Listener Questions: Index Funds, Bonds, Robo Advisors

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.

So I'm in Minneapolis. I can't say quite why just yet. It's— I'm working for Barron's. It's for reporting for the future story, and we're going to answer a few Listener questions. And then I'm going to go across this highway here over to the Mall of America where I've never been. Look, I don't want to bum people out, but it's Valentine's Day and, you know, my wife dropped me off at the airport. I'm here by myself. I was going to go across to the mall and have some dinner, maybe find a steak, maybe have a beer. And then I was going to go see a movie. And I just heard an interview with Brendan Fraser, who's in this movie called The Whale, which is like I think it's— is it depressing? Seems like it might be depressing. And then I'm thinking after that steak and that beer watching that movie, I'm definitely crying during the movie. And I thought, what kind of a way is that to spend Valentine's Day? That's not where you want to be.

You got to watch the latest Puss in Boots.

I got good news though. The Whale is not playing. I mean, I'll see it eventually. The Whale is not playing. It's a pretty thin film slate out there right about now. They're actually playing Titanic and Sleepless in Seattle. I know what you're thinking, there have been sequels? No, there haven't been. They're playing the original ones. That's how thin the film slate is right now. So among the new movies, I saw Magic Mike's Last Dance, which I don't know, is that about men who dance? Entertainers. Yeah, like Chippendales kind of situation, right? You know what? I don't wanna come in late on the story. I didn't see the original ones. I bet you it's great, But you should just go to the amusement park.

I think there's a roller coaster in that mall.

Definitely not going on a roller coaster. This is why you need a video arcade. I mean, they don't have them anymore. I could really go for a couple of runs at Dragon's Lair right now.

I wish I knew what that was.

We'll talk about it later.

Is that arcade? All right.

It's—

it was the first one to ever go to 2 quarters. It was shocking at the time. Couldn't believe the outrageous demand for 50 cents for a video game. And you died after like 30 seconds. It was a money pit. Let's get to some questions. Who do we have? Who's up first?

Well, first we have Warren Duffy who's asking about differences between the Russell 2000 and S&P 600, which are two small-cap indexes that we talked about a few weeks back.

My name is Warren Duffy and I'm a big fan of your podcast. Listen to it every Saturday morning when I'm walking my dog Winnie. Anyway, the question I had was for this last podcast, you're talking about small cap differences between the Russell 2000 and the S&P 600. And I understand the rule or filter that the S&P 600 has around profitability. If you're in the index and you have a bad year and you're unprofitable, do they kick you out? And if so, is there any problem with that? I'm just thinking like they're selling low, they're pushing you out at probably when your stock price is low and then they'll bring you back in when you're profitable. And my hunch is your stock price is probably going to be high. And if this is supposed to be passive, is that really passive or is that kind of active?

Thank you, Warren. And shout out to Winnie. Your question is about indexes, the S&P 600. We had mentioned that difference between the performance on that and the Russell 2000, and we attributed that to the fact that S&P uses an earnings screen. They use a profitability screen. So you tend to get, I guess, you know, higher quality companies in that, in that index. I want to read you what S&P says about deletions. They say that they'll delete companies that substantially violate one or more of the eligibility criteria at the index committee's discretion. So I don't think it's automatic that they just take a company off because a company has a loss. And in fact, if I run a screen for S&P 600 companies and I look at last year's profits and see how many of those companies had negative profits in their most recent fiscal year, I get 107 companies. Out of 600. And there's no way they're turning over more than 100 companies a year in that index. They, you know, based on the past few announcements, it looks like maybe several a month tops. So the answer to your question is I don't think a company drops out just because they have negative profits. There is some discretion there. But your broader question is, is this index effectively actively managed if they're only taking companies that are profitable. And the answer is, yeah, kind of. I mean, every index, we call it passive investing, but even passive investing is a little bit active in the sense that you have to make a decision. If you say, I want to invest in the universe of stocks, well, how do you define the universe of stocks, right? If you say, I want the S&P 500, what you're saying is, I want US companies and I want the largest 500 by stock market value. And so one criticism of the S&P 500 is people say, well, it tends to overweight the companies that have gone up the most. And so it tends to be kind of growth tilted. But then the other side of that is, you know, it's true that it does that, but it's also true that returns over time tend to be driven by just a handful of tremendous winners. And you really want to have exposure to those winners. So we Even passive investing is making some kind of an active decision, if you want to call it that. I don't think it's necessarily a bad thing. By the way, S&P recently updated the market cap guidelines on their index funds. So you have the new range now for companies. If you're buying into the small cap index, a small cap now as of January 4th is defined as a company between $850 million and $3.7 billion. So you're saying you want to invest in companies in that range. And it adjusts those ranges every so often because the value of companies changes over time. And that's it. Anything else I should add here, Jackson?

