Indexing doesn't just mean plopping your money into the S&P 500, money manager Tom Posey tells Kate Stalter in today's interview. Posey explains why diversification into small caps, value, emerging markets, REITS and bonds is key to using a successful indexing strategy.

Kate Stalter: We're joined today by Tom Posey of Posey Capital Management in Houston and thanks so much for joining for us today, Tom.

Tom Posey: You're welcome. Thanks for having me.

Kate Stalter: One of the first things I want to ask you about is your view on the current market conditions. What are some of the factors that an individual investor really needs to be aware of these days?

Tom Posey: Well, as you know I'm an indexer, meaning I believe that markets are fundamentally efficient, and that individual investors, or institutional investors, or anybody else can't consistently out-guess them. Investing in the market over a long period of time is the way to make money, and over a long period of time you're probably going to make money in the market.

So just as a general rule, the way I look at the market right now, I would say that the current market price is the best estimate that I can come up with for what the market is actually worth.

You know, a lot of people look at the market now, and they think it seems really high. Then it goes down a little bit like it did in June, and that confirms it for them. They think, OK, now it's going to go down farther.

Then, of course, you get to the last week of June, and it goes up more than it has in two years in just one week. And they figure well, okay, maybe it's not. But now they think, “It’s overvalued again, so I'm still not going to buy.”

In my experience, the best thing to do is just to ignore that, because you can't tell what's going to happen. The best thing to do is, if you have long-term money to invest, invest it and not worry about it.

The way it strikes me is: While some valuation metrics would say markets are high, others would say they're not.

A big X out in the future, in my view, is inflation. One of the things the markets are factoring in is the possibility of increasing inflation down the road. If we were to see inflation like we saw in the ’70s, we would turn around ten years from now and look at the current market price and go, "Holy cow, why didn't I invest then?"

My thought is, nobody knows, but the market price is the best guess that we have.

Kate Stalter: So given that viewpoint, Tom, what are some of the sectors or industries or even global regions that you believe are showing strength right now, and why?

Tom Posey: I suppose I would say European stocks in general. You can kind of imagine they're undervalued at least a bit, but on the other hand they outperformed for a decade before now. So I'm really not sure if that's true.

There may well be particular sectors that are undervalued, but again, my own perspective would be to look at the market as a whole. The answer is: I don't know, and don't really have a guess as far as sectors, but I would look at the market as a whole and just make a long-term bet on the market as a whole. I don't see anything that I think is so vastly undervalued that I would jump into it.

Kate Stalter: On the flip side, then, any particular sectors or global regions that you think should be avoided at this moment?

Tom Posey: No, no, I would diversify well. With our clients we just really diversify into:

  • US markets;
  • developed world markets, which is Europe and Asia;
  • emerging markets, which would include India, China, etc.;
  • and REITs, or real estate investment trusts.

We diversify among all of those sectors, and just rebalance to target from time to time, and just stay invested over a long period of time. We've had great success doing it that way. I don't see any reason that that success would not continue.

Kate Stalter: Let's talk about some of the specifics then. You and I have talked in the past, and you've mentioned a number of the funds that you put your clients into. So tell me about your ideas now, with regard to the funds that individuals should be invested in.

Tom Posey: You bet. One of the things that I found, Kate, is that people tend to think about indexing, and they think, “Yeah, yeah, that's the S&P 500 right? If you're an indexer, you just put everything in the S&P and you’re done, right?”

You know, that's really not true at all. That's one of the ways that indexing is really misunderstood, and by building a portfolio that is better diversified, you can actually beat the S&P consistently over a long period of time. You can demonstrate that historically.

Let me explain. Let's say, for example, you put a percentage of your portfolio into the S&P. Okay, fine, but you also invest in foreign large stocks, which is the iShares MSCI EAFE Index Fund (EFA). Then you invest in emerging market stocks; let's say with the Vanguard Emerging Market ETF (VWO), and you invest in REITs with the Vanguard REIT ETF (VNQ).

What you're going to build is a portfolio that is diversified into more than just the S&P. So you're actually going to pick up the historical returns and the future returns of all of those asset classes. If some of those asset classes have a higher expected return than the S&P, you know your portfolio is going to have a higher return than the S&P.

Like, say, emerging markets. The emerging markets do, as a whole, have a higher expected return than the S&P, and a higher historical return than the S&P. So it makes sense. If you add them into a portfolio, you've created a portfolio that you've got a reasonable expectation is going to beat the S&P over a long period of time. How many actively managed portfolios can you say that about?

