot of that. They don't have to maintain that trading desk. They don't have to maintain that research staff. They are outsourcing that to the market or the index provider.

Now, again, some of those costs are shifted on to you, the individual investor. Again, you are now the one who has to trade. So you have to make that decision. You might incur a trading cost when you buy through your broker. So let's say you're with Charles Schwab or E-Trade; you have to pay that $10 commission every time you make the trade. So now that's borne by you. When you buy your mutual fund, you are not paying a commission for that. So some of the cost savings that you get with ETFs are actually costs being shifted, just to a different area. Maybe it doesn't show up in the expense ratio. Maybe it shows up on your brokerage statement in another way. But in general if you add in those costs, ETFs generally are still cheaper than mutual funds.

So a lot of people ask me, "What should I be in? ETFs or mutual funds." Well it really depends upon your own investment philosophy and how you like to invest. ETFs tend to appeal to two types of investors: those that prefer a passive index-based approach--so these type of investors who want to use an index-based approach can go with either index ETFs or index mutual funds. But ETFs also tend to appeal to those active traders who want to trade throughout the day and get targeted niche exposures, which you can get with ETFs which you may not have available to you through a mutual fund. And that's really not Morningstar's style to cater to that more active day trader type of mentality, but that freedom is available to you through ETFs.

Mutual funds tend to be better suited to investors who are looking for an active manager to make those buy and sell decisions for them, to make the decision whether to be in the market or out of the market. If you're in an ETF in 2008, your ETF is not going to raise cash for you. You are the one who has to make that decision. If you are in an active mutual fund and the mutual fund manager feels a little bit like the market is too risky, he may raise cash inside his mutual fund, whereas the ETF is not going to do that for you.

Mutual funds also appeal more to people who want to use some kind of a dollar cost averaging strategy, and the reason for that is that you don't pay a commission every time you buy the ... mutual fund, whereas you will when you transact in an ETF. That's why ETFs really haven't taken off so far in 401(k) or IRA plans, because of the commission that you are going to incur

Now a lot of people in the news media talk about ETFs that are dangerous, and Christine mentioned these leveraged and inverse funds. If you look at the 10 largest ETFs, those type of dangerous or more risky ETF products aren't on the list. So, the 10 largest ETFs, the ETFs that are being used most heavily, are not those ETFs that you hear about often in the media or on CNBC. These are the kind of ETFs that you could feel comfortable with, or you could recommend to your mother who maybe doesn't know much about investing. These are the plain-vanilla type of index ETFs. The most complex we get here is the iShares Barclays Tips Bond or maybe the PowerShares QQQ. But you see on here, the S&P 500 Gold. The SPDR Gold shares, which actually owns physical gold in a vault. So these are pretty plain-vanilla, easy-to-understand type of instruments. These are the kind of funds, if you looked at their factsheet or their prospectus, you'd probably be able to understand it without too much difficulty.

Now, there certainly are more exotic ETFs, and we're not going to really touch on them here, because as Christine mentioned, and I also agree with Christine: We believe in the power of a simple approach to investing, and there is really no need to go with those more complex products.

So, now I'm going to walk through a couple of really simple portfolios, no babysitter required. And I'm going to talk about how I would implement these kind of portfolios using ETFs. So, here is a hypothetical portfolio for someone who has retirement pretty far off in the distance--maybe they are younger and plan on retiring sometime around the year 2050. There is a handful of ETFs, just with this list of funds, I can create a completely balanced portfolio. So, I had the Vanguard Total Stock Market ETF VTI. That fund only costs 7 basis points. I don't have the expense ratios listed here. But the Vanguard Total Stock Market ETF invests in the entire U.S. stock market for just 7 basis points. That's the kind of low expense ratio that previously was only available to institutions, and now you and I can have access to that kind of pricing.

So you see, because retirement is pretty far off for this particular investor, he's got a lot invested in both stocks, domestically and internationally. A very small allocation to bonds through the iShares Barclays Aggregate Bond, and this SPDR Barclays International Treasury Bond, just 7% total in bonds. A little bit of an allocation to gold, but really no allocations to TIPS because really the best form of long-term inflation protection will probably be through stocks. And no cash reserve.

