Index for show, smartly diversify for dough

By DAVID MOON, Moon Capital Management, LLC
March 4, 2012

Despite what you’ve heard, the Transportation Safety Administration (TSA) doesn’t provide airport security. It provides the illusion of airport security. Walking barefoot through metal detectors makes some people feel as if they are actually doing something when it is merely a theatrical production.

This also describes the way some people invest. Action for the sake of show.

If you own five or more broad-based stock mutual funds, you have likely created a de facto index fund, incurring unneeded expenses in the process. Those five funds may own as many as 100 or more stocks each. If there is significant overlap among the stocks, owning multiple funds isn’t providing diversification. And if there isn’t any overlap, those five funds will own as many stocks as are in the S&P 500.

The TSA investment method: closet indexing.

There is nothing wrong or evil with index funds. An index fund is the best way to guarantee that your stock investments don’t deviate from the averages. If an investor isn’t going to give himself a chance to outperform the overall market, he should buy index funds. Most people ought to own them.

And most people do – but they don’t know it.

Adding to the silent travesty is that many people pay a second or third layer of fees for someone to advise them on creating their closet index fund.

The justification given for such portfolios is “diversification,” but actively owning mutual funds that represent ownership in the entire stock market is over-diversification. It gives someone the feeling of making an actual investment decision without any relative consequences. All of the consequences – both positive and negative – depend on the performance of the overall market.

The individual pretends to manage his capital, spending significant time and effort, but isn’t managing his money at all. It is the illusion of active investing.

If an investor doesn’t know what to do, this TSA model of investing suggests doing a little bit of everything. Being active and being productive are not the same things.

Too many investors – including investment professionals – use diversification as a theatrical proxy for knowledge. Many don’t even realize it. They’ve been fed an academic alphabet soup of Greek letters claiming that things like beta describe risk and can be calculated to two decimals places. Then they charge more than the fund managers make to tell people to buy a little bit of everything.

They aren’t necessarily evil; many simply don’t know any better.

Within the stock component of your investments, first decide if you are even going to try and outperform the market averages. If not, buy the Vanguard Total Stock Market fund and pay annual fees of 0.22 percent.

If you want a chance to beat the S&P 500, three funds is plenty; maybe two. Hire managers whose portfolios are varied but hold as few as 25 to 50 stocks. That’s plenty diversified. Make sure the portfolios don’t overlap. The managers should have understandable, replicable, logical investment philosophies; top long-term performance; and significant amounts of their own wealth in the funds they manage.

This won’t guarantee success, but it will give you a chance – something the TSA investment method doesn’t.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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