'Lazy portfolios' outrun S&P 500 (Jan 16, 2006)

By Paul B. Farrell, MarketWatch

Last Update: 6:01 PM ET Jan 16, 2006

ARROYO GRANDE, Calif. (MarketWatch) -- Wall Street hates "lazy portfolios." So do commissioned brokers. So do all active mutual fund managers. Why? They can't make big bucks on buy-and-hold portfolios of low-cost, no-load index funds.

They make money by getting you to forget the fact that they're losers: From the peak of the dot-com insanity in 2000 to the end of 2005, Wall Street's lost an average of 2.7% of your money every year. By contrast, lazy portfolios consistently beat the market, usually by wide margins. For example, during the bear market of 2000-2002, one of the laziest portfolios beat the S&P 500 by about 15 percentage points each of the three years.

So welcome to our annual update of America's laziest portfolios. Last year ended with the S&P 500 gaining just under five percent. The lazy portfolios all beat that benchmark.

And for the third year, Ted Aronson's lazy portfolio came out on top with a 13.7% return. Aronson's rare among America's 70,000 money managers. He discloses his portfolio. The other 99.9% are too embarrassed to expose themselves. Aronson heads AJO Partners, managing $23 billion in institutional money.

Before reviewing his lazy portfolio, his rebalancing strategy and what he sees ahead in 2006, Ted opened with a few caveats:

• "The good results of my portfolio are driven by the focus on international stocks (especially volatile emerging markets)."
• "Vanguard does the heavy lifting by providing capital market returns at rock-bottom costs."
• "My retirement assets are not indexed, they are invested in two retail funds [Quaker Small-Cap Value Fund ) and Highmark Large-Cap Value Fund (HMIEX) both up 10%, and consistently [outperforming] their benchmarks, Russell 2000 and Russell 1000 Value]. But for this exercise, I focus on my family's index fund taxable holdings exclusively."

Everybody knows asset allocation, not the individual funds you pick, is the key to portfolio returns. In 2005 Aronson's portfolio of 11 funds was made up of 40% domestic equities, 40% foreign stocks and 20% fixed income. The portfolio returned 13.7%. Here's his analysis of these sectors and their 2005 performance:

• Bonds. With distributions reinvested, up about 4%. "TIPs were disappointing, pretty much matching inflation (up 3%), while long Treasuries made the best showing (up 7%)."
• Domestic equities. Up 7%, from 5% in the S&P 500 to up 10% in mid-/small-Caps. "Fortunately, most of the weight was in the latter."
• International equities. "Up an eye-popping 25%. Emerging markets, the largest weight at 20% of the portfolio, gained almost a third in value and Pacific stocks were close behind, up 23%."

Aronson says "nothing about last year surprised me, except the extent of Pacific and emerging market returns. But now my instincts are to head in the opposite direction."

Rebalancing strategy for 2006

Aronson said it's time for a little rebalancing. Get "back to 40% in domestic equities (last year's weights; add a few percentage points, especially to S&P 500). And much less in international, back down to 30% (from nearly 44%, the current weight after the strong performance in 2005). Spread it out equally among emerging markets (10%), Pacific (10%), and Europe (10%)."

The "international stocks' performance is too good to be true, or at least too good to continue," says Aronson. "Over the past three years the emerging markets index fund is up almost 38% annually, compounded. Pacific fund compounded at a 'mere' 26%. As the late Herb Stein said, if something is too good to go on forever, it won't."

Aronson reminds us that in his day job, he's "a bottom-up stock picker and benchmark hugger." Once the portfolio's domestic equities and fixed income are back to 40% and 30% respectively, "leave well enough alone."

So going into 2006, he has a new, bigger cash position. Cash is his "buffer, a hedge. Investors should be prepared to act when things look the gloomiest." And while he says he doesn't expect a crash, "there could be a one (rates spike up, emerging markets melt down, small-cap value loses lead to small-cap growth ...). If any of these categories crash, the cash should be deployed earlier than a year from now."

Aronson warns: "All this implies a 20% turnover, certainly far from buy-and-hold. But portfolio rebalancing is a sure-fire way to limit risk and improve return even though there will be capital-gains taxes involved. By definition, the best performing investments rise in influence in a portfolio. So when the inevitable reversion to the mean (fancy way of saying, what goes up comes down) occurs, the exposure is amplified, and the pain worse. Think March 10, 2000!"

Which lazy portfolio is best ... for you

This year we asked Morningstar's research analyst Sumita Ghosh to help us, providing an independent comparison of five lazy portfolios we track.