As we move forward in time: Let's say we have another portfolio here for someone who is closer to retirement--maybe retirement is about 15-20 years out--you notice the allocation to U.S. stocks is about the same, but they've reduced their allocation to foreign stocks, because if they're living in the U.S., they are probably going to be more impacted by what's going on in the U.S. But also notice that the allocation to bonds really increased. On the previous slide, we only had 7% total to bonds; now we've got 12% plus 3%, at least 15% in regular bonds, plus we've started to allocate some money to TIPS, or Treasury Inflation-Protected Securities.

Finally, here is a hypothetical portfolio for somebody who is already in retirement. Again the allocation to bonds went way up. So, now we've got about 37% in traditional bonds, 11% in TIPS, and our allocation to gold also went up. And if you recall, Christine mentioned that as you get closer to retirement, inflation protection becomes a bigger priority, because you have less time to make that up.

Stocks in the short term, they tend to underperform when inflation rises, but in the long term, stocks tend to keep up with inflation pretty well. Bonds tend to get hammered by inflation in the short term. So, by increasing our allocation to TIPS and gold, we're kind of protecting ourselves once we are already in retirement from the risk of inflation.

Now, one thing I didn't have on the previous two slides was any kind of allocation to cash, and that was because I was figuring, in your investment portfolio there wasn't any allocation to cash. But it's a good rule of thumb to maybe keep at least six months of expenses in a separate cash reserve, something that's separate from the risk that you take in the markets. But even in addition to that, I have added a little bit of cash in this portfolio. And these are all based on the Morningstar Lifetime Allocation Indexes, the only thing I have done is, I have applied an ETF to each of these categories. And there are other ETFs that you might want to choose, these are just some of our favorite ETFs, because they tend to be low cost, they tend to be widely held, but there are certainly other ETFs that would fit the bill.

And with that, I'm going to turn it back over to Christine.

Benz: Thanks, Mike, for that overview. I'm just going to spend a few moments here talking about the final steps to putting together a "no-babysitter required" portfolio. So assume you have gone through this process of giving a lot of thought to asset allocation, giving thought to seeking out those well-diversified building blocks--whether index funds or ETFs or maybe actively managed funds or some stocks, just putting a lot of thought into making sure that those holdings require very little in the way of ongoing oversight--there is still some more work to be done.

And one of the key things that I like to focus on, and something I write a lot about, is managing the overall portfolio for tax efficiency. Again, I was talking about the importance of focusing on what you can control as an investor, and I see tax costs--even though there is a lot of uncertainty out there in terms of what might happen with tax rates--I see tax costs as being one of those factors that, as investors, fall somewhat within our sphere of control. There are a lot of different layers to managing for tax efficiency, but I'll just take you through some of the ones that I think are essential when building your portfolio for maximum tax efficiency.

So, obviously, a key one would be making sure that you're taking the maximum possible advantage of any tax-sheltered wrappers that you have available to you, such as 401(k)s and IRAs; that's a first step, and certainly particularly important if you're in the accumulation phase. But I think it's also important to keep tabs on what is often called asset location, so which types of assets you put in which accounts. So, the general rule of thumb--and I think it's a good one--is that, if you have income-producing investments, specifically bonds, which are kicking off ordinary income, which in turn is taxed at your ordinary income tax rate, you want to house those in your tax-sheltered accounts for as long as you possibly can. By contrast, you'd want to hold more tax-friendly investments--so that might be index funds and ETFs, it might be individual stocks, it might be municipal bonds, if you need liquidity--in the taxable portion of your portfolio. Thinking about which types of assets you hold where can be very important in terms of reducing the tax drag on your portfolio from year-to-year.

Finally, one thing I didn't include on this slide, but I think it's also important to think about, is sequencing your withdrawals. If you are someone who is already retired, thinking about holding off on those investments that carry the most tax benefits--and that would generally be adding Roth-type vehicles--saving those for last in terms of which pools of assets you withdraw from. Generally taxable accounts would go first. Traditional IRA and 401(k) assets next, and Roth assets would go last. And certainly, if you're someone who is over 70 1/2 and required to take those minimum distributions from your traditional IRA and 401(k) accounts, you'd want to put those in the front of the queue also, because the tax costs of missing those distributions, considering that you'll owe income tax and a penalty if you miss those distributions, you'd want to put those first in the queue if you're required to take RMDs.

