05/13/2008 10:48 pm ET | Updated May 25, 2011

Smart Advice for the HuffPost Investor: Is Vanguard A Trap For The Unwary?

Question: What do you think of Vanguard's new Managed Payout Funds?

Answer: As readers of this column are aware, I am a big fan of Vanguard's low cost index funds. I also believe that John Bogle, the founder of Vanguard, is one of the most important financial gurus of all time. His latest book, The Little Book of Common Sense Investing (Wiley 2007), is a must read for all investors.

Unfortunately, Vanguard has made the commercially expedient decision to work both sides of the street. It sells both index funds and hyperactively managed funds. Its fund offerings are divided almost equally between these two categories.

Its new "Managed Payout Funds" reflect this schizoid personality. They are a "fund of funds" consisting of both index funds and hyperactively managed funds, including (potentially) hedge funds.

The purpose of these funds is to provide older investors with a steady and predictable income stream.

I don't like them. Here's why:

I don't believe Vanguard's active managers will have any better track record than its peers.

These funds are hard to evaluate because of their complexity and the uncertainty of what they will contain. They permit investments in non-directional funds and commodity related investments, both of which have very spotty track records. In January and February, 2008, non-directional funds experienced losses of 17.5% on average.

It will be very difficult to measure the risk of these funds.

The peril of relying on hyperactive management is nicely illustrated by Vanguard's Strategic Equity Fund (VSEQX). This fund seeks long term capital appreciation. The fund manager "...selects securities that it believes offer a good balance between reasonable valuations and attractive growth prospects relative to their peers, by using proprietary software programs that allow comparisons among thousands of securities at a time."

Sounds pretty good. A world class company using sophisticated "proprietary software."

The fund lost 9.97% in the first quarter of this year. In the past year, it ranked 354 out of 507 funds in its category.

Investors would be better served by determining their asset allocation and investing in a globally diversified portfolio of low cost stock and bond index funds available from Vanguard, Fidelity, T. Rowe Price and others.

Question: How much do I need to save for retirement?

Answer: This is a far more complicated question than it appears.

The short answer is 15% of your income. Under the right circumstances, this would replace 75% of your pre-retirement income.

Here's the problem. This number assumes:

o 40 years of savings;

o No borrowing from your retirement plan or savings;

o A market rate of return on a medium risk (60% stocks; 40% bonds) portfolio, producing the highest rate of return for the risk taken;

o Low cost index fund fees.

The reason we are headed into a crises of mythic proportions is that very few investors can satisfy all of these requirements. For example, we know that the average investor achieves only one-third of market returns on her investments.

Therefore, as a practical matter, the 15% number should be significantly higher.

Question: Is it mathematically possible for investors as a group in hyperactively managed funds to "beat the markets"?

Answer: Not according to Nobel Prize Laureate William F. Sharpe. In his seminal work, The Arithmetic of Active Management, Sharpe wrote: "... after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar."

This makes perfect sense. If you take the pre-cost returns earned by all active investors as a group, what do you get? Total market returns.

Now deduct the costs of active management. You are left with a number that is less than total market returns.

Passive management (index funds) have lower costs than active management. Therefore, the net returns to passive investors must exceed the net returns to hyperactive investors, as a group.

Here is Sharpe's conclusion: "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

It should be yours as well.

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