No, but on the topic of indexes, Paul Pope has a question about bond indexes versus buying individual bonds themselves.

This just took a crazy turn. That's probably overselling it, right?

Yeah, just wait until you're on that roller coaster today.

All right, let's hear it.

Hi, Jack. This is Paul Pope. I live in New York, but I'm currently calling from Tennessee. I have a question about bond ETFs. I understand the general advice that it's better to buy bonds directly rather than investing in bond funds. I know that was certainly true over the last decade as people were looking ahead towards the possibility of rising interest rates. However, my understanding is that most of the damage now has been done. With those interest rates. I'm looking at, uh, bond mutual funds and bond ETFs. I'm wondering, is it possible that bond ETFs could actually outperform the mutual funds considering the fact that there's so much investor attention now on bonds? Perhaps the market value of those ETFs could actually be above the NAV. Do you think that that's a good idea, that bond ETFs could actually outperform both bond mutual funds and bonds themselves? Thank you.

Thank you, Paul. So there's a couple of things that you're asking about here. One of them is about ETFs and could the value of the bonds go above the net asset value of the ETF. That's a mechanism that's more common in closed-end funds where you close the portfolio, it trades like a stock, and it can trade at a discount or premium to the net asset value. ETFs can vary from the value of the underlying securities, but they tend to do so minimally because there's this ongoing mechanism where you can create new shares and swap them back and forth for the underlying assets. And it tends to hold that share price pretty close to the value of the assets in the fund. The other matter that you asked about or that you mentioned in passing was this idea of it being better to buy individual bonds than bond funds. And I think it depends what kind of investor you are. First of all, you have to have kind of a lot of money to put together a diversified portfolio of individual bonds. I don't know what the exact dollar figure is, but I'd say it might be in the millions if you wanted to put together a portfolio of Treasuries and corporate bonds and all different types of maturities and all different types of credit quality and so forth. If you just want to buy, you know, 1 or 2 very safe bonds, Treasury bonds, let's say, and you know exactly what you want, fine. And if you can keep fees very low, fine. But for most people, they'll get more diversification and lower fees from a fund. And I get the idea that with an individual bond, you can make the decision to hold it until maturity and get your money back. So if interest rates rise, the trading value of that bond might fall for people who are going to sell it before maturity., but you can ignore that dip in the trading value and you can hold it to maturity and get your money back, assuming it's a very safe bond. That's true. But what you don't get is the ability to reinvest money between now and the maturity date at these higher interest rates. It's a rise in interest rates that's going to push the value of that bond down. And if that happens in a mutual fund, that fund manager has bonds that are continually coming due and cash that needs to be reinvested, and he or she can take that money and put it to work at those higher higher interest rates. So those are kind of offsetting factors. Even if we expect rates to rise, I'm not sure that the investor who's buying a diversified bond mutual fund with low fees is getting a worse deal than the investor who's putting money into individual bonds. I think either type of investor is fine as long as they're keeping fees low and getting the right diversification.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks. What's driving the markets this week? What's on investors' minds as they look ahead? Find out on The Markets Podcast from Goldman Sachs. A breakdown of market moves and macro signals in 10 minutes or less. The Markets Podcast from Goldman Sachs.

Listen now. Jackson, how am I doing so far? Is this— I mean, is the enthusiasm coming through? Can you hear?— from the tone of my voice that I'm in a hotel room with my phone and a little plug-in microphone propped up on a pillow, staring—

You sound like you're on SportsCenter.

Oh, I do.

I do sound— You're wearing like a beige blazer and chunky tie.

Yeah, that's what I meant to say. Yeah. What's in the minibar over here? Should I check the minibar for $12 Milk Duds, or do you want to go on to our third and final question?

Say first Milk Duds, then question.

I'll investigate while I'm listening. Let's go ahead and play it. Who do we have?

