Smart Advice for the HuffPost Investor: The Secret to Obtaining "Endowment" Returns.

05/21/2008 08:54 am 08:54:26 | Updated May 25, 2011

Question: I found the analysis of Vanguard's Managed Payout Funds to be a touch strange. Comparing these funds to the Strategic Equity Fund is a bit of a stretch. The philosophy of these investments are as dissimilar as the proverbial "Apples and Oranges." Also, we're always advised to invest for the long term. Dan neglects to point out that the Strategic Equity Fund has an average annualized gain over the past 5 years of 13.75%. Finally, Dan should acquaint himself with the concept of the university endowment, something that until now was unavailable to the individual investor. A check of the investment record of the Yale Endowment might have been a good idea before dismissing the Managed Payout Funds out of hand.

Answer: I realize this is not a question, but it does raise some serious issues that merit a response.

My use of Vanguard's Strategic Equity Fund was not intended to be a comparison to Vanguard's new Managed Payout Funds. I used that fund solely as an example of "the peril of relying on hyperactive management."

The promise of "endowment" returns is premised, in part, on the ability of the active managers to achieve superior returns. My point was that this is the same promise of the Vanguard Strategic Equity Fund. Sometimes active managers achieve their goals, but most of the time they don't. I have no way of knowing which category the active managers of the Managed Payout Funds will fall into, but the odds are seriously stacked against them.

I am familiar with the performance record of endowment funds. It is underwhelming. The average rate of return for endowment funds for the period from 1987-2002 was 9.17%. During this same period, the S&P 500 index had an annualized return of 10.87%. The returns of a globally diversified portfolio invested in a 60% (stocks)/40% (bonds) of passively managed funds run by Dimensional Fund Advisors (DFA), was 8.85%, with less risk.

In 2006, the average return of endowment funds was 10.7%. The return of the S&P 500 index was 15.73%. The return of a 60/40 portfolio of DFA's passively managed funds was 15.10% .

I fail to see the allure of "endowment" returns.

You are correct in noting the stellar returns of the Yale endowment fund. It has returned an annualized 17.2% over the ten-year period ending June 30, 2006. What you fail to mention is that this fund is in the top 1% of large institutional investors. There is no assurance (and little statistical likelihood) that Vanguard's Managed Payout Funds will achieve this level of performance.

David Swenson ran Yale's endowment fund. He is a vigorous proponent of index funds for individual investors noting that, when you take all relevant factors into consideration, it is a "virtual certainty" that investors in hyperactively managed funds will underperform the markets.

The stark reality is that endowment funds as a group would be better off if they fired all of their hyperactive managers and invested in a globally diversified portfolio of low cost index funds. Maybe that is why trillions of dollars of institutional money is invested in this manner.

Individual investors would be well advised to do the same and to avoid actively managed funds that promise "endowment like" returns.

Question: How, if at all, should an investment strategy vary between my tax-advantaged accounts (IRA or 401k or similar ), and my non-tax advantaged savings?

Answer: Your asset allocation should be the same for your taxable and non-taxable accounts. Unfortunately, the selection of funds for some of your non-taxable accounts can be challenging. Most 401(k) plans do not offer a broad choice of low cost index funds or target retirement funds. Many plans that do offer target retirement funds offer ones that are composed of hyperactively managed funds.

One often over-looked decision is which assets should be placed in non-taxable and taxable accounts. As a general rule, assets that generate returns taxed at ordinary income rates should be placed in non-taxable accounts. These would include bonds, real estate investment trusts and tax inefficient funds, in that order. Most hyperactively managed funds are tax inefficient.

In your taxable account, you want to have assets that you intend hold for a long time, like stocks and index funds.

A far more complex issue is how much of your assets should be in tax deferred accounts at all. While the financial media and many financial advisors extol the virtues of 401(k) plans, they can be a trap for the unwary and many employees would be better off if they refused to participate in these plans. I deal with this subject in detail in my new book, The Smartest 401(k) Book You'll Ever Read (Perigee Books), which will be published next month.

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