So, paying a lot of attention to tax efficiency as you set up this portfolio and as you think about your decumulation strategy from the portfolio, I think, is a very important set of considerations. These are just some rough guidelines for doing that.

Last, but not least, even though we've been talking about "no babysitter required" portfolios, I think it's important to still call once in a while, check in now and again. And I think it's important to schedule those regular checkups with the portfolio. So, just because you're not babysitting on a day-to-day basis doesn't mean that you can be completely hands-off. I do think to the extent that you are checking up on your portfolio, it's quite important to be very structured about it and to actually schedule those checkups.

I think for most people, a quarterly portfolio checkup is plenty, semiannual or maybe even annual is just fine for people who want to be quite hands off. But definitely less is more in my experience in terms of ongoing oversight. I think investors who do spend a lot of time monitoring maybe get in there and make more changes than they probably should, and in talking to investors, I've heard a lot of people admit that they do just that--that if they had just sat on their hands and not been so active in their portfolios, they might have had an even better result than they had by being more active.

So, scheduling those checkups [is important], and then also knowing what you are looking for when you do those checkups. I know that my eyes often go to what my bottom line is when I check up on my portfolio. I see what my balance is and how I've done in various investments, but to the extent that you can take your mind off your portfolio's performance or individual fund holdings' performance, I think that is going to contribute to a better investment result.

I like to structure portfolio checkups around what I think of as the fundamentals of the portfolio. So, certainly checking up on that asset allocation mix and thinking about making changes only when you see significant divergences in your asset-class exposure versus those targets that you've laid out. So, if you want to be a little more hands-on, I would rebalance maybe when I saw divergences of 5 percentage points versus my targets. If you wanted to be truly hands-off, you could think about tolerating asset class exposures that drift 10 percentage points from your targets.

But again, I think less is more in terms of rebalancing, mainly because rebalancing can have costs. There can be transaction costs; there can be tax costs. So, generally, you want to minimize the amount of rebalancing that you do, even though rebalancing is a good exercise overall.

As you can see, I favor the idea of rebalancing based on divergences versus targets rather than on a calendar-year basis. I know a lot of people talk about rebalancing every December or something like that. I think generally focusing on those asset class exposures is a better way to go about it.

So, in addition to checking up on that asset class exposures when you do that checkup, you also want to take a look at whether anything has fundamentally changed with your holding since you originally purchased them. So, certainly if you have actively managed funds, you want to think about manager changes as a possible red flag. Changes at the corporate level--so, something going on with your fund company being acquired by another fund company. Even if you have index funds, you still want to focus on those expense ratio changes. So I know that firms over time have changed the expense ratios that they've charged--raised them, lowered them--and so you want to keep an eye on that as well, just to make sure your thesis for that holding syncs up with what it was when you originally purchased it.

As a side note, I really like the idea of creating an investment policy statement that lays out your overall asset allocation parameters: when you'll make changes to your portfolio, when you'll check up on your portfolio, and what will be your triggers for selling--what are you looking for that would trigger a sell in a given holding.

And last but not least, I think it's important to periodically check up on whether you are hitting your financial goals, whether you're still on track to meet your targets. And there are certainly lots of tools out there on the web to help you get your arms around this question. Fidelity has some really good retirement-planning tools that I often recommend. I also like T. Rowe Price's retirement income calculator. But I would survey an array of opinions to see whether you are on track to hitting your goals and see whether some corrections in terms of what you're doing may be in order. So, it might be an asset allocation change or a decision to allocate more to equities. It might be a decision to save more than you are, or spend less. So, periodically checking up on how you are progressing toward the goals you've set out for yourself, I think, is an important part of the checkup process and can help get your mind off how some of the constituent holdings in your portfolio are performing, or maybe underperforming, at any given point in time.

