A great retirement portfolio owns precise measures of specific investment types, depending on your age and personal tolerance for the ups and downs of the market.
But what if the mutual funds you buy don’t hold the investments you think they do? Known as “style drift” in the finance world, the more accurate word for it is return-chasing.
It happens when a mutual fund manager gets punished for doing what he or she promised to do — own mostly one kind of investment. Morningstar data shows 70 mutual funds that advertise as fixed-income products currently hold more than 4% in equities. Nearly half of those bond funds had stock holdings of between 10% and 63.4%, reports Investment News.
So what, you might say? Well, if you are trying to stick to an investment plan and rebalance in a timely fashion, style drift is something you should worry about: Are you 60% stocks right now? Or is it 75%? How would you even know?
The goal of any serious, long-term retirement plan is to get the highest possible return at the lowest possible cost and with the least amount of volatility. A steady, reliable division of assets in a well-designed portfolio accomplishes this, as research has shown time and again.
The biggest risk is volatility, which can trigger a raft of very dangerous emotions — either way the dial moves. For instance, a sharp sell-off can prompt an investor to bail out of a perfectly good position, usually at or near the low, after which it typically recovers.
A strong upward shift creates a completely different problem. Significantly higher prices should set off alarm bells and lead to at least some cautious, programmatic selling.
Instead, what often happens is the individual investor can’t get enough of whatever is shooting higher. As more buyers pile on, things get hotter and hotter and valuations go higher and higher. Inevitably, a nasty crash follows.
As strange as it might seem, that’s exactly what some bond funds are doing. Rather than own the asset class they purport to own and doing the work required to survive a difficult patch (and earn their fees!), they take the easy way out. They cheat and buy whatever’s hot, hoping to add return and avoid losing clients.
I say “cheat,” yet mutual fund prospectuses typically are very clear about the leeway given to fund managers. Often, the language is along the lines of “at least 80% of fund holdings” is in the asset class that appears in the name of the fund — bonds, stocks, real estate, whatever.
The other 20%? You might assume it’s in cash, as the fund actively buys and sells securities and rotates its portfolio from time to time.
Maybe, but maybe not. “Return envy” is pretty hard to resist, and more than a few fund managers have been caught out when short-term bets suddenly go the wrong way. Rather than own developed-country foreign stocks as advertised, they’ve been dabbling in the wilder emerging markets. Instead of holding dividend-paying blue chips in a blue-chip fund, the manager has developed a fondness for technology small caps.
Meanwhile, your carefully considered retirement portfolio looks nothing like what the names of the funds imply. You think you’re running a solid plan, but the managers you’ve hired are all over the map.
The solution: Fire them all. Index funds are what they say they are, straight up. You’ll get a better, more predictable return out of a solid and simple rebalancing program, and you’ll get it at the lowest possible cost.