These are all pure-play buy-and-hold lazy portfolios from respected experts. All beat the S&P 500. The Margaritaville Portfolio is from Scott Burns, columnist with the Dallas Morning News who alerted us to his earlier Couch Potato Portfolios. The No-Brainer Portfolio is from money manager and neurologist Dr. William Bernstein. The Coffeehouse Portfolio is from money manager Bill Schultheis. And the Yale Portfolio is new, coming from David Swenson's "Unconventional Success."

One final note: At 13.7%, the Aronson Portfolio is on top of the five portfolios. Yet some may challenge whether it's really "lazy enough," with the rebalancing and turnover. Consider this: Even if Aronson's portfolio was totally "lazy" and not rebalanced from last year's allocation, his returns would still have been 11.5% instead of 13.7%. So no matter which lazy portfolio you pick, you'd have beaten the S&P 500's 4.7% return last year.

The Aronson portfolio

Fund	Asset allocation	1-year return	3-year return	5-year return
Vanguard Total Stock Market Index VTSMX	5%	5.98%	16.13%	1.97%
Vanguard 500 Index VFINX	15%	4.77	14.24	0.42
Vanguard Extended Market Index VEXMX	10%	10.29	23.37	6.92
Vanguard Small Cap Growth Index VISGX	5%	8.64	21.68	8.62
Vanguard Small Cap Value Index VISVX	5%	6.07	21.60	11.89
Vanguard Emerging Markets Stock Index VEIEX	20%	32.05	37.96	18.74
Vanguard Pacific Stock Index VPACX	15%	22.59	26.34	6.14
Vanguard European Stock Index VEURX	5%	9.26	22.35	3.67
Vanguard Inflation-protected Securities VIPSX	10%	2.59	6.26	8.53
Vanguard High-yield Corporate VWEHX	5%	2.77	9.33	6.47
Vanguard Long-term U.S. Treasury VUSTX	5%	6.61	5.45	7.37
Total portfolio	100%	13.77	21.47	8.28

The Margaritaville portfolio

Fund	Asset allocation	1-year return	3-year return	5-year return
Vanguard Total Stock Market Index VTSMX	33.33%	5.98%	16.13%	1.97%
Vanguard Total International Stock Index VGTSX	33.33%	15.57	25.14	5.85
Vanguard Inflation-protected Securities VIPSX	33.33%	2.59	6.26	8.53
Total portfolio	100%	8.04	15.83	5.44

The No-brainer portfolio

Fund	Asset allocation	1-year return	3-year return	5-year return
Vanguard Short-term Investment Grade Index VFSTX	40%	2.20%	2.83%	4.35%
Vanguard Total Stock Market Index VTSMX	15%	5.98	16.13	1.97
Vanguard Small Cap Value Index VISVX	10%	6.07	21.60	11.89
Vanguard Value Index VIVAX	10%	7.09	17.75	2.62
Vanguard European Stock Index VEURX	5%	9.26	22.35	3.67
Vanguard Pacific Stock Index VPACX	5%	22.59	26.34	6.14
Vanguard REIT Index VGSIX	5%	11.98	25.67	18.27
Vanguard Small Cap Index NAESX	5%	7.36	23.30	9.10
Vanguard Emerging Markets Stock Index VEIEX	5%	32.05	37.96	18.74
Total portfolio	100%	7.25	14.27	6.28

The Coffeehouse portfolio

Fund	Asset allocation	1-year return	3-year return	5-year return
Vanguard Total Bond Market Index VBMFX	40%	2.40%	3.53%	5.43%
Vanguard 500 Index VFINX	10%	4.77	14.24	0.42
Vanguard Value Index VIVAX	10%	7.09	17.75	2.62
Vanguard Small Cap Index NAESX	10%	7.36	23.30	9.10
Vanguard Small Cap Value Index VISVX	10%	6.07	21.60	11.89
Vanguard Total International Stock Index VGTSX	10%	15.57	25.14	5.85
Vanguard REIT Index VGSIX	10%	11.89	25.67	18.27
Total portfolio	100%	6.24	14.18	6.99

The Yale portfolio

Fund	Asset allocation	1-year return	3-year return	5-year return
Vanguard Total Stock Market Index VTSMX	30%	5.98%	16.13%	1.97%
Vanguard Total International Stock Index VGTSX	20%	15.57	25.14	5.85
Vanguard REIT Index VGSIX	20%	11.89	25.67	18.27
Vanguard Short-term Treasury Index VFISX	15%	1.77	1.73	4.16
Vanguard Inflation-protected Securities VIPSX	15%	2.59	6.26	8.53
Total portfolio	100%	7.94	16.20	7.32

Source: Morningstar Inc. Data through Jan. 10.