So, at this point, Mike and I are happy to field any questions from all of you related to this presentation, or I'm certainly happy to field any questions related to personal finance generally. And Mike, as an ETF specialist, is also happy to address any questions geared toward his knowledge base.

Yes, a question here in the front.

Q&A

Audience Question: This is aimed to Mike. You mentioned two bond funds: You mentioned AGG and BWX. Whenever I look at bond funds, they pay whatever it is, depending upon whether it has exposure to--if it's government securities, it pays less.

But then I look at bonds, where the interest rates are, and I'd say, "My god, as soon as these interest rates start rising, these bond funds are doomed to go down." And we've been saying this for, I don't know, three or four years now. But one day, it has to happen. How are these particular bond funds or any bond funds that you like, going to try to mitigate this?

Rawson: Sure. So, the question--let me know if I'm getting this correct--you're asking about, just generally in bond funds, we have this risk that interest rates are very low. If interest rates should rise, bond funds are going to get hammered by the rising interest rates?

Audience Question: You said it a lot better than I did.

Rawson: You're absolutely correct, if interest rates were to rise, or if we get a spike in inflation, either one happening, bond funds are going to get hammered. But so do individual bonds. Some people think that if I hold my bond to maturity, I'm going to get the interest rate back. But you still have this opportunity cost that you could have had a better return if you invested at these new higher rates. Retirees would love to have 6% returns guaranteed on their portfolios. Yes, it's a risk you're taking. However, what is Ben Bernanke trying to do? He is trying to stimulate the economy. So, he's trying to get you out of those safe haven assets, get you out of gold, get you out of bond funds, and into stocks. And the dividend yield on the S&P 500 is about the same as the interest rate on the 10-year bond. So, he's trying to make the argument that you should go into risk your assets, because that helps spur investment, and it helps create jobs, and it helps the economy.

Now, to the question about "well, interest rates have to go up, don't they?" Yes. They can't go down much more, but I think they could stay at current levels. You yourself said that they've been at this level for about 2-3 years. People were saying we were in a bond bubble three years ago, and interest rates have stayed low. The Japanese experience shows that interest rates could stay low over an extended period of time.

Ben Bernanke is a student of the Great Depression, and during the Great Depression, one of the major errors that the Federal Reserve at that time made was to start tightening too quickly. They started tightening monetary and fiscal policy too quickly. Ben Bernanke is not going to make that mistake. He would rather err on the side of having inflation and a stimulated, overheated economy ...

Audience Question: Where did they do wrong…?

Rawson: They tightened monetary policy and fiscal policy too soon. The economy started to recover, and they raised interest rates too soon, essentially. So, he doesn't want to raise interest rates too soon. He's come out and said--and this is the first time the Federal Reserve has ever said anything like this--that we're going to keep interest rates essentially at zero--the short term rate at zero--until 2014. They've never said that before.

He's trying to signal, "go into stocks." Now I'm not recommending that you go into stocks because that's an individual decision. But I don't think you necessarily need to worry about rates skyrocketing tomorrow, because I don't think the U.S. economy is going to recover that quickly. If rates go up, it's likely because the economy recovers, and I don't see that happening. Everyone is entitled to their own opinion. I think, Christine might think that rates are as low as they're going to get and you have a lot of risk being in bonds now, which there is some risk there, but I think rates could stay low for the next few years.

Audience Question: How do you mitigate that risk that you accepted is there?

Rawson: The question is, how do you mitigate the risk that interest rates are going to go up. I think, one way to mitigate that risk is to go into dividend-paying stocks. Morningstar, if you read some of the articles at Morningstar.com, a lot of our strategists are talking about high-quality, large-cap stocks. Bill Gross at our conference two years ago talked about stocks like Procter & Gamble. These high-quality companies that are going to be able to provide a dividend. If interest rates were to go up, stocks should be a little bit less sensitive to that, so I think that's one way you mitigate the risk.

Audience Question: When the day comes and eventually interest rates go up, what are the pros and cons of selling all your bond funds at that time versus keeping your bond funds at that time?

Benz: I can tackle that, but first I'd like to piggyback on a couple of things, Mike said in the preceding question.