We have Chuck Warner from Pasadena.

Hey, Jack and Jackson, it's Chuck Warner from Pasadena, California. I love the podcast. I think a good topic would be investment portfolio management alternatives, including using a paid investment advisor, using a robo-advisor. Self-managing a portfolio. I'm currently self-managing my portfolio. I'm talking to somebody from my brokerage firm who would like to manage it for me. I'm reluctant to switch. My wife is favorable, and I need some help.

Thanks, guys. Thank you, Chuck. I agree, that is a good topic. It's a tough one to answer because it gets into matters of, you know, personal taste. It's not just math. It's like saying, which is better, a $35,000 family car or a $60,000 luxury car? Well, you know, different people like different things and have different means. But let's just define some of the things we're talking about and give some guidelines in terms of costs. First of all, managing your own portfolio, that's pretty clear. It costs you next to nothing. Stock commission, you know, commissions to buy things like ETFs are incredibly low. A robo-advisor. So that's a piece of software offered by a financial firm that tells you over time what your asset allocation should be, and it manages your money for you, and it changes as you grow older, you know, puts your money in different things. Ultimately, those decisions are made by financial advisors at the firm who program the software or inform the software about how to make these decisions. It's kind of a way to get investment advice automated for cheap. Barron's does a yearly ranking of robo-advisors. I'm reading from a story last August that says robo fees vary, but clients are typically charged about a quarter of a percent on their invested assets. Traditional advisor fees are closer to 1% of assets. Okay, I think that's fair. You know, for some, you can buy a cheap index fund and you can pay a 10th of a point on fees and you can do it yourself and figure out which ones you should buy. And by the way, it's not super complicated. If you're listening to this podcast, if you're somebody who, you know, reads Barron's, surely you already have the wherewithal to do it. Anybody else can bring themselves up to speed pretty quickly if they're motivated. You can read some books and find different ways to inform yourself. But I think for someone out there who says, look, I don't know how to do this or I don't have the confidence,, but I don't, I also, maybe I don't have a lot of money to start or I don't want to get killed on fees. I think robo-advisor is a, is a, you know, fair way to go. Quarter of a point. I can live with that. So I'm looking at this ranking from the Saga story in Barron's and some of the names that are mentioned near the top are SoFi and Wealthfront and Fidelity and Sigfig. Those are some examples of, um, robo-advisor products. Now, The human advisor, the non-robo advisor. Barron's also publishes reviews of advisors, and they can get paid a number of different ways. Some of them get commissions on the products they sell. I don't love that model. Some of them get fees on managing portfolios, and I'm going to read from a story here from the Barron's advisor folks last year, last May. It says one common model is a fee that's equal to a percentage of the total assets the advisor is managing for you. The fee is usually 0.2% to 2%, with the percentage decreasing on assets above certain thresholds. For example, say a wealthy client has $12 million under an advisor's care. There may be a 1.5% charge on the first $3 million in assets, 1% on the next $3 million, and 0.35% on the last $6 million. Now, one way to look at that is you say, hey, I'm rich enough to really get a discount on those fees because they're dropping down to, you know, just over a third of a percent on that last $6 million. Another way to look at that is you're paying over $90,000 a year for an advisor, which that's a lot of money, right? If you're looking for a job in retirement, you're thinking about work in retirement, well, here's a job you can make $90,000 $100,000 or save that much by not paying that much in fees for a financial advisor by learning how to do it yourself. But it's not for everyone. Some people like to have, like, the added confidence that comes with a professional. And there are, of course, many advisors out there who are well worth their fees. So that's the difference in the cost. Which one is best for you? I know which one's best for me. I like to keep it cheapy, cheapy, cheap, low-fee index funds and do it myself. But not everyone shares my tastes and not everyone has the same interests. That gives you a sense of how much you'll pay for the different routes you can go. Okay, I think that takes care of us here. I'm gonna head over to the Mall of America. It's my first visit. Um, do you want to tell folks the story about how when your parents took you to the National Mall as a kid and you thought it was an actual mall and you were wondering where the, uh, Auntie Annie's pretzel.

I was looking for the Cinnabon in the Washington Monument.

I think that tells us everything we need to know. Thank you, Warren, and Winnie, and Paul, and Chuck, and thank all of you for listening.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data. So you have the right ingredients to help you shine.

Morningstar.

Where data speaks.