The mix of indexes in your portfolio, or your asset allocation, accounts for a little more than 100% of your total return on average. The "little more than" refers to the negative returns of active management. Active returns are near zero, but negative on average. This is also referred to as your Investment Policy. As Charles Ellis points out in his 1985 classic, Investment Policy, it is the most important choice an investor can make. In this Step, we will review various mixtures of risk exposures and show the long- term historical returns of those portfolios. Now that you have established a Risk Capacity, you need to evaluate risk before actually taking it. This will complete the matching of risk capacity (people) and risk exposure (portfolios).
Numerous studies, including one by the worldwide accounting firm PriceWaterhouseCoopers, conclude that index funds will best achieve an investor's goals, making them a perfect way to implement your Risk Exposure. This concept is even incorporated into legal guidelines, under the Prudent Investor Rule.
Prudent Investor Rule
In 1992 The American Law Institute published Restatement of the Law, Trust, Prudent Investor Rule. This is meant as a guideline for the prudent management of trust assets.
In 1995, the National Conference of Commissioners on the Uniform State Laws adopted the Uniform Prudent Investor Act as a guideline for states to create their individual laws. It has been made into law in many states. In California it became law in 1996 under the title of the Uniform Prudent Investor Act.
This rule points out the value of the Modern Portfolio Theory. It essentially tells trustees that index funds are the prudent way to invest trust assets. The rule acts as a legal road map for estate planning attorneys, trustees of all types of trusts, and investment advisors.
The Reporter's Notes to the Prudent Investor Rule point out the problems with active management.
"Economic evidence shows that from a typical investment perspective, the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in the market prices of securities. As a result, fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to 'beat the market' in these publicly traded securities ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs. Empirical research supporting the theory of efficient markets reveals that in such markets skilled professionals have rarely been able to identify under-priced securities (that is, to out guess the market with respect to future return) with any regularity. In fact, evidence shows that there is little correlation between fund managers' earlier successes and their ability to produce above-market returns in subsequent periods."
Principles of Prudence
Sound diversification is fundamental to risk management and is therefore ordinarily required of trustees.
Risk and return are so directly related that trustees have a duty to analyze and make conscious decisions concerning the levels of risk appropriate to the purposes, distribution requirements, and other circumstances of the trusts they administer.
Trustees have a duty to avoid fees, transaction costs and other expenses that are not justified by the needs and realistic objectives of the trust's investment program.
The fiduciary duty of impartiality requires a balancing of the elements of return between production of current income and the protection of purchasing power.
Trustees may have a duty and the authority to delegate as prudent investors would.
Now we need to decide which index funds to use. When weighing the factors, we looked at many aspects of different index funds. The most important factor is the criteria used to create the index. As you will see, they do vary considerably. After an extensive review, DFA came out the clear winner. When 1,100 advisors were asked to rate mutual companies, DFA came out as #1. In this step you will see the reasons why we think DFA has the best index mutual funds for your portfolio.