I like dividend-paying stocks as much as the next person, but I would argue that even though they are attractive, you don't want to throw your whole asset allocation blueprint out of the window, because the key reason is that the volatility profile is just so very much higher on any type of equity, even on very high-quality equities, versus fixed income. So, I still think you need that baseline asset allocation blueprint.

And then a second thing on that front is, even though we've just set out some portfolios that consist entirely of index funds, I think that this is actually a pretty decent time to think about using an active fund for at least a component of the fixed-income portfolio, where perhaps the manager can be more opportunistic and can be defensive. But I think you have to understand that active managers will be wrong at various points in time. And I think, the classic case in point of that was in 2011, where you had a lot of active fund managers getting defensive way prematurely, and you were better off just hunkering down in a total bond market index fund--you would have had much better returns than you had with the typical actively managed fund during that period. So, that's just a quick comment on the general question about managing fixed-income portfolios.

In terms of the active fund managers that I personally like, obviously Bill Gross is one at PIMCO Total Return, but a no-load version of that that I like is Harbor Bond. MetWest Total Return Bond is another one, as well as Dodge & Cox Income.

So in terms of your specific question about, if you see rising rates starting to come your way, just getting out of fixed income altogether. I think, the problem is, that that shift could happen very, very quickly, and you might not have time to react to it and to get your portfolio into defensive position in time to protect it. So, I think that's a risk.

Audience Question: But I think you can. It's just simply a keystroke away that you sell those bond funds. So are you better off to get rid of them when you see the rates go up, push the keystroke? Or are you better off to keep them? What are the pros and cons?

Benz: Well, I think the risk is--and you're absolutely right, it's quick to accomplish--but think back to the first quarter of this year, for example. It was a period that actually one might say rates rose, in a way, and certainly the longer duration your portfolio was, the more you got crunched. But was it a head-fake or not? It's really hard to know whether that shift is for real, and whether it's going to be the start of this long-term secular trend or maybe just something short-term and short lived.

So, I think that that's the risk--is that the first signal that you get that rates are going to rise may not be something that's necessarily persistent. You would have shielded your portfolio maybe temporarily, but then maybe long duration bonds would go up again. So I think that if you get too active in terms of that interest rate jockeying, you can really shoot yourself in the foot.

The other metaphor I often think about is, there was a fund manager, and I can't remember who it was, but he gave a speech at one of our conferences, and he was talking about maneuvering within the bond market. And he said, so you think you're playing tennis with your neighbor, and you're hitting lobs across the court, you're playing, and then you take a closer look, and you realize you're playing one of the Williams sisters. Every time you're trying to jockey in terms of your interest rate positioning, you are playing against professional money managers; and the bond market is a very efficient beast, certainly in the realm of a very high-quality securities. So I think that you just need to be mindful of the fact that you may not have all the information that some of the pros have. So my bias would be to maintain a more or less static asset allocation mix, maybe adding some dividend-paying stocks and thinking about using an active manager to help do some of that work for me, rather than trying to do it on my own.

Audience Question: So continue to hold those bond funds, even though you could lose a substantial part of your life savings by doing that?

Rawson: In my mind, unless you're a very astute master of the markets, better than Bill Gross, in my mind the con is, by the time you recognize interest rates are going up and it's time to sell that bond fund, you've already experienced a price depreciation in the bond fund--that's already happened. At that point, stocks have already risen, because he's not going to raise rates, rates aren't going to go up unless the economy has improved and stocks have appreciated. So you're going to be buying stocks at a high level if you shift to stocks, and if you try to get out of the bond fund, you're going to have a price depreciation of your bond fund. If you try to sell your bond fund and go into a different bond fund, both of them will have adjusted automatically. There is no great way to time the market. In my opinion, you're better off doing that from an asset allocation standpoint from the get-go. It's not as sexy, but I don't think I could time the market as you're suggesting. So I don't think there is really a pro in that scenario of trying to wait until the market is clear that interest rates are going to rise ,and then shift into stocks. Stocks will be expensive at that point.