Kate Stalter: Any other particular funds or ETFs that you wanted to mention that you have clients in at the moment?

Tom Posey: Yes. One of the things we do is we exploit what's been identified in scientific research about the stock markets in value stocks and small stocks.

We diversify in US and in foreign markets into value stocks, that is, underpriced stocks and small stocks. That is, of course, not a large one. Of the funds in particular that we use, I recommend two.

One I always recommend is Vanguard. Vanguard is a fund company with very low fund expenses. It's actually a company that's owned by its shareholders. That is, its fund holders own Vanguard, which is pretty cool. So its expenses are very low and you're actually an owner in the company if you own Vanguard, so I really like that about Vanguard.

In certain asset classes, though, Vanguard is the best that's available at a retail level. We as an institutional investor have a better alternative available for our clients, and that's a company called Dimensional Fund Advisors, or DFA. Dimensional is a company that
specializes in investing in those value- and small-cap asset classes.

Dimensional funds in general, and the value and small cap, are going to be more value-y, if you will, and smaller, than Vanguard. Scientific research has demonstrated that the value effect and the small-cap effect in general are more pronounced with smaller companies than with more value-y companies.

So it makes sense that the DFA funds over a long period of time would have a better return than their Vanguard counterparts. When you look back historically with the DFA versus Vanguard funds, you find that's true.

Kate Stalter: Any particular funds within those?

Tom Posey: Some of my favorite DFA funds are the US Large Cap Value Fund (DFLVX). I also like the DFA US Core Fund (DFQTX) and the DFA International Core Fund (DFIEX).

The DFA Core Funds are an extremely well diversified portfolio of funds within the US and foreign markets. They're tilted toward value and toward small cap, so you're getting that value and small-cap tilt, but in a single sort of tax-efficient package.

I also like the DFA Emerging Markets Value Fund (DFEVX) for the emerging-markets piece, and I like DFA Core Emerging Markets (DFCEX) for emerging markets as well. I'm pretty much 50/50, either one is fine.

Our final piece of the equity portfolio is REITs. For that, I'm pretty much indifferent between the DFA offering, which is Dimensional Real Estate Securities (DFREX), and the Vanguard version, which we’ll very often use. That’s VNQ, and that’s an ETF.

On the bond side, we have a different philosophy, which we can go into.

Kate Stalter: What are a couple of the bond funds that investors might take a look at?

Tom Posey: I guess I'd start out at the outset and just say, our perspective or our philosophy on bonds is different than many investors would take.

A lot of times people nowadays look at bonds and they go, “Wow you know the yields are so low, I’ve got to go really long term to get any kind of a yield that's worthwhile at all. That's really true, right?”

The problem is, when you go really long term, you take on so much term risk. I did an article on my blog a while back where I concluded, as I recall, if interest rates go up three points, then 30-year Treasuries will go down by 40%, something like that. I mean, it's huge.

People think of long-term bonds as being safe. Well, they are anything but! They're very risky when interest rates go up, as you know.

So what we do is focus on short-term bonds. We'll have in our portfolio an average maturity of somewhere around 3.5 years, which is not very long. It's not going to be a yield that you can write home about and say, “Wow I'm making so much money on fixed income.” It's like 2.5% right now.

But if we do see inflation going forward, which I wouldn't be at all surprised to see, you won't find the bond fund in our portfolio really getting hammered like you'll find long-term bonds will.

So turning to the particular funds, we like Dimensional Funds. We also like Vanguard Funds in this space. A good example of a Vanguard fund would be Vanguard's Short-Term Bond Fund (BSV), which is an ETF. It's a high-quality fund, and we've had good experience with it.

DFA also has really great fund offerings: Dimensional Two-Year Global Fixed Income (DFGFX) and Dimensional Five-Year Global Fixed Income (DFGBX).

Both of those funds, although they're called global, the currency effect is hedged away. So it's not actually a global bond fund from the standpoint of taking a lot of currency risk, but they've been good funds for a long time.

I also like Vanguard's Total Bond Index ETF (BND), although it's a little longer term than I want. It's a very fine fund. But I wouldn't with any client, to go out more in term than the total bond index. I just don't think it's a good idea, because I do tend to think interest rates are going to, at some point, probably go up.

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