(PUB) Investing 2015

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other ETF providers don’t. But if reported annualized returns are off by 25 basis points over 10 years, you can readily figure that is going to add up over time. And if this is what’s going on at Vanguard, I would be really, really skeptical about others in the industry. How accurate are their numbers? Are investors actually flying blind? Plus, are ETFs really better than open-end funds? I went back and matched up Vanguard’s ETFs with its open-end siblings. Now, obviously the Investor shares of Vanguard’s open-end funds have higher expense ratios than the ETFs. And yet, 36% of Vanguard’s Investor share index funds outper- formed their like ETF shares. The ratio swings much further to the benefit of the open-end fund when you look at a comparison with Admiral shares, where the operating expenses are identical in WHEN STOCKS HIT NEW HIGHS, only one of two events can follow: Stocks can either go on to make a new high, or they can decline to some lower level. Given the number of highs hit last year, these two prospects have many inves- tors unsure of how to proceed today. But is there a better way to think about potential outcomes when investing at what might be a high-water mark? Depending on how heavily you’ve invested in the stock market, you may view new highs with excitement. But for many, a new high is met with trepi- dation. For those investors, there’s a sense that the market is overvalued and, like a hot-air balloon, will inevitably come back down to earth—sometimes faster than they’d like. I hear this most often from those who are either not cur- rently invested or aren’t invested heav- ily enough in stocks and are worried they’ll be getting in at the top, as well as investors who have been in the mar- ket for a while and worry that it may be time to lock in some gains. To put some numbers on it, take

Errors in ETF Return Reports

1-yr.

3-yr.

5-yr.

10-yr.

Largest outperformance reported by Vanguard Largest underperformance reported by Vanguard Note: Differences in annualized returns for periods ending 12/31/2014.

0.26% 0.33% 0.16% 0.32% -0.47% -0.68% -0.39% -0.21%

better over a short, 12-month period. As you know, I’m not a fan of ETFs per se, as I believe Vanguard’s best active managers will run circles around their index benchmarks. That said, because many FFSA members asked for an index-only model portfolio, I built the Growth Index Model Portfolio to attempt to mimic the Growth Model Portfolio and accommodate those requests. But if performance is really what ETFs are all about, then someone needs to remind investors they might be better off sticking with the tried and true, rather than the new. n that’s not in the cards. That’s a posi- tive for U.S. stocks, which compete for investors’ dollars with bonds. I think the bigger issue is whether profits keep growing, and at what rate. Profit margins have been healthy, but much of that has been a bit of earnings engineering and cost-cutting. What we need to see is more top-line, or revenue, growth. If that can be revved up, then the bottom line should follow. While earnings are a basic metric by which stock values are often mea- sured, it’s a tricky business, as there are seemingly endless ways to “value” a stock, or a market of stocks. There are multiple ways to measure earnings, and some investors prefer to look at corporate sales or cash flows or book values or even GDP—the list goes on. Vanguard’s research team has looked at myriad valuation metrics and conclud- ed that not a single one has even a 50% chance of predicting where the stock market will be in the not-too-distant future. And still, without getting hung up on any one valuation ratio, it’s fair to

most if not all cases. Fully 74%, or 23 of the 31 Admiral share mutual funds, outperformed their ETF clones. That outperformance ranged from as much as 64 basis points (0.64%) to as little as 1 basis point (0.01%). When the fund shares lagged the ETF shares, it was by between 3 and 13 basis points. In other words, not only were the odds in favor of an Admiral share outperforming an ETF share by about two-to-one, but when the ETFs did win, it wasn’t by much, whereas the Admiral shares could, at times, gener- ate returns a good half of one percent a look at 500 Index, which gained 13.5% in 2014, hitting 57 new highs along the way. At the end of January, the index fund was only 4.5% below its December 29 high (on a total return basis). Yet, investors seem scared. Investors are struggling with two con- cerns here. One has to do with the ques- tion of whether stock market values have gotten too high and are poised to revert to the mean—that the pendulum will swing the other way. The other deals with how one should approach investing when markets are at or near all-time highs. Let me try to unpack these. You’ve heard me say it before, but it all comes down to earnings and interest rates. We can all flap our gums about jobs and housing starts and consumer confidence and the like. But when it all gets to be too much, simplify. Interest rates are low, and they’ll stay that way for a long time. Even when the Fed starts lifting short-term rates, there’s no reason to believe that long-term rates will go sky-high unless we get some serious inflation. So far

NEW HIGHS Investing at a (Potential) Top

6 • Fund Family Shareholder Association

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