Audience Question: But just moving to cash and then moving back into bonds after we get the big uptick that's eventually going to come.

Rawson: That sounds great, but it's very hard to do in practice. I mean I would go back and look at what happened in 1994. The market got caught off guard in 1994 when interest rates went up and bond investors got hurt. So it's very hard to time that.

Benz: I think the other thing to keep in mind is, so even when rates go up and that depresses the value of the existing bonds in your portfolio, you get some of it back, as yields go up and your manager is able to buy those higher-interest-rate bonds. So it helps offset the principal declines.

One strategy that I have talked about in my writing is an interest rate sensitivity stress test. And I got this from Ken Volpert at Vanguard. What he suggested was looking at the duration of each of the funds in your portfolio--so if you have bond funds in your portfolio, you should be able to find a stated duration for them. Find that number, subtract the fund's SEC yield--you may not find that on Morningstar, but you can certainly find it on the fund company's website--subtract the SEC yield, and that's the amount you could expect to have that fund lose in a one-year period if interest rates went up one percentage point.

So you can run that stress test, just to see what kind of losses you might be in for. Certainly if you have very long duration bonds in your portfolio, that's not something I would be fiddling around with at this point. I really would try to prune true long-term exposure. So if you run your funds through that duration stress test and you see, "Ugh! I am in a position to lose 6%, 7%, 8% on some of these holdings in a year, and that's more than I care to lose," definitely pare back on them. But I think if you run through that exercise, you'll find that these losses are more in the neighborhood of 3% a year, if interest rates were to go up 1% in a year, which is a lot. So I think that that's something to run your holdings through, just to see what sort of interest rate sensitivity you have baked into your current portfolio.

Audience Question: Maybe this relates to a point that you made before, Mike, but for the conservative investor or investor in retirement, the idea of buying individual bonds where you know what you'll get your principal at maturity versus bond funds. How do you feel about having some individual bonds that have that security?

Rawson: I feel that you are just as safe with a bond fund, and the reason why is, first of all you get the diversification with a bond fund. Again, you have an opportunity cost. When interest rates go up, you've already incurred that loss, whether you are in individual bonds. ... Let's say you are getting 2% now on a bond, and interest rates go up. You say to yourself, "Well I am still going to get 2%." Yes, you still get that 2%, but if interest rates went up, you could have had 2.5% somewhere else. So there is always that opportunity cost. You have to look at it that way. Once rates have gone up, you've incurred the loss; you can't undo it.

I would just echo what Christine said. When I mentioned before about Ben Bernanke wanting you to take on more risk, that doesn't mean you should shift your whole portfolio asset allocation; again, that's an individual decision. I still prefer bond funds to individual bonds, unless you are talking strictly Treasury bonds, because bond funds have a lot of diversification. I wouldn't want to buy one single corporate bond in my portfolio and have that corporate get downgraded and suffer a credit impairment type of event. So I would stick with bond funds over individual bonds, if possible.

Benz: One other issue I think that falls beneath the radar a lot of times is some of the trading costs that investors can incur in terms of bid-ask spreads [being] very unattractive for smaller investors. I had this conversation with my colleague Eric Jacobson, who is a fixed-income specialist, and he is always talking about this, and I said, "Eric, how much are we talking? ... Say someone had $1 million that they wanted to invest in an individual bond, would they still get hurt by the bid-ask spread?" He said, "Yes, probably." You actually might need to have multi-million dollar investments in individual bonds, which I know a lot of investors don't have. So, I think you want to be mindful of that, especially in the realm of municipal bonds. I think that the bid-ask spreads can be quite unattractive and harmful and really undermine your take-home yield from that fund. So I think that that's another thing to keep on your radar as well.

Audience Question: Yes, you gave an example of three [portfolios] and you put the same funds in the three examples, maturing at different times: retirement in 2050, 2030, etc. Do you have a ballpark figure, if let's say you're retired, and you wanted to garner income to sustain capital, do you have a ballpark figure on what kind of return that type of portfolio that you put on has?

Benz: In terms of its current yield?

Audience Question: Yes, in terms of current yield, exactly.

Rawson: Well, I think you're thinking there of some of the tools that I think Christine was alluding to earlier about how much you can withdraw from your portfolio?

Audience Question: Yes, exactly. How much you're garnering in interest or dividend or whatnot in the fund, and you want to gain capital so that you can withdraw when you're retired.

Rawson: ... For that kind of question, I think you're better off looking at some of these tools that are available, or speaking to a financial advisor, about your withdrawal rate and what kind of withdrawal you could have and still expect to live comfortably through retirement and be safe that you have plenty of assets available to cover your expenses for the rest of your life.

That I don't think has much to do with the underlying investments. I mean you can look at yield, but you also want to look at capital gain, so you could look at the dividend yield or SEC yield or yield to maturity on your funds, but you also want to take into account capital gains that you're going to get on your stock funds. I think that kind of question is better geared toward a retirement planning tool that you put in a bunch of assumptions, put in numbers for yourself: How long do you expect to live? What is your net worth? What are your yearly expenses? And it will spin out a withdrawal rate. I don't have those kind of statistics off the top of my head, but it's a simple program that you could find online.

Audience Question: You mentioned the fact that the ETF is probably not the best investment for an IRA? Can you expand on that?

Rawson: The reason why ETFs have not become very popular in IRAs and 401(k)s--even though ETFs are extremely popular in the market, they are still only about a tenth the size of the mutual fund market. They are gaining assets more quickly, so they are growing faster, and they are the latest thing, but mutual funds are very entrenched in the 401(k) and IRA market, and one of the reasons is that, as an employee, and I invest in let's say Morningstar's 401(k) plan, they take a little bit out of my check and they spread it across a mutual fund. And even if I'm only going to buy let's say half of a share of the fund, ... the shares are divisible. ETFs, that's not really the case. It's not possible to divide an ETF share. Also there is that commission cost I mentioned.

And basically the real reason why ETFs haven't taken off in IRAs and 401(k) plans is that mutual funds are just entrenched in that industry. They've got the distribution network, the salesforce, they've got the connections, the relationships. They will come, but it will take time. So right now, I don't have any ETF options in my own 401(k). It's just not common. In time, it will become common, and I'm not saying you can't invest in an ETF and your IRA; it's just not as common.

Audience Question: There's been a large outflow of assets from mutual funds and active managers, and you read those books like Random Walk Down Wall Street and those types of things. What do you think is going to happen to that industry as a whole--active managers like American Funds, Franklin Templeton, all those things? They say it's a race to the bottom, because really the expenses are so low in those things, and I don't understand how anyone's really making any money on it?

Rawson: Well, I'll share with you a little bit of my own personal experience. Before I joined Morningstar I was working for a mutual fund company, and they were charging really high fees, and you know what, they lost assets. And I was laid off along with my colleagues, and now I'm working for Morningstar, and now I'm analyzing ETFs.

So, there is a race to the bottom, and I think what's going to happen is you're going to weed out the weaker mutual fund players. There's far too many mutual fund managers out there. We don't need as many charging high fees. You see these hedge funds charging exorbitant fees. They are going to get weeded out. But it's going to create opportunities for the really high-quality active manager. Active management is not going away. If anything it's going to be stronger than ever, because it's going to create opportunities. If everyone is managing their money passively, someone's got to be watching the store, someone's got to be doing the due diligence and the fundamental research that markets thrive on, and it will be those high-quality managers that Morningstar is trying to identify, that we do a lot of good work identifying those good high-quality managers.

So, I don't they are going anywhere. There are going to be more tools, and I think there are going to be more passive management, but it will co-exist with active management.

Benz: I would agree. I think that we have seen some of the stronger players in the field of active management continue to get money. So, Templeton, for example, the global bond fund, and some of Vanguard's actively managed funds have continued to pick up money at a pretty good clip.

So, I think investors are being more selective, and I think that is long, long overdue. So I think that you'll continue to see spoils go to the truly good active managers, I hope, that investors will continue to be more discerning. I'm happy to see, though, some of these passively managed products pick up assets at the expense of some of the active funds that were just not getting the job done.

Okay. Thank you all for being here tonight. We